My uncle advised me to focus on war, sex, drugs, and rock ‘n’ roll if I wanted money. The reason was that these industries were expert in generating it. BAE Systems (LSE:BA) is in the war section, so it’s a big tick on behalf of my uncle. The company is the largest defence contractor in Europe. If I’d invested in BAE Systems shares just three years ago, I would have doubled my money. There are not many stocks I can say that for.
Funnily enough, it’s not just within the last three years that I’d have been generously rewarded. Whether I invested last year (30%) or 10 years ago (260%), I would have deemed it a worthwhile pursuit.
I invest to make money. BAE Systems certainly seems a suitable investment based on its historical total returns. But let me dig underneath the bonnet and assess a key metric for my investment — its profitability.
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Rising profitability
The best gauge of profitability for me is Return on Capital Employed (ROCE). This assesses how well a company is generating profits from capital it has put to use.
From my perspective, it’s a reassuringly stable picture. The company has employed 40% more capital in the last five years, and the returns on that capital have remained stable at 10%. I consider this a standard return. But positively, BAE Systems has consistently earned this amount. If this level of return can be maintained over the long run, I think it’s a nice reward to shareholders.
Of course, historical returns are no indicator of the future. Therefore, I need a firmer grasp of the company’s outlook, and it’s a mixed picture.
Outlook
Its dividend is low compared to other aerospace and defence companies. Meanwhile, its annual earnings are forecast to grow slower than the British stock market.
However, I need to weigh this against some positive tailwinds into the future. Despite the risk of anaemic earnings growth, its revenue growth is expected to outpace the UK market as a whole.
Additionally, I think the stock looks cheap based on its price-to-earnings valuation. This suggests there could be upside in store for the share price.
Secondly, the company makes most of its money in the US, where it has huge manufacturing plants. The strong US dollar has made it cheaper to import the key metals the company uses. Simultaneously, the robust dollar means that the firm benefits from foreign exchange trends.
So, in the medium term, I foresee cheaper production costs and greater demand. The combination of these factors is bound to rub off on the company’s share price. City analysts have already forecast a 20% rise in its valuation this year.
A repeat performance
I repeat, historical performance is no indicator of the future. But clearly, for the last three, five, and 10 years, BAE Systems has demonstrated a strong track record of delivering double-digit total returns.
If I’d invested £5,000 in this stock just three years ago, I’d have received over £10,000 and some change.
Can the trick be replicated after the next three years? It’s a mixed picture. I’d require more future guidance from the company and its business outlook.
If management foresees a benign environment, it’s likely I’ll be purchasing some shares.
