Rishi Sunak
Rishi described Russia, Iran, North Korea, and China as "an axis of authoritarian states." (Photo: UK Prime Minister/ Instagram)

On April 23, UK Prime Minister Rishi Sunak announced a significant hike in government spending on the country's defences to overcome emerging threats from Russia and the Middle East. This move will increase defence spending to 2.5% of the UK's GDP by 2030.

"It is a generational investment in British security and prosperity, which makes us safer at home and stronger abroad," the PM said during his visit to the Polish Capital, Warsaw. He believed his actions were necessary amid threats of war in Russia and the Middle East. Sunak also described Russia, Iran, North Korea and China as "an axis of authoritarian states."

On the same day, the HM Treasury and the Investment Association jointly stated that investing in the sector enhances national security. Many have avoided exposure to these stocks, given the sector's poor ESG outlook. However, the statement said investing in well-managed defence firms fits with ESG standards since long-term sustainable investments in defence help other sectors grow in a secure environment.

1. BAE Systems

Market Cap: £51 billion

52-Week Range: £45.56-£69.15

BAE System is the UK's top defence firm. It has been critical in manufacturing the Eurofighter Typhoon jet, tanks, and submarines while developing cyber-defensive capabilities. The company secured a healthy order book of £37.7 billion last year and witnessed an impressive 35% stock-price jump in the same period. Rishi's latest announcement is likely to keep the healthy pipeline flowing.

Susannah Streeter, head of money markets at Hargreaves Lansdown, said over 40% of the sales come from the US, which is in its own league to bolster defence spending.

"From an investor point of view, BAE Systems is a difficult company to overlook," said Keith Bowman, equity analyst at Interactive Investor. "With an attractive annual dividend of around 2.4%, the City consensus is that its shares are a buy."

The broker believes that BAE is one of the top-most-bought stocks in the UK this month.

2. Rolls-Royce

Market Cap: £34.14 billion

52-Week Range: £143.3-£429.10

Known for its premium cars and efficient jet engines, Rolls-Royce also manufactures and supplies advanced propulsion systems for combat aircraft and submarines. Under the new leadership of CEO Tufan Erginbilic, Rolls Royce has reduced company debt significantly while its shares have surged by a whopping 170% over the last year.

The company's revival helped it achieve £2.4 billion in 2023 profits. It also observed a 13% year-over-year (YoY) rise in operating margin from its defence and power systems. Meanwhile, its free cash flow jumped by 150% to a record £1.3 billion on higher operating profit.

In its 2023 full-year results, the company disclosed a defence order intake of £5.2 billion as demand remained strong across transport, combat, and submarines. Meanwhile, revenue from defence sales jumped 12% YoY to £4.1 billion on the back of the UK's GCAP Programme and the F130 Program for supplying engines to the US B-52 fleet.

"A multi-billion-pound order book points to strong future revenues – and with the promised swelling in the UK's defence budget, it puts the company in an even better position," added Streeter.

While it halted dividend payouts during the pandemic, the company is hopeful of reaching a stage where it can resume shareholder distributions.

3. Compass Group

Market Cap: £48 billion

52-Week Range: £23.98-£29.34

As Europe's most prominent contract food service company, Compass has provided various services to the UK's armed forces, including catering and managing military facilities. PM Rishi's move to bolster defence spending may result in more hiring of UK armed forces personnel across bases globally.

Compass has rewarded shareholders with 7% returns over the past year and dividends higher than pre-pandemic payouts. Defence, offshore, and remote operations in 2023 comprised 8% of the company's annual YoY statutory revenue, which grew 22% to reach £31 billion.

Despite a massive global outreach, the company continues to expand aggressively into new markets and economies. Compass spent $352 million in Q1 2024, mostly on completing the acquisition of the German manufacturer and supplier of cooked and frozen meals, HOFMANN. The firm also announced the takeover of CH&CO, which offers premium contract and hospitality services in the UK.

"We've had a strong start to the year with sustained balanced growth across all regions," said Group CEO Dominic Blakemore. He highlighted robust outsourcing volumes amid high inflation and market volatility while pointing out the company's healthy cash flow, enabling expansion and organic growth.

4. Chemring

Market Cap: £1.001 billion

52-Week Range: £254-£373

Chemring's order book in 2023 witnessed a healthy YoY growth to £992 million from £651 million. The company manufactures and supplies naval and radio-frequency countermeasures, space launch initiators, sensors used in warfare, and aircraft safety components.

The majority of its order intake comprises countermeasures and energetics devices. At the same time, strong cash generation encouraged the group to initiate a £120 million expansion plan to match the high demand in the energetics market.

The stock has surged more than 27% over 2023 even when profits fell last year through October. Stuart Widdowson, manager of Odyssean, said all core business divisions of Chemring will likely gain from the PM's announcement as the need to protect ships and planes takes centerstage.

The firm's extensive ESG commitments around employee wellness, diversity, inclusivity, and safety through reducing accident hazards also had a positive impact. There was a marked reduction in high-potential incidents and zero injuries from energetic events last year. Diversity within the board also improved as women comprised 44% of the total strength compared to 38% in 2022.

5. Diversification Through Investment Funds

David Coombs, multi-asset portfolio manager at Rathbone Asset Management, said investors may diversify beyond UK defence stocks into markets like France and the US.

Investors can achieve diversified exposure via low-fee, defence-themed investment funds like the Hantf Future of Defence, which tracks 50 firms like BAE Systems, Rheinmetall, Safran, and Thales. These companies benefit from the North Atlantic Treaty Organisation's (NATO) defence spending.

Head of ETF Research at HANetf, Tom Bailey, said: "The key beneficiaries of this [shift in defence spending] are big European defence firms such as Rheinmetall, BAE Systems and Leonardo, headquartered in Italian. All have massive order books."

The recently launched £266 million HANetf fund charges a nominal annual fee of 0.49% and offered 29% in returns in the last six months. The listed JPMorgan Claverhouse investment trust also provides exposure to defence stocks like Rolls Royce and BAE Systems and is available on popular investment platforms. As per the Investment Association, investment funds currently have a staggering £35 billion invested in defence stocks.

Disclaimer: Our digital media content is for informational purposes only and not investment advice. Please conduct your own analysis or seek professional advice before investing. Remember, investments are subject to market risks and past performance doesn't indicate future returns.