Smart security: Ongoing megatrend and investment hedge to geopolitical tensions

A volatile geopolitical environment will likely be a defining pillar of the 2020s and could have material investment implications.

While such an environment presents many challenges, there are also areas of the market that could benefit as governments, corporations and households seek to protect themselves in an increasingly fragmented world. Going forward, key areas of security concern that may benefit from this environment include computer system integrity, military power and national border security systems.

Collectively, we call these areas “Smart Security,” and below we detail the drivers and investment outlook for each of those three pillars.

Boom times could be coming in cybersecurity

There are multiple tailwinds behind the cybersecurity industry, and the sector remains a high conviction recommendation across AWM (the investment case was recently reiterated in the Eye on the Market 2022 Outlook.)

1. Cybersecurity is an enabling technology for the “digital transformation” of the economy. Many of the exciting high conviction growth areas we already emphasize to clients (5G, Cloud computer, internet of things, AI etc.) are only possible if companies are able to protect their networks and keep client data confidential. Data losses could undermine the trust people have in the technology they use. Hence, just like semiconductors, we believe cybersecurity technology is a must-have in the digital age and will therefore benefit as the digital, connected world expands. Indeed, the chart below shows the increasing number of software vulnerabilities discovered in recent years.

2. Pandemic-induced vulnerabilities: The shift to remote working due to the pandemic increased the “attack surface”, as hackers shifted to target organizations through the weaknesses of employee home-computing set ups. This caused individuals to purchase new cyber protection software, but has also caused businesses to change their cyber-setup to protect cloud-based infrastructure required for remote working.

3. Cyber is now an essential part of war, with every major country investing heavily not just to defend their own systems and societies, but also to play offense and be able to inhibit the military and domestic infrastructure capabilities of their rivals.

It therefore seems clear there are catalysts to a multi-year enforced upgrade cycle across the global private sector, and throughout public sector institutions as well. Chief Investment Officer surveys held prior to the Ukraine conflict were already showing cybersecurity at the top of corporate spending priorities due high-profile breaches like Log4J¹. Grand View research calculates that these forces will lead to the U.S. cybersecurity market to grow at a CAGR of 10.2% between now and 2028.² This compares to a long-run expected revenue growth for U.S. large cap in the LTCMAs of 5.3%.¹

Importantly, cybersecurity is investable.

On top of the revenue tailwinds identified above, there are some other aspects to investing in cyber which may attract investors including possible appreciation during times of cyber conflict and an active cycle of merger and acquisition activity. These factors have been gradually recognized by the market and have helped to drive out-performance of cyber stocks over the broad market in recent quarters.

In summary: Investments in cybersecurity are simultaneously a play on the digital transformation megatrend and a beneficiary of the rising geopolitical tensions we see in today’s world.

Defense spending is back and here to stay

In the aftermath of the Cold War, the world enjoyed a “Peace Dividend,” where military spending fell as a share of budgets and GDP. This allowed those funds to be re-directed to schools, hospitals and to tax cuts, helping the West boom during the 1990s. We are now seeing a global reversal of this trend.

For those that might not be aware: all NATO members are supposed to spend 2% of their GDP on the military. In reality, most do not: as the table below shows, in 2021 13 NATO members spent less than the 2% they agreed to.

While the two largest countries in Europe, the UK and France, already spend 2% of GDP, many of the other European countries do not. If all European members raised their spending to 2% of GDP, the aggregate amount spent would rise by around a quarter—a notable increase. A key unknown at this point is whether these countries will need to push their spending ABOVE 2% in coming years. Given past years of underspending, we suspect they will.

To get a sense of the likely scale of forthcoming spending that is required, we went back and calculated, in today’s money, the size of the deficit (relative to the 2% target) in each year since 2000. The chart below shows the cumulative deficit in NATO spending since 2000. In today’s money, the current undershoot totals $1.47 trillion! We suggest much of this deficit will now need to be spent in order to restore their military systems to the expected operating level. 

We are already seeing this become a reality as multiple NATO countries are already announcing significant increases in spending.

• In the U.S, the recently released FY23 budget proposal and its National Defense Strategy update. Both pointed to a new era of elevated military spending no matter which party control the government.
• The European Council recently approved its Strategic Compass, a plan of action for strengthening the EU’s security and defense policy. This complements Europe’s pre-existing statements on creating greater European strategic autonomy in a range of areas, including industrial development and semiconductor manufacturing capabilities.
• On a single country level, Germany’s historical pledge to raise defense spending shows how rapidly the situation can change given the right combination of threats. Many other European nations have made similar pledges in recent weeks.

Looking at defense companies as an investment, we find that it has the “defensive” characteristics of being divorced from the economic cycle, often provides inflation protection, has a strong cash-flow position and dividend history and valuation starting point is not stretched: After underperforming the S&P 500 by ~30% since March 2020, valuations still look quite reasonable, with the leading companies in the U.S. investment universe (known as “primes”) trading at an average NTM PE of 18x. Indeed, despite having significant revenue visibility along with superior capital return profiles, the stocks are valued at an 8% discount to the S&P 500. 

The third subcomponent: “smart borders”.

Maybe the most potent political issue in western democracies remains immigration. Fears over the disintegration of the nation state in an increasingly globalized world have been key wedge issues for political movements that have shaped markets in recent years, such as the Brexit movement, the Orban government in Hungary and the Trump campaign. It appears likely governments will continue to emphasize ensuring borders are made secure from people without legal status or with virus infection. Furthermore, immigration flows are now clearly part of the “hybrid-war” playbook, with agitators looking to stress western democracies through the flow of migrants towards their borders. Lastly, one could argue that the security of borders is a long-term hedge if society fails to adapt to climate change. Current projections estimate the warming of the planet will lead to a migration of tens of millions of people towards the northern developed countries.

¹ IDC, May 2020

² Grand View Research, April 2021.