Dividends matter.
If you’d put £1 into UK stocks in 1900, it would have grown to £161 a century later. With dividends reinvested, that figure turns into £16,946.
Sure, most of us don’t have a 100-year time horizon to invest over. But the figure proves the basic point. And with markets stuck in a viciously volatile, but ultimately sideways trading pattern, getting an income while you wait for happier days to arrive is more important than ever.
But with everyone looking for income, where can you find a decent yield in the stock market these days?
One currently unfashionable sector fits the bill nicely in my view.
The trouble with finding a decent income
I had a chat about income stocks with Chris Wright of the Premier European Optimum Income Fund earlier this week. What struck me most was that the trouble with finding a decent income in the stock market just now is that many of the highest-yielding sectors come with serious.
Take, for instance, the French bank BNP Paribas (PAR: BNP), one stock which Wright likes. While relatively staid (by banking standards), it still has exposure to eurozone debt. It also looks as though any lasting eurozone deal will involve tough EU-wide regulation, which could cut into its profit margins in the longer run. Also, particularly following the Libor-rigging scandal, banking’s not a sector we’re keen on, as my colleague Merryn Somerset Webb notes.
Energy, water and telephone stocks are possible options. In theory, these industries should be fairly immune to the eurozone downturn. My one concern is that this stability also makes them tempting targets for revenue-hungry governments.
Where both Wright and I agree is that there is one sector where the market may have gone too far in pricing in a decline. It’s a sector that some may not feel completely comfortable investing in. However, for those who are, it offers some great opportunities.
I’m talking of course, about the defence sector. In particular, two companies: BAE Systems (LSE: BA) and Lockheed Martin (NYSE: LMT). Here’s why you should think about adding them to your portfolio
Big companies can cope with – and even profit from – defence cuts
The papers have been filled with news about the latest defence cuts. Many have complained that the cuts will make it harder to wage operations. However, at a time when governments are looking to reduce overall spending, defence is a relatively easy target.
The benefits it offers are less visible than those of other public services. And even the top brass are talking about scaling back – a sure sign that there may be more cuts to come. So you can see why the market might be concerned about defence stocks.
However, the impact on BAE and Lockheed Martin’s bottom line may not end up being as significant as the market seems to think. The cuts will mainly hit personnel, rather than equipment.
As Wright points out, both companies also have close, longstanding relationships with both the Pentagon and the Ministry of Defence. This means that even if the military scales back, it may do so by buying less from small suppliers, rather than cutting back heavily on deals with the two larger companies.
Indeed, the outlook for high-end equipment may not be that bad. While officials talk of having a smaller army, they also talk about using technology to make it ‘smarter’. Of course, much of this is rhetoric to make the cuts seem less bad.
But it does fit with the trend towards smaller operations, and the use of drones rather than ground forces. Again, this should play to the strengths of BAE and Lockheed, with their large research and development departments.
Defence giants are branching out
The other point is that BAE and Lockheed do not rely solely on business from the US and UK armed forces. Indeed, BAE considers India, Australia and Saudi Arabia as its “home markets”.
Meanwhile both companies are branching out into other areas of technology. BAE’s latest annual report notes that 7% of its revenue now comes from its Cyber and Intelligence division. Meanwhile a fifth of Lockheed’s sales come from what it calls “Information Systems & Global Solutions”. This provides support to a wide range of companies in the public and private sectors.
The biggest opportunity may come from drones. The use of drones to kill terrorists has grabbed the most headlines. However, their main use has been in surveillance. Because of this, police and security forces around the world now want to get their hands on them.
This has – reasonably enough – raised concerns about privacy. There are also fears they could collide with planes. However, others argue they are a cost-effective way to reduce crime (making them attractive in an era of austerity), and also to carry out more mundane tasks such as crop dusting.
As a result, the US recently passed laws aimed at making it much easier to operate drones. And BAE recently conducted trials over the Irish Sea that could see drones routinely flown in UK airspace.
In all, the outlook for the big players in the defence industry is brighter than many give it credit. They should escape the worst of the cuts, and they are also active in some of the fastest-growing areas of military technology.
Most importantly, they look cheap, and they pay you a decent income while you wait for better times. Lockheed Martin trades at 10.6 times earnings with a yield of 4.6%, well above the S&P 500 average of around 2%. UK-listed BAE looks even better, trading at 8.3 times earnings and offering a yield of 6.2%.
• This article is taken from the free investment email Money Morning. Sign up to Money Morning here .
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