Low-level investor sentiment and current market correction makes for a great opportunity to find undervalued companies to invest in. When I’m building my portfolio, I’m looking for companies that are able to weather short-term problems such as rising inflation and ultimately produce long-term gains.

If I had £1,000 spare this September, I would invest £500 across two cheap UK shares – one in the retail industry and the other in defence. Let’s take a look at them.

Retail

British retail has had a tough time in recent years. Not only were plenty of businesses forced to shut during Covid-19, but since reopening many have struggled given the rising costs of running a business and consumers spending less due to a rise in the cost of living.

One company I think could bounce back is WH Smith (LSE: SMWH). Down just over 6% in the last year, I believe that the current price of 1,466p looks like an attractive entry point.

To see how the company might perform in the long term, I’m looking at data from the travel industry as a large part of WH Smith’s revenue comes from its airport outlets.

In June, WH Smith said the travel division was performing particularly well, so much so that full-year results are now set to be “at the higher end of analysts’ expectations”.

As international travel continues to recover, WH Smith’s airport footfall will increase and this could lead to potential expansion – something the company is already looking into after the success of its Chicago and Las Vegas airport stores.

Of course, WH Smith’s success relies on a strong global economy and is extremely dependent on the travel sector, an industry that has seen much uncertainty recently given problems such as staff shortages.

A potential decrease in winter holiday-goers could also prolong WH Smith’s recovery as its airport revenues are likely to be lower than anticipated, at least in the short term. 

Defence

The other stock I would invest £500 in is one of the UK’s largest defence contractors, QinetiQ (LSE:QQ).

The FTSE 250 stock is up 23.16% year to date, partly driven by the increase in military spending following Russia’s invasion of Ukraine.

I believe the stock could go up further in the coming years given the new Prime Minister’s pledge to increase defence spending to total 3% of GDP by 2030. Other countries such as those that are NATO members may increase spending in this area given growing geopolitical tensions and threats.

QinetiQ reported strong Q1 earnings recently. It has a cash position of £225m, and during its results the company said it predicts “mid-single digit organic revenue growth”, which is impressively high for a UK company in this sector.

73% of QinetiQ’s revenue comes from the UK government, meaning the company is over-reliant on the government’s funding and contracts. If defence spending is cut in coming years, which is a possibility given the current economic climate, then the stock may not see the current growth levels it predicts.

Defence tech and security

As an introduction, Qinetiq is a defence and security company. It manufactures and supplies defence and security products using cutting edge technology. Some of these products include sensors for weapons, robotics systems, and advanced security for computer systems.

So what’s happening with Qinetiq shares currently? As I write, they’re trading for 355p. At this time last year, the stock was trading for 326p, which is an 8% return over a 12-month period. Since the turn of the year, the shares are up 36%, from 260p to current levels.

FTSE 250 stocks have risks

I believe the Qinetiq share price has rallied due to the unfortunate events in Ukraine. These events have led to a spike in defence spending, which has boosted investor sentiment for firms like Qinetiq. These events won’t last forever so I can’t help but wonder if the share price will eventually fall. This is something I will keep a keen eye on.

Next, I’ve also noticed that Qinetiq shares are trading very close to all-time highs. Whenever any stock is trading at its highest levels, I am wary that any negative news or poor performance could cause a sharp price drop.

The bull perspective and what I’m doing now

So to the positives then. From a market perspective, governments’ defence spending is a lucrative market and a renewed focus on this will only benefit businesses like Qinetiq. I notice that the company has an order book spanning hundreds of millions of dollars well into the future. This could support future growth and boost returns too.

Next, Qinetiq shares would boost my passive income stream through dividend payments. The current dividend yield on offer stands at just over 2%. This is higher than the FTSE 250 average of 1.9%. I am aware that dividends are never guaranteed and can be cancelled at any time, however.

Finally, I can see that Qinetiq has a good track record of performance. This is a plus point for me as positive performance underpins returns, although I am aware that past performance is not a guarantee of the future. Looking back, I can see it has grown revenue for the past four years in a row. Based on the current defence market and geopolitical landscape, I wouldn’t be surprised to see this trend continue, at least in the short-term.

