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With market consistency thin on the ground and conditions remaining shaky, which sector is keeping its balance? Russ Mould gets defensive

Even after last week’s welcome rally the UK equity market still appears confused as to what direction to take. As the table below shows there has been remarkably little consistency in terms of which sectors have driven the market. This is in marked contrast to the early stages of 2007, when mining, construction, oil, oil services and technology stocks took key indices upward. When the market is seemingly driven purely by short-term events – such as metals price weakness or the rumoured bidding war for British Energy (BGY) – it is rarely a good sign.

As such, it still seems best to focus on sectors and stocks which have good balance sheets, fat order backlogs and operate in areas where demand is all but guaranteed, regardless of the broader economic environment. One such sector is aerospace & defence, which has fallen by 5% so far this year, against the FTSE All-Share’s 7.5% drop.

This marked outperformance is all the more notable, given the backdrop of an enfeebled US dollar. Most defence contractors have their cost base in the UK or Europe but price their goods in US dollars, which is also the domestic currency of formidable global competitors such as Raytheon (RTN:NYSE) and Lockheed-Martin (LMT:NYSE).

BAE Systems’ (BA.) £38.6 billion order book represents more than twice the firm’s annual sales figure for 2007, and the stock has outperformed the FTSE All-Share by over 20% over the past year as a result. Selective acquisitions such as Armor Group, which will make its first 12-month contribution in 2008, and the recently announced MTC Technologies and Tenix, should neatly supplement organic growth.

Yet the major contractors are not the only way to play the sector. Babcock International (BAB) is not as cheap as it was after a good run over the past 12 months but the support services stock still looks a good bet. A £3.3 billion order backlog underpins the firm’s prospects and Babcock, which manages the Royal Navy’s Rosyth dockyard as well as living accommodation for members of the armed forces, should continue to prosper.

VT Group (VTG) is still in the process of moving away from its shipbuilding roots and toward a strategy focused on civil and defence support services. Last summer saw VT agree to merge its Portsmouth shipbuilding operations with BAE’s Rosyth yard, in a deal, which will leave it with an initial 45% stake but an option to sell down to zero. A deal to provide refuelling and related aircraft services to the RAF has take VT’s backlog to £4.7 billion, more than three times the £1.1 billion forecast cap’s annual revenues for fiscal 2008.

Haggling with the MoD over a £3.9 billion aircraft carrier has slowed down progress with the VT/BAE deal, and the sector does face its risks. The UK government is clearly having to tighten its purse strings and defence spending has not escaped. The £20 billion FRES armoured vehicle programme has already suffered delays, and the Joint Strike Fighter (JSF) and latest tranche of Typhoon fighter orders could also be hit.

Second tier contractor SciSys (SSY:AIM) has already been caught out by the delays in FRES, although the firm’s share price collapse last year already bakes in a lot of bad news, and the stock looks cheap. The risk of delays has also impacted the share price of training provider Pennant International (PEN:AIM) but a lowly £4.6 million market cap is underpinned by £800,000 of net cash.

Shares says:

BUY Babcock International, BAE Systems, Pennant International, SciSys, VT Group