Fears of an escalating trade war with China – and of saber-rattling more generally in the region (and further afield) – have rattled markets in recent weeks. In recent published research notes, we have discussed a few individual securities that currently, or could soon, present opportunities thanks to market trepidation.
Today, we dig a little further, exploring two types of stocks that could present opportunities in a choppier stock market fearful of tensions boiling over between the U.S. and China.
Fear can make a bargain of stocks exposed to Chinese markets
Sectors with heavy exposure to the Chinese market can present excellent opportunities for bargain-hunters in the face of trade war panic. We have already discussed examples of this type of stock in previous research notes, including Caterpillar (CAT, Financial), which has seen its growth strengthened by insatiable Chinese demand for heavy construction and mining equipment. China now accounts for just over 20% of Caterpillar’s revenue. Any fear of access to the Chinese market being squeezed off would assuredly roil Caterpillar’s stock price. It has already been on an upward tear for the past year, so an overcorrection downward could present an excellent opportunity for value-focused investors.
Similarly, we identified Boeing’s (BA, Financial) recent dip off the back of trade war concerns as a more immediate opportunity for investors to exploit. With China a major market for Boeing aircraft, fears of tariffs or canceled orders has helped put downward pressure on America’s largest and most important aerospace firm.
Cummins (CMI, Financial), a maker of engines for heavy equipment and industrial trucks is another example of a company with considerable exposure to China. With a bit over 10% of its business coming from China, choking off market access would be troubling for the company’s bottom line. Perhaps it is unsurprising, then, that the stock is down nearly 10% in 2018.
What all of these stocks have in common (and there are plenty more examples to be found) is exposure to the Chinese market, but also a degree of inelastic demand that will keep China buying irrespective of tensions or tariffs. China needs heavy equipment and the engines to power it, as well as airplanes to serve ever-expanding routes. Markets may panic at the thought of them being shutout or compromised, but that moodiness will pass. Wise value players will position themselves to take advantage of the crises of confidence as they arise.
Defense and aerospace stocks thrive when war drums sounds
When trade wars escalate, governments tend to crank up the heat in other ways too. In the case of China, trade and economic disputes have generally led to provocations and escalations in disputed territory. This has been happening quite a bit in recent months as Chinese President Xi Jinping pushes back against American threats of trade war. As the security guarantor of many countries on China’s periphery, the U.S. has been, and will continue to be, at the center of these activities.
When governments posture militarily, they need to back it up with firepower. Thus, it is unsurprising that defense industry stocks tend to do well when talk of conflict and military buildups is in the air. Boeing, as a major aerospace industry player, might be included in this set of opportunities alongside other, purer defense firms.
Other companies that have benefited already from the Trump administration’s bellicosity include Kratos Defense & Security Solutions (KTOS), a niche defense firm we highlighted as an intriguing potential investment back in November. Despite some ups and downs since then, Kratos shares are trading at almost exactly the same price as when we first discussed it. Kratos provides a range of security products and services, including state-of-the-art military drones, to the U.S. government. The current, relatively high-tension geopolitical environment is good for business as far Kratos is concerned.
Opportunity may also be found in tracking the larger, more established defense industry players, such as Lockheed Martin (LMT) and Raytheon (RTN). Lockheed might be of particular interest after its marked drop after the recent summit between the leaders of North and South Korea. That drop looks more like a temporary blip, since the many underlying reasons for extreme bellicosity between North Korea, South Korea and the U.S. remain largely unchanged despite the latest attestations of goodwill. But that has not stopped the market from crediting words of peace as being the real thing.
Furthermore, the far more geo-strategically important conflict between China and the U.S. continues to unfold. As China continues to assert its claims to islands in the South China Sea, as well as apply pressure to the American-led security order that has dominated the region for decades, the tension between the incumbent superpower and the rising power is bound to escalate. That does not mean a shooting war or anything so drastic, but their need to show strength, and their desire to maintain and expand their capacity to project power in the region, means defense companies will be doing a booming business.
A parting note on ideology and stock-picking
Our recent research note on Goldman Sachs (GS, Financial) took some time to address the moral disquiet investors might feel at investing in the stock of a company they deem to act unethically, or to profit from the pain of others. Bank stocks have gotten that reputation in some circles, while other sectors like fossil fuels have experienced even greater pressure from investors with changing moral codes at odds with their business practices. Such can be the case with defense stocks, especially when they are being discussed in the context of a play on the fear of escalating military tensions.
We would argue that value should be sought out anywhere it can be found, especially in the current arguably overpriced stock market. In the case of defense industry stocks, we see these companies as purveyors of critical equipment, services and expertise that keep our nation – and much of the world – safe. Thus, we feel no moral squeamishness at investing in the industry and individual securities within it.
Disclosure: I/We own no stocks discussed in this article.
