Investment View: Holding action is the order of the day with this defence duo

Over the medium term things are not going to be easy for BAE. That is especially true of the US

It has become fashionable to decry this country's poor manufacturing base, even though the picture isn't quite as bad as some of the gloom mongers would have you believe. But there is one sector in which no one denies the UK is a significant player: the arms industry.

It is a sector that employs 110,000 people on these shores and turns over £22bn, at least according to the trade body ADS. That makes it a very significant part of the economy.

But it's facing a problem in the form of big defence cutbacks.

The UK military is saddled by any number of foreign commitments – not to mention the recent sabre rattling over certain small islands in the South Atlantic – but the defence budget has to accept its share of the pain. Something has to give when you have a Government which is planning to spend billions on US-built nuclear weapons that can never be used to replace Trident.

A similar chilly climate prevails in Europe, while even the US military is feeling the pinch, despite the latter's keenness to retain its status as global top dog, which the rising power that is China certainly threatens.

This column is unusual among its peers in that it goes beyond a discussion of purely financial issues to highlight the ethical dimension in making investments.

But first let's consider the cold, financial case for Britain's biggest defence contractor, BAE Systems, together with Cobham, which also operates in the field.

BAE's shares sit on an extremely low multiple – they trade on just 6.7 times this year's forecast earnings while offering an extraordinary prospective yield of 7 per cent.

This reflects the brutal trading climate, one that moved defence secretary Liam Fox last year to urge UK defence contractors like BAE to prioritise export markets – if they want to survive, that is.

And there are plenty of markets to target.

How about India, which also casts nervous eyes at the Chinese dragon, not to mention its long running feud with Pakistan?

Then there's Saudi Arabia and various other Middle Eastern "allies" of Western powers for which getting an export licence shouldn't prove all that much of a problem.

At the end of last month, BAE announced the signing of a £1.6bn deal to supply the very same Saudi Arabia with Hawk jets to train pilots to fly the Eurofighter Typhoon which it has already ordered. This granted the shares some much-needed relief, pulling them up from a trough that they had been mired in.

But over the medium term things are not going to be easy for BAE. That is especially true of the US where BAE does lots of business but where an incoming president may have to further prune America's already declining defence budget.

So this is not a stock which can be counted on to perform very strongly over the months ahead. However, for income seekers that juicy dividend is at least twice covered by earnings. The yield isn't going to rise by much looking forward, but it probably is sustainable, although the net debt is hardly insignificant (gearing is at over 80 per cent).

At least BAE hasn't yet reported any deterioration in its pension scheme (it is pumping in £200m a year to plug its funding gap).

For the ethical investor, BAE is almost certainly a no no. Even if you accept that it has cleaned up its act following scandals of the past, it doesn't boast a place in the FTSE4Good index and the necessity of supplying high-tech weaponry to regimes that take a cavalier approach to human rights would be enough to rule it out.

For people seeking income who aren't worried about that, there is a financial case for holding the shares.

The smaller and more nimble Cobham is reacting to the new environment by seeking to increase revenues from the commercial side of its business.

It does things like refuelling jets in midair, training Royal Naval pilots, and has specialisms in communications, radar and electronic warfare, but its recent M&A activity has focused on dealing with the cutbacks by entering new markets.

The company's focus on high-tech communications ought to pay off long term, but it does do a lot of business in the US and trading on 10.5 times this year's forecast earnings with a prospective yield of nearly 4 per cent, the shares are fairly rather than keenly valued at the current level and are worthy of a hold recommendation at best.

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