I don’t hold shares in BAE Systems (LSE: BA), but I wish I did (as well as wishing there was no need for such a company). The aerospace and defence contractor has been one of the best-performing stocks on the FTSE 100 lately, and I’ve missed out on a lot of dividends and growth.
One reason I’ve held off is that I prefer to buy high-yielding dividend stocks that have fallen out of favour. This allows me to pick them up at a bargain price then sit back and wait for the recovery. That’s the theory anyway. Sometimes I have to be very patient.
This stock is flying
I’ve been waiting for a dip in the BAE Systems share price but it hasn’t arrived. Instead, its shot up like a high-grade combat aircraft. BAE shares have climbed 22.91% over three months and 102.68% over three years. Over 12 months, they’re up 32.99%.
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If I’d invested £5,000 in May 2022 I would have an impressive £6,650 today. That’s a capital gain of £1,650.
I would have slightly more after including my dividends. BAE currently yields 2.68%, which would have given me another £134, according to my crude calculation. That lifts my total return to £1,784.
So much for hindsight. The only question worth asking now is this, should I buy BAE Systems shares today?
Yesterday’s trading update saw full-year 2023 guidance unchanged, with sales expected to rise by 3-5% and underlying earnings per share by 5-7%. 2023 free cash flow should top £1.2bn, although that’s a drop from £2bn in 2022.
However, free cash flow should total £4bn-£5bn over the three years to 2025, which should help to sustain its dividend and maybe another share buyback too.
The undervalued stocks I tend to favour typically have much higher yields than BAE’s 2.68%. My most recent purchase Legal & General Group yields 8.1%, for example.
It’s not dirt cheap though
It all comes down to mathematics. Yields are calculated by dividing the dividend per share by the share price. So if a share price falls, yield rises. If it rockets, the yield inevitably plunges.
BAE’s relative low yield – notably below the FTSE 100 average of 3.5% – is therefore a sign of success rather than failure. It should rise over time, with the forecast yield now 2.8%, covered twice by earnings. As ever, no dividend is guaranteed.
It trades at a 18.4 times earnings, above the 15 generally seen as fair value. That’s another mark of success. It’s not cheap but given recent strong performance, it could easily be higher.
As ever, there are risks. Global peace could suddenly break out and dictators and democracies stop buying weapons. Sadly, that doesn’t seem likely. A bigger worry is that defence companies are blocked from many environmental, social and governance (ESG) portfolios, effectively excluding a growing source of demand. This could weigh on future share price growth.
My main worry is that I missed my chance a year or two ago. I’ll keep buying dirt cheap high-yielders like L&G, and wait for BAE to fall out of favour. I might have to be very, very patient with this one.
