Equities edged higher yet again in July and the selection of stocks representing the Global Defence & Security Fund (GDSF) portfolio has now outperformed its relative benchmark on 1, 3, 5, 10 and 20-year basis. From a risk-adjusted perspective GDSF has achieved this outperformance with a higher risk-adjusted return on each benchmark on 1, 3, 5 and 20-year basis.

The investment thesis of GDSF is based on a long-held belief that the world military budget will experience a sharp rise over the period 2014 – 2024 and enter into a longer-term uptrend in military spending as a percentage of GDP after decades of reduced military spending. The analysis supporting this thesis is carried out by the GDSF Investment Team, whom with collectively more than fifty years’ experience within the Swedish Defence Industry, apply a technique known as Global Intelligence (GI). GI combines Geopolitical Intelligence, Market Intelligence and Competitive Intelligence to seek out and conduct deep analysis of actual or potentially interesting investment objects, market segments and trends. Currently, the culmination of these trends indicate that faced with increased pressure from the US, NATO member countries are likely to deliver upon their pledge to increase military spending, most likely beyond the 2 percent target set in 2014. Our conservative estimates expect the annual military spending of this group to increase between USD 290 billion and USD 598 billion by 2024 and that this increased budget pool is likely to follow a similar tender process with similar target companies. For those countries not already covered by NATO, OECD member countries are facing similar pressures and, in many instances, the governments of these nations are now creating significant incentives to promote the growth of industries focused on defence. Combined, NATO member countries and OECD member countries make up over 60 percent of today’s world military budget.

The GDSF employs a range of fundamental models to help provide an indication of forward expectations. It is our preference to identify fundamental models that have a successful track record in quantifying stock price action and exhibit a high correlation with subsequent long-term pricing. One of these models is based on the research by Dr. Hussman, where, using a combination of revenue, earnings, book value and price it is possible to produce forward long-term returns estimates that have historically exhibited a correlation greater than 0.9 with subsequent realized long-term returns. Broadly speaking, fundamental models that exhibit a high correlation with current fundamental valuations and long-term forward estimates indicate the stock market is, in general, richly valued and that longer-term return expectations (annual returns measured over a 10 to 12-year period) are likely to be far lower (low single digits) than what has been the case during the most recent bull market. One of the reasons we believe these fundamental models are likely to be proven correct, yet again, is due to the mean reversion tendencies of fundamental factors – that is, we tend to see corrections in the fundamentals and thus stock prices when they become extreme and move beyond their historical range for an extended period of time.

Industries that are heavily dependent on the business cycle are likely to experience a mean reversion in the fundamental factors that help explain longer term returns, whereas industries such as the defence, whose revenue source are not dependent upon the business cycle to the same degree are far more likely to experience a continuation of fundamental trends. This is where we recognise the importance of combining Global Intelligence and Fundamental Analysis. By successfully identifying the macro trends that will likely shape the defence industry over a longer period of time and recognising where the economy may be in terms of its economic cycle we place a larger focus and value on companies that are either undervalued relative to their peers, or where longer-term revenue expectations indicate a continuation of current trends rather than a mean reversion.

The GDSF portfolio is currently allocated to companies we believe are most likely to benefit from an increase in global military spending. Over time, our allocations will shift from a lower concentration to higher concentration as we align our positioning with our views of the economy. When the outlook indicates a lower expected return, as is the case today, we believe it is best to be positioned defensively and without any concentrated holdings. When that outlook changes, we are more willing to adopt a more concentrated portfolio composition.

The economic cycle does not stand still – it fluctuates. Sometimes it extends beyond our higher range expectations and sometimes it extends beyond our lower range expectations. Over the next ten to twelve years we believe there are likely to be an enormous set of opportunities for active strategies that are able to take advantage of these cycles and at GDSF we believe the edge lies in producing analysis that enable us to identify and exploit opportunities long before we arrive at those points in the cycle.