This weapon maker’s shares have taken off – it’s time to buy

Questor believes elevated geopolitical risks will catalyse BAE’s performance

Questor is The Telegraph’s stockpicking column, helping you decode the markets and offering insights on where to invest for the past six decades.
Share prices and investor sentiment are positively correlated. This means that as a company’s shares rise in price, investors typically become more inclined to buy them. Falling stock prices, meanwhile, tend to prompt weaker demand among investors.
But in Questor’s view, this is wholly illogical. Indeed, the stock market is arguably the only industry in the world where customers (in this case investors) want to pay more for a specific product (in this case a company’s shares). The idea of buying at low prices and subsequently selling at high prices to make a profit seems to have been superseded by a far more difficult aim to buy at high prices and somehow sell at even higher prices further down the line.
Of course, there are occasions when buying a stock that has risen significantly in price makes perfect sense. Firms that are in the midst of experiencing a step change in their financial performance, for instance, can justify a substantially richer rating and higher share price. 
Aerospace and defence firm BAE, for example, has soared 129pc higher and outperformed the FTSE 100 index by 121 percentage points since our original tip in December 2019. Yet it still offers good value for money and scope for index-beating capital returns due to its rapidly improving financial outlook.
Its latest half-year results showed that it is performing extremely well. Sales and operating profits both rose by 13pc versus the same period of the prior year as the firm experienced strong demand for its range of products. This prompted it to raise financial guidance for the full year. It now expects to deliver top-line growth of 12pc-14pc, which is two percentage points up on its previous forecast. Its operating profits are also forecast to grow by 12pc-14pc, which is one percentage point higher than its prior estimate.
The company’s long-term prospects are becoming increasingly upbeat. Geopolitical risks have dramatically increased since our original tip nearly five years ago, with conflict in Europe and the Middle East showing little sign of abating. Those events appear to have prompted a revised outlook on defence spending among several major developed economies which for many years had failed to prioritise their military capabilities.
Defence spending among Nato members, for example, is expected to rise by around 11pc this year. This compares with an annualised increase of just 1.7pc in the previous four years, with a growing proportion of members set to reach the 2pc of GDP spending target in the current year. And with a Trump presidency potentially on the horizon, it would be unsurprising if the amount spent on defence, particularly among major European countries, continues to rapidly rise in the coming years.
Interest rate cuts should also equate to higher overall military spending. Since defence expenditure is a function of GDP, a rise in economic output catalysed by a looser monetary policy that has already commenced in the US, Eurozone and the UK should be good news for BAE and its sector peers. 
The company’s solid financial position, meanwhile, means it could continue to engage in mergers and acquisitions to boost profit growth. Despite making several acquisitions over recent months, its net gearing ratio of around 70pc remains relatively modest. Its cash flow is also strong, with the firm’s encouraging performance in the first half of the year leading to a rise in guidance for the full year. It now expects to produce free cash flow in excess of £1.5bn versus a prior forecast of around £1.3bn, with it being partly used to fund a previously announced share buyback programme.
Despite its improving financial performance, the company’s rising share price means it now trades on a relatively lofty price-to-earnings ratio of 20.8. Its bottom line, though, is expected to rise by around 11pc per annum over the next two financial years. This helps to justify its rich market valuation and suggests that further capital growth lies ahead.
Unfortunately, BAE has not been a member of Questor’s wealth preserver portfolio until now. We have excess cash available following recent sales, which will be partly used to fund the stock’s inclusion in our portfolio.
Although the company’s share price has risen significantly since our initial tip, its solid financial position, vastly improved operating outlook and sound strategy mean it continues to merit purchase on a long-term view.
Questor says: Buy
Ticker: BA
Share price at close: 1299.5p
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