A controversial topic, defence as an investable asset class has become more prominent because of heightened geopolitical tensions, and wars in places such as eastern Ukraine. We talk to an Edinburgh-based fund manager on his approach.

It’s a truism, however unfashionable to state, that some of the most powerful innovations have been prompted by war. Whether it is missile defence, satellite navigation or night-vision goggles – to take just three – military life has required innovation. 

And on the second grim anniversary of Russia’s invasion of Ukraine, and with memories fresh of how Ukrainian forces have adopted satellite tech and devices such as drones, this is a very immediate conversation. 

For all that some investors, such as those influenced by ESG ideas, reject the very idea of defence-related businesses, it’s a view that isn’t shared by Graeme Bencke, fund manager at Edinburgh-based Amati Global Investors. He is a manager at the WS Amati Global Innovation Fund, which was founded in May 2022; it is a relative minnow with £6.8 million ($8.62 million) in assets, comprising 38 holdings.

“The nature of defence has changed since Ukraine. Many people thought that investing in nuclear arsenals would be a sufficient deterrent – mutually assured destruction. They [nuclear weapons] are seen as table stakes but not usable.” Bencke elaborated: “If the other side has them you can’t afford not to be using them, [it] is not really an option. This means that warfare regresses to more conventional methods but incorporates newer technologies including satellite surveillance, drones, robotics, and cyberwarfare. Denying capital to these companies is problematic.”  

Defence-linked holdings account for about 10 per cent of the portfolio he runs, consisting mainly of three stocks. Bencke's fellow fund manager is Mikhail Zverev. The fund, which is benchmarked against the MSCI ACWI, is available as a UK UCITs fund, requiring at least £1,000 ($1,267) in initial investment, with an 0.75 per cent annual management charge.

“I should emphasise that just as we don’t invest in businesses in non-free countries (according to the Freedom House ratings); we also apply stringent tests that our defence companies do not do business in countries without free and democratic governance,” Bencke said. 

Defence 
Although the Russian/Ukraine conflict has been a sharp jolt to many investors, making the argument that defence spending sectors can be investable is still controversial, if not quite as difficult in the past. A report by Capital Monitor (17 March 2023) noted how JP Morgan had argued that the ESG credentials of weapons manufacturers’ stocks should be re-evaluated. It also noted that Swedish banking group SEB reversed a blanket ban to allow some of its funds to invest in these businesses, citing the Ukraine situation. On the flipside, others argue that defence remains off limits, however sympathetic certain causes might appear.

It is worth putting today’s debate in context. In 1960, military spending as a share of GDP accounted for 6.4 per cent; it fell – with the occasional pause or rebound as in the early 1980s – to as low as 2.1 per cent in 2018 before a slight uptick in the past three years (source: World Bank).

Amati is looking at innovative businesses in areas such as data intelligence, cybersecurity, AI, Bencke said. The firm Booz Allen, for example, is a large cybersecurity player for the military and intelligence services. (The firm. which calls itself one of the world’s largest cybersecurity solutions firms, accounts for a 3.5 per cent holding in the Amati fund.)

“The mood is now definitely more understanding about owning these kinds of companies,” he continued. 

Bencke brings plenty of experience to his role, and is able to see such issues in perspective. He joined Amati in May 2022 as a fund manager for the WS Amati Global Innovation Fund, the same month as it was founded. He started his career as an equity analyst at F&C Investments before going on to manage the European Smaller Companies fund for five years. Bencke then spent 12 years with AIG (later renamed PineBridge Investments) where he led the European and then global equity teams, combining this with his role as equity strategist for the group. A constant theme for Bencke is managing concentrated, high-conviction equity portfolios from across the full market cap spectrum, and with a focus on strong businesses with longer-term growth potential. 

A passion for innovation by Bencke extends beyond the fund. He has a non-executive role at Torvius where he helps to mentor startup companies. 

Bencke’s fund’s largest sector weighting is information technology (34.8 per cent), followed by industrials (30.7 per cent), healthcare (21.6 per cent), materials (5.8 per cent), communications services (3.3 per cent), financials (2.7 per cent), and 1.1 per cent in cash.

Philosophy of action
Amati looks at innovations that have already begun to take shape, that is early in their rollout.

For all the examples Bencke gives of businesses he can or could hold, there are areas he avoids.

“There is (rightly) concern about investing in nuclear weapons, cluster munitions and landmines” and these are strict areas of exclusion for [us]. Our approach is to be ‘pragmatic but principled’.” 

Geopolitical risks are rising, and defence spending will do so as well; so-called “conventional” warfare between “near peers” is back on the agenda, and emerging asymmetric risks (on the one hand drones and low-cost missiles, on the other hypersonic weapons, space and cyber warfare) require new defence capabilities, Bencke said.

This publication asked Bencke what he says to people about why defence is a sector that has a place in portfolios.

“Defence is an important investment area for any country and has historically been a fertile sector for the creation or utilisation of innovation. Sadly, the greater uncertainty we see from the conflicts in Ukraine and the Middle East mean that the defence equipment suppliers are once again the focus for increased investment to solve the newer challenges that military forces are presented with,” he replied.

This is, of course, an intensely political area. One possible way to manage risks is by holding technologies that have civilian, peaceful uses as well as defensive ones, this publication suggested. 

“It is sometimes the case that innovations in this area will have civilian applications and these can make attractive investment opportunities,” Bencke replied.

“Moog Inc, for example, supplies actuators for control surfaces on military as well as civilian aircraft, in addition to involvement in highly innovative mobile air defence platforms,” he said. Moog is a holding of the Amati fund. Another holding is Leonardo DRS, a US defence contractor. This listed firm specialises in advanced electro-optical and infrared sensing for both targeting and protection. It also designs and installs next-generation electric power and propulsion systems, including for naval applications.

“Leonardo DRS is a key supplier to the US M-SHORAD (Manoeuvre Short Range Air Defence) system for armoured personnel carriers,” Bencke said. “Connecting DRS’s specialist RADA radar system and its surveillance, tracking and targeting capabilities allows vehicles to destroy incoming weapons,” he said. “This system is housed on top of Moog’s Reconfigurable Integrated Weapons Platform (RIWP) which uses the company's precision movement control technologies to create a stable yet rapidly reacting base to allow weapons to lock-on to and bring down inbound threats.”

As explained in another conversation with Amati last year, innovation is the driving force.

“Our investment philosophy in general is to identify proven, but early-stage innovation which will have a material impact on a business or industry, and then invest in the beneficiaries which offer the most attractive combination of risk and reward. We invest only in companies with self-sustaining capital structures and proven business models, where the innovation-led growth opportunity is not fully appreciated in the share price,” Bencke added.

Controversy around defence and how it might fit into portfolios is unlikely to disappear. But also, alas, is the reality of conflict and threats to security. Given the situation, defence will remain a major area of spending and activity in democratic states, never mind others. It would be odd, therefore, if it did not figure in the investment conversation.