• Rising geopolitical tensions around the world have prompted the Hosking Partners team to re-examine a long-held underweight to the Defence sector.

• Under new management since 2020, Babcock is a well-positioned turnaround tale built on the foundations of unique strategic assets and a revamped revenue model.

• Meanwhile, tight governance and clear alignment with democratic Western governments provide confidence in the company’s broader impact.

The Hosking Partners portfolio is – and has historically remained – underweight the Defence and Aerospace sector (as of the end of Q3, the portfolio holds 94bps in Aerospace & Defence versus 179bps in the benchmark, based on the Hosking Representative Portfolio and MSCI ACWI respectively). This is a result of our bottom-up, capital cycle approach. Valuations amongst the large US Defence companies have been high, while we have been cautious that they are overearning as beneficiaries of inefficient state procurement systems. The direction of government spending is hard to predict at the best of times, and the US Defence industry is doubly difficult to penetrate due to the scaffold of complex and opaque lobbying relationships. Meanwhile, although the Defence megacaps have maintained a theoretically attractive oligarchic hold on ‘big bits of kit’ (think aircraft carriers), the relevance of this sort of technology seems increasingly challenged by non-conventional military competitors. In short, the market for delivering Defence effect has seemed oversupplied, while the future character of conflict remained unclear.

Since the invasion of Ukraine, we have begun to reexamine this position. While overall the sector remains a difficult one with which to get fully comfortable, if the world is indeed entering a period of geopolitical multipolarity then opportunities should exist at the right price. In March 2023, we initiated a position in British Defence engineering services company Babcock International Group Plc. The thesis is predicated on the idea that maintaining a continuous at-sea nuclear deterrent – and the naval hardware that supports it – will remain critical for the UK and is in fact seeing increased cross-party government support after years of uncertainty. International treaties like AUKUS, with other Western allies, further entrench this trend. Due to high technical and security-related barriers to entry, the companies that can deliver this service are few.

After years of mismanagement, Babcock International is a turnaround story. The new executive team, who joined in 2020, has focused on operational streamlining, including cleaning the balance sheet and resolving a pension drag, both of which are running ahead of target. The most interesting change, however, has been the renegotiation of submarine maintenance work to something close to a cost-plus model, as government priorities have shifted to maintaining availability rather than cost containment. Refitting the fleet of 20-year-old submarines caused Babcock major issues in the past, as the work is difficult to price before the submarine is dry-docked and works begin. As Babcock’s largest contract, accounting for 20-30% of sales, one could now think of the new cost-plus model as providing a fixed 20-year annuity stream, which significantly de-risks the group and should justify a rerating.

Meanwhile, the British government remains fiscally constrained, and so outlays on new submarine hardware are likely to be delayed with extended maintenance of existing capability instead prioritised. Babcock’s part-ownership of Devonport and Rosyth dockyards means it is the only company in the UK that can conduct most of the UK’s surface fleet refits and upgrades, as well as maintain its nuclear submarines, which provides a tangible moat against competition. This position is being further entrenched via the £750m construction of Dock 10 at Devonport, providing an additional nuclear submarine drydock, an essentially irreplaceable strategic asset for the UK.

Any investment in Defence also requires consideration of the target company’s role within the broader military-industrial complex, where the mixture of a profit incentive with the occurrence of conflict demands careful appraisal. The frequency and severity of conflict is an emergent property of a multitude of geopolitical, economic, and sociocultural factors. Despite fluctuations over time, conflict has never truly disappeared from the global stage. Nuclear weapons are intended to act as a stabilising force by deterring large-scale interstate conflicts but come at the cost of the perpetual threat of their use. Meanwhile, the concurrent emergence of the digital age with the rise of growing powers like China and India means multipolarity is the increasingly dominant geopolitical paradigm. Pulling apart whether Defence companies benefit passively from the occurrence of conflict, actively contribute to it, or help prevent it, is no simple task.

At Hosking Partners, we believe the consideration of such issues should be about embracing complexity, rather than simplifying or reducing it. As the world moves towards a period of heightened tension and instability, the importance of transparency and accountability in the governance of the companies that produce weapons rises. Whether nuclear, conventional, or otherwise, we believe these companies should be publicly owned entities with shareholders who take an active interest in their management. This governance structure promotes greater oversight and ethical responsibility. In our view, companies like Babcock, who work overwhelmingly with Western governments whose procurement strategies are backed by a democratic mandate, represent the most responsible and long-term way to access this opportunity.