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One investment idea for FY18 that you’ve probably missed

The close to $800 million contract to build warships that shipbuilder Austal Limited (ASX:ASB) announced today highlights a promising investment thematic for the new financial year that most investors have probably overlooked.

This investment idea is based on gaining exposure to rising defence spending by governments around the world at a time of increasing threat from terrorism and geopolitical tensions, which includes the militarisation of China that is sparking an arms race in the region.

Don’t forget the pressure placed by US president Donald Trump to force NATO partners to spend more on defence too.

The Australian government is also feeling the heat. It has committed to lifting its defence budget to 2% of Gross Domestic Product (GDP) from around 1.5%. This would put the Australian government’s defence spending on track to hit $42 billion by FY21 – a 54% increase from FY16.

The biggest problem to riding this global investment thematic is stock selection. The ASX has a pretty shallow pool of stocks that are directly related to defence. The most obvious candidate is Austal and news that it has secured another contract worth up to $779 million to build the Independence Class Littoral Combat Ship for the US navy is a case in point.

The stock barely moved from its previous day’s close of $1.80 as the good news appears to be priced in with the stock already trading close to a one-and-a-half year high and on a FY18 forecast P/E of 16.2 times.

Another stock that has some defence-exposure is Alexium International Group Ltd (ASX: AJX), which produces flame retardant spray on chemicals for fabrics. It can be used in military uniforms but the company is also pursuing other opportunities such as bedding.

The third stock idea is weapon and space defence technology company Electro Optic Systems Hldg Ltd (ASX: EOS). The company recently confirmed it has won a $170 million contract to supply weapon systems to Orbital ATK – a NASDAQ-listed aerospace and defence technology company.

While the stock has nearly doubled in value over the past year and is trading at $3.14, it probably still has room to climb given its market cap of $191 million and the size of its addressable market.

The last stock is Xtek Ltd (ASX: XTE) and is the stock I am most excited about (and yes I own shares in Xtek). It is currently in a trading halt as it undertakes a capital raising after a strong run up in its share price recently. But it still has a market cap of around $16 million, and that’s pretty modest given that it is the primary contractor in the $100 million LAND 129 Phase 4 program for the supply of drones to the Australian army.

Xtek has also been given a grant by the US government to test its XTclave technology to create lighter and more effective helmets and bullet proof plates. While the commercial opportunity from this is still some time off, it represents a very material potential for this tiny Australian company.

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Motley Fool contributor Brendon Lau owns shares of Xtek Limited. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.