Defence shares BAE Systems (LSE:BA.) and Babcock International (LSE:BAB) got a boost in the FTSE 100 today (21 July). As I type, they’re up 0.8% and 4%, respectively.

The catalyst was new PM Andy Burnham’s pick for Chancellor of the Exchequer, John Healey. He quit as defence minister last month after a row over military spending.

Therefore, his appointment is being interpreted as a bullish signal for future defence spending. Let’s unpack what’s going on here.

The backdrop

As a reminder, Healey was pretty scathing in his resignation letter. He wrote that the previous government was “unwilling to commit the resources that the nation needs to defend the country at this time of rising threats“. Ouch.

While Starmer had agreed to a NATO commitment to reach 3.5% of GDP on defence by 2035, Healey argued that to realistically hit that Britain needed an interim target of 3% of GDP by 2030. This is what most European allies are doing.

But he said the new Defence Investment Plan fell short of this, implying just 2.68% spend by 2030, up marginally from 2.6% in 2027.

Why the stock divergence?

Essentially, Healey argues that the additional spending should be frontloaded to address immediate threats from Russia. And with him now in a position to influence things, the stock market is responding in kind.

As mentioned though, Babcock is up a lot more than BAE. This is because it would likely benefit more from quicker UK defence spending. Over 70% of the firm’s revenue last year came from the UK, versus just 28% for BAE.

However, this is one reason why I prefer and have money in BAE — it has far more geographic diversification. In particular, the defence giant sources a significant proportion of sales (almost half) from the US, where the military budget seems set to go through the roof, at least if Donald Trump gets his way.

In contrast, less than 5% of Babcock’s sales were from North America last year.

BAE also has a higher dividend yield, at 2.2% against Babcock’s 1.2%. And while the stock’s forward price-to-earnings (P/E) ratio of 21 is higher than Babcock’s 16, this reflects a much larger order backlog and superior operating margins.

Mega-projects

In other news today, it was announced that Canada will join the Global Combat Air Programme (GCAP) as an observer nation. This could be a stepping stone for it to join the three founding members (UK, Italy, Japan) that are building a next-generation stealth fighter jet.

Rolls-Royce sees this new jet as having greater export potential than the Eurofighter Typhoon. These are the sort of mega-projects that BAE is involved in, which is another reason I’m bullish on the stock long term.

Is Babcock worth a look?

Both stocks could pull back sharply if there’s any whiff that higher UK and European military spending is in jeopardy.

Also, as a BAE shareholder, there’s the strange ethical situation of wanting the war in Ukraine to end while acknowledging this could cause a short-term dip in the stock price. I appreciate defence stocks are not for everyone.

That said, I don’t think an end to the Ukraine war would undo the multi-decade government commitments that underpin the company’s real value. 

So I think BAE, and potentially also Babcock, could be worth considering buying today. 

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Ben McPoland owns shares in BAE Systems and Rolls-Royce.