The defence sector has experienced a challenging period since the financial crisis. Cutbacks to military spending have become the norm across the developed world, as governments have sought to reduce budget deficits in an era of austerity. This has caused sales and profit growth to be lacking for many companies in the industry.
However, the increased military spending plans of President Trump could be the catalyst for growth in the defence sector. Higher earnings could mean strong dividend growth, which could make these two defence stocks worthwhile buys for the long term.
A changing outlook
While it can be difficult to ascertain exactly what President Trump’s views are on a range of topics, on military spending his position has been clear for some time. He is seeking to boost the capabilities of the US military for two apparent reasons.
First, he would like to make the US even stronger relative to other countries in terms of its defence capabilities, with the idea being that military conflict becomes less likely.
Second, higher military spending has historically been beneficial to at least some degree for economic performance. As he is seeking to increase the rate of GDP growth, spending heavily on defence could be a useful means of achieving this aim.
Higher military spending by the US could stimulate defence spending elsewhere. President Trump has stated in the past that the US may only provide military support to NATO members that commit to higher military spending in future. Similarly, China continues to seek a more powerful military, while conflict in the Middle East seems unlikely to abate in the medium term.
Larger sums spent on the military could boost the performance of defence companies such as BAE (LON:BA.) and Rolls-Royce (LON:RR.). Both companies are expected to deliver modest EPS growth of 3% in 2018, but this figure could move significantly higher due to the potential tailwind from an improving industry outlook.
This could prompt higher dividends – particularly since both stocks have relatively low payout ratios. BAE’s payout ratio is just 52%, while the figure is only 35% for Rolls-Royce. Therefore, a rapidly-rising shareholder payment could be sustainable in the long run. In fact, Rolls-Royce is forecast to grow dividends by 12% this year, while BAE’s payout growth is set to remain ahead of inflation at 3.4%.
While Rolls-Royce has a dividend yield of only 1.4% at the moment, a restructuring programme and cost-cutting drive could improve its financial performance in the long run. Its Civil Aerospace segment continues to perform well, while strong cash flow could provide the capital required for continued investment in R&D.
BAE’s 3.9% dividend yield is likely to remain ahead of inflation over the medium term. Its strong competitive position in key markets as well as rising order intake show that it could capitalise on an improvement in the outlook for the industry.
Therefore, while uncertainty may remain high for both stocks in the near term, they could prove to be profitable investments over the long run.
For more dividend ideas, enter your email address below to never miss an issue of the Master Investor magazine.