Hedge Funds Bearish on Specialist Defence Firms

With the UK announcing a 7% to 8% reduction in defense expenditure and comments that US defense secretary Robert Gates is looking to economize despite total military spending rising in real terms, it is time to take a look at how investors are playing this sector. There is a noticeable trend for institutional investors to sell out of big companies such as BAE, Lockheed Martin and Cobham and short sellers are not active given the long term nature of the contracts. However, they are shorting certain more specialized firms which sell military related goods to the Government such as FLIR, Aeorvir, Taser and Qinetiq.

The chances of any single piece of news derailing a firm like BAE Systems (BA.) is low. They have contractual commitments from many countries for military equipment for years and years to come. Also, they can and are, doing new business with countries such as Saudi Arabia who are expanding their militaries in contrast to the contraction occurring in the UK. This makes short sellers uninterested with borrowing in both the ordinary and the ADR shares standing at less than 1% of the company. Even the news that the UK government would like BAE to review existing contracts has not moved the price downwards.

On the other hand, institutional investors who lend have reduced their holdings in BAE from 33.8% of the company pre credit crisis to a 3 year low of 24% today. It is a similar story for Lockheed Martin (LMT) where short selling is very low but funds who lend own the smallest amount of LMT now, compared to any point over the past 3 years – moving from 31% of the firm to 18% today. The UK listed Cobham (COB) has gently rising short interest, but it is still a low level in absolute terms at 2%. COB mirrors the others in having much lower institutional ownership now than 3 years ago – a reduction from 32% to 25% of the firm.

The behavior of these funds is entirely logical. 3 years ago the outlook was rosy for defense companies with the US fighting 2 wars and with a strong political backing (President George Bush). Times have clearly changed with public opinion increasingly anti-war and Western governments generally unable to afford to continue to spend such a large proportion of GDP on defense.

Short sellers are negative on the outlook for certain smaller defense specialists who nervously await the US defense budget for 2011. One of these is thermal imaging firm FLIR Systems (FLIR) which relies on the US government for a third of its sales. Short interest has just hit a one year high in FLIR at 11% of the company and this looks profitable with the shares also at a 52 week low. There has been no short covering as yet and with the budget announcement delayed to December at the earliest there is no hurry to cover the position.

Taser International (TASR) saw short interest sky rocket in April from 2% to 14% of the company. The shares fell in this humane weapon producer and it looks like the short sellers are trying to cover as quickly as they can but with such low volume this is taking a long time. There remains another 7% of the company to buy back to eradicate the short interest. Short sellers are also covering unmanned aircraft systems maker AeroVironment (AVAV) but the position remains high at 9%. Finally, short interest is taking off in the UK’s defense consultancy Qinetiq Group (QQ.) and is at 4% of total shares while the price is slowly drifting lower.