Just when I thought the BAE Systems (LSE:BA.) share price was building up a head of steam, it’s gone into reverse again. Today (6 October), BAE stock was the worst performer in the FTSE 100, falling 4.7% to 1,843p.
This means it has slumped 21% since March’s peak of 2,360p. What on earth is going on?
Sector sell-off
To be fair, this is a sector-wide pullback, as Babcock International (-2.6%), QinetiQ (-5.7%), and Chemring (-6.2%) also fell today. And looking at Babcock’s peak-to-trough slump of 41%, I’m glad I plumped for BAE in my own portfolio!
The reason for the sell-off is that market sentiment toward BAE Systems and UK defence contractors has soured over slower-than-expected military spending.
Already, this issue caused problems for Keir Starmer’s government after John Healey resigned as defence secretary, saying spending was going too slow, threatening the safety of the realm.
As a reminder, the UK has committed to meeting NATO’s defence target of 3.5% of GDP by 2035. The problem is where to find the extra money (about £17.3bn) to quickly get to the interim 3% target (from about 2.3% currently).
Today, The Times suggested that Healey (now Chancellor, somewhat ironically) and Andy Burnham are considering kicking the can down the road, raising doubts about the roadmap to higher defence spending.
Not helping matters are higher government borrowing costs. As these march upwards, the government has less money for everything, including defence.
For the record, the government has said that all this is just “speculation“. But that’s not really reassuring the market, which hates uncertainty.
What to make of this?
Stepping back as a long-term investor, I fail to see how the UK will not meet its NATO spending obligations. In recent days, we’ve seen the US remove bombers from an airbase here, showing that threats are real.
If spending cuts aren’t possible (because Labour backbenchers won’t accept them), and the UK economy isn’t growing much (which it isn’t), then taxes will surely have to go up. Who will pay?
Well, Healy met with bank bosses today, but apparently no decision has been made on whether to make lenders cough up. A windfall tax on banks is unlikely to boost the economy, so the government is stuck between a rock and a hard place.
However, when push comes to shove, I think difficult decisions will be taken to find the extra money. And if not, there’s always the possibility that another government could come in and do so at the next election.
Thinking long term
Turning back to BAE then, this is another reason why I favour it over other domestic defence players. It sources almost half its revenue from the US, with another 23% coming from Europe, Australia and Saudi Arabia.
Therefore, the business is diversified, offering investors exposure to higher defence spending globally. Its order backlog recently hit a record £84bn.
After the latest dip, the stock’s also a fair bit cheaper than it has been for a while. It’s trading at 19.5 times next year’s expected earnings, while offering a forecast yield of 2.5%.
If the government officially delays the roadmap to 3%, the stock could drop further. However, I don’t think it changes the long-term investment case for BAE.
In my opinion, the 21% dip is worth considering.
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Ben McPoland owns shares in BAE Systems.
This story originally appeared on Motley Fool
