Sage Investment Club

Image source: Getty Images The war in Ukraine is a dreadful humanitarian disaster. But it reminds the investing world of the importance of the defence business. The BAE Systems (LSE: BA) share price has been climbing since February 2022, and it shows no sign of faltering. Over the past 12 months, BAE shares are up 43%, after previously going pretty much nowhere for years. The rise has dropped the forecast dividend yield to a modest 3%, mind. And there are some far bigger FTSE 100 yields out there. But I can’t help seeing the BAE revaluation as overdue, and I see signs of long-term earnings and dividend growth. Earnings growth One of those signs comes from analysts’ forecasts. Over the next two years, they show rising earnings that would drop BAE’s price-to-earnings (P/E) ratio down from this year’s predicted 17 to just 14. At the same time, cash generation would help boost the dividend yield to around 3.6% by 2024. It’s risky going on forecasts, as they’re often wrong. But at the moment, I can’t help thinking we could be facing a very healthy decade for defence procurements. And looking at historic P/E multiples of only around 11, I really do think the upwards movement in the BAE share price is justified. Looking forward We should have full-year results from BAE on 23 February. In its November update, the company reported £10bn in order intake in the second half of the year to date. Perhaps more importantly, BAE describes its order book as being on a “predominantly long cycle“. At the time, 30% of BAE’s £1.5bn share buyback had been completed, and it’s still ongoing to this day. The board reckoned the balance sheet is strong enough to support it. But it does raise one of my concerns. Debt At the end of the first half, BAE reported £3.1bn in net debt, excluding lease liabilities. Is it wise to be ploughing £1.5bn into a share buyback with that amount of debt on the books? On balance, it might be a good choice, especially if the share price is low. And if the debt is reasonably priced, it could be a profitable activity. But I’m always wary when I see companies prioritising short-term shareholder returns over reducing debt. I also wonder about the often fleeting nature of stock market sentiment. What will happen when the war in Ukraine ends? Once the immediate daily reminders of the benefits to the defence industry are gone, might investors look for the next big sector swing? Verdict To come back to my headline question, I still think BAE Systems could end 2023 ahead of the index. I doubt it will show the same outperformance as 2022, but I expect a decent result. Saying that, it wouldn’t take much easing of the current bullish mood to weaken the year’s gains. But then I reckon investing with such a short-term horizon is a poor strategy anyway. I do think investors who understand the business and the risks could find a good long-term buy here. But while military conflict is big in the news, we could be in for a fair bit of volatility.

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