Can BAE, Rolls-Royce and Babcock continue to soar? What investors should do now

An agreement to end the war in Ukraine is said to be closer. The truce between Israel and Hamas is largely holding, too.

Is this the moment to give thanks, breathe a huge sigh of relief and sell defence stocks after their stellar rises?

Or are Nato countries and other governments set to further increase their defence spending plans?

Geopolitical instability remains high, with tensions in the Far East and elsewhere.

Meanwhile, the US may, in future, prove less willing to be the global policeman.

In 2024, Nato members’ military expenditure was $2.7 trillion, but this will be raised as they move towards their pledge to allocate 5 per cent of GDP to defence by 2035.

Supersonic: Eurofighter Typhoons are part-built by BAE Systems

In this week’s Budge, Chancellor Rachel Reeves reiterated that 2.6 per cent of Britain’s GDP will be dedicated to defence by April 2027, although the commitment to boost this target to 3 per cent by 2035 – at a cost of £32billion – was mysteriously missing from Budget forecasts.

Not so long ago, shares in UK aerospace, armaments and munitions operators such as BAE, Babcock and Rolls-Royce were shunned by some on moral grounds. Russia’s invasion of Ukraine in 2022 sparked a significant shift in thinking, as part of which investing in the defence of the realm began to be seen as ethical.

One result of this alteration in attitudes has been a jump in the share price of Rolls-Royce, which is some 1050 per cent higher than three years ago at 1068p, despite having moved sideways in recent weeks.

But analysts seem to consider the shares to be what you could call reassuringly expensive. Brokers UBS – which first recommended Rolls-Royce in March 2023 (when the price was 153p) – are even targeting another leap to 1345p.

This forecast suggests that Rolls-Royce and other defence stocks have become an essential defensive part of a portfolio in a world that remains hugely uncertain. These are three UK stocks that could be the bulwark in your portfolio.

Ambitious plans: Tufan Erginbilic

ROLLS-ROYCE

Tufan Erginbilic, the engineer’s chief executive, aspires to turn the £87.5billion business into the largest FTSE 100 company. This is the kind of ambition that sets shareholders’ pulses racing, although they have already enjoyed a considerable bounty from the turnaround at Rolls-Royce, driven by the energetic Erginbilic.

The leap to the top of the FTSE 100, unseating AstraZeneca from this prized position, would be propelled partly by the artificial intelligence (AI) arms race.

Rolls-Royce makes nuclear reactors for submarines, but it will also be building small nuclear reactors (SMRs) to provide energy for data centres. These are vast, server-filled structures vital to the deployment of AI.

Of course, Rolls-Royce would also need to rely on more demand for its engines from its civil and defence customers.

The business derives most of its revenues from engine maintenance and servicing, ensuring that they spend more time in the air. The recent third-quarter results showed that engine flying hours (EFHs) are at 109 per cent of their pre-pandemic level.

As this column reported last week, Stephen Anness, head of global equities at Invesco, remains upbeat about the prospects for Rolls-Royce, highlighting such strengths as improving margins in its civil aviation operation and the contribution that SMRs will make in getting cash to flow.

His optimism is widely shared. Analysts rate Rolls-Royce a ‘buy’ with an average target price of 1198p.

RBC Capital Market has a target of 1275p, contending that the company will keep on exceeding profit expectations.

Chloe Lemarie of Jefferies is even more enthusiastic, with a target price of 1290p.

BABCOCK

At the announcement of its better-than-expected full-year profits this week, Babcock confirmed the view that nations do not intend to trim defence spending. Chief executive David Lockwood cited a ‘sustained uplift in global defence budgets’ – particularly in the fields of marine and nuclear.

Babcock, a £5.62billion FTSE 100 member, designs and manufactures specialist equipment, building vessels such as the Type 31 warship. It also provides support services, maintaining the Royal Navy’s nuclear submarines, for example.

Babcock shares are up by 124 per cent since January to 1133p. Nevertheless, analysts rate them a ‘buy’, with a target price of 1308p, enthused by the firm’s strong order pipeline.

BAE SYSTEMS

BAE is Britain’s largest name in defence. The output of this multinational corporation includes aircraft, fighter jets and submarines. It will also be making the satellites for America’s Golden Dome missile defence system.

This £48.3billion FTSE 100 business’ shares hit a high of 2073p in October. They have fallen to 1651p. But this is still 43 per cent higher than at the start of the year, suggesting that investors have been taking advantage of the dip to snap up a slice of this British success story.

Just two of the 20 analysts that follow the stock consider them to be a ‘sell’. Seven believe you should ‘hold’, but 11 think they are ‘buy’. The average target price is 2121p. Major trusts, such as City of London, have exposure to BAE.

But if you would like a spread of global players in the armaments, aerospace and munition industries, the Han Future of Defence exchange traded fund (ETF) tends to be the option preferred by the professionals, including Ben Yearsley of Fairview Consulting.

He points out that the fund aims not only to benefit from the defence spending of Nato members and their allies, but also from a portion of state budgets now being reserved for cybersecurity.

The fund’s major holdings include the French aerospace contractor Safran and German group Rheinmetall, known for products such as the Lynx armoured vehicle and the Skyranger air defence system.

The largest stake is Palantir, the US technology titan famous for its expertise in the AI-powered analysis of battlefield data.

It is one of President Trump’s favoured defence names. Shares in Palantir have soared by 2240 per cent over the past three years, but were caught up this month in the alarm over the overvaluation of AI stocks.

These concerns persist, but a diversification into defence could prove a shield at this nervous time in our history.

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