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BAE Systems (LSE: BA.) shares have dropped 16% in just under two months. Zooming out over a multi-year horizon though, this FTSE 100 defence stock is thrashing the market. It has nearly doubled in value in five years, while the Footsie has returned just 10%, excluding dividends.
And since the start of 2023, BAE stock is up 37%. With dividends, the total return is even higher. In fact, an investor who put £5,000 to work in the stock two years ago would now be sitting on about £7,200.
Why has the share price dipped?
BAE sells combat aircraft, armoured vehicles, naval ships, missiles, electronic systems, as well as cybersecurity solutions. The demand for these things has been incredibly high since Russia’s invasion of Ukraine nearly three years ago.
However, the stock has sold off recently due to uncertainty around Donald Trump’s incoming administration. He says he will end the war in Ukraine in a day upon taking office on 20 January. A more peaceful world could, in theory, lead to reduced arms spending worldwide.
Additionally, the Elon Musk-led Department of Government Efficiency (DOGE) will be casting an eye over the massive US military budget. This has also likely caused a bit of uncertainty, given that America is BAE’s key market. In 2023, it derived more than 40% of sales from the US. So this is a potential risk.
But the worrying backdrop hasn’t changed
Admittedly, we simply don’t know what will happen yet. But if Ukraine is compelled to cede land to Russia to end the war, then Moscow could be emboldened, in my view. Therefore, I’d expect neighbouring European nations to continue ramping up their defences.
Meanwhile, at a press conference yesterday (7 January), Trump said that European NATO members should spend 5% of their GDP on defence, up from the current 2% level. “They can all afford it,” he asserted.
European defence stocks jumped higher today after these comments. As I write, BAE is up nearly 2%.
Trump has also refused to rule out military or other action to seize Greenland and the Panama Canal, which he said the US needs for “economic security”.
Finally, the President-elect said “all hell will break out in the Middle East” in two weeks if Israeli hostages are not returned by Hamas.
I’m buying the dip
Given all this, I doubt that global defence spending is going to head lower. Quite the opposite, in fact. Consequently, BAE’s revenue, profits and dividends should all move steadily higher over the next few years.
In 2025, the company’s revenue and earnings are expected to increase 8% and 12%, respectively. And the forward dividend yield is 3%, with the prospective payout very well-covered by forecast earnings. While nothing is guaranteed with dividends, the payout is tipped to rise nearly 10% this year.
After the dip, the stock is now trading at 15.5 times this year’s forecast earnings. That valuation looks very reasonable to me, given the dire geopolitical backdrop and strong earnings growth prospects.
I first bought shares of BAE in late 2022, but I plan to add to my position in the coming days. I’m also considering defence exchange-traded funds (ETFs) to get a bit more portfolio exposure to the industry.