I’m tempted to open a small position in Qinetiq shares. The FTSE 250 incumbent looks in a great position to benefit from a burgeoning market. Furthermore, the passive income opportunity is also enticing. What’s putting me off is its current valuation as well as the cyclical element of bullishness towards defence stocks.

Ultimately, I’ve decided against adding Qinetiq shares for my holdings. This is because I would prefer to buy BAE Systems shares instead if I’m buying a defence stock for my holdings. Its fundamentals look better and it is a firm with a larger profile and presence, in my opinion.

For the year to date, Euromoney Institutional Investors (LSE:ERM), Mediclinic International (LSE:MDC), and QinetiQ (LSE:QQ) lead the way in share price performance. While the way the shares move is obviously important, I want to delve deeper to understand what the driving forces are behind these moves.

Euromoney

Euromoney was subject to a takeover offer from a couple of private equity firms and the current offer on the table is equivalent to 1,461p per share. At the time of writing, the shares are trading at 1,314p.

The private equity companies seem keen to complete the takeover of Euromoney, a financial publishing firm, given that they’ve made four previous offers.

For the six months to 31 March, the company reported that revenue had increased by 14% year on year. Furthermore, adjusted pre-tax profit grew by 16% to £38.6m over the same time period. 

However, it’s still unclear how the economic environment and the war in Ukraine may impact the business, and whether these factors will lead to a fall in demand for services, which means this is a risk.  

Mediclinic

Like Euromoney, Mediclinic has also been subject to an offer from a consortium. The approach, worth somewhere in the region of £3.4bn, was rejected last month. Despite this, the takeover deadline has been extended, meaning that talks are still under way.

The shares are currently trading at 474p.

For the year ended March — which included some months when the effects of the pandemic were still visible — operating profit at the business surged 34% to £280m and revenue was above pre-pandemic levels. Of course, these figures make sense, given that there were likely increased levels of client demand during the pandemic.

However, with the worst of the Covid crisis behind us, it’s possible that results will not be as impressive in the future.

QinetiQ

Finally, the QinetiQ share price has performed well this year. The company – a defence specialist – has a strong forward order book to supply governments around the world with weapons and equipment.

Indeed, there has been heightened interest from investors due to the ongoing war in Ukraine and the shares are currently trading at 380p. 

The business had a net cash balance of £225m at the end of March, while it estimates that it will derive £900m in revenue from contracts due in 2023. 

However, while the company is in a healthy financial position, much of the share price performance of late has come from the fallout from the war in Ukraine. That conflict won’t last forever, and I wonder if an end to hostilities might result in the shares falling.

Overall, these three firms top the index for share price performance in 2022. But while they’re all attractive propositions, there are too many unknowns for my liking. Yet I won’t rule out purchases in the future, when things are a bit clearer.

Value and growth

With a market capitalisation of £1.89bn, this top UK defence tech firm is a manufacturer of autonomous robotic and integrated artificial intelligence surveillance systems, and has just achieved record order intake for the full year contributing to revenue of £1.278bn, equating to 19% growth in full year-on-year revenue. QinetiQ has also maintained dividends for the last 10 years, despite having to contend with supply chain headwinds and a shift of focus to renewed growth via acquisitions since 2016.

The company is mission-driven and has been involved in a range of projects that aim to reduce the need for fuel and assist in global ESG targets. Looking forward, the company expects to maintain its growth rate over the next five years by increasing market share in the UK, and crucially has set its sights on markets in the US and Australia.

QinetiQ appears to be on the right track to meet its ambitions, with the recent award of a framework U.S Department of Defence (DOD) BOA that could be worth up to $241m over five years. This contract — immediately after the news that it will play a central role in the Royal Navy’s £100m next-generation Electronic Warfare system — follows on from recent contracts and partnerships with US Army, European Space Agency, Australian Department of Defence and Australian Missile Corporation.

Currently, the QinetiQ Group share price has a lot of momentum behind it in the market and is up 36% from its annual low (trading at 326p) but is still trading below its pre-Covid range (18% off its all-time high of 396p), with a price-to-sales ratio below that of its peers on average and in a sector expected to grow at a compound annual growth rate of 26% up to 2025.

The company’s current addressable market is estimated to be in excess of £20bn and still offers a tremendous growth and value story for me, as it looks to retest and surpass its all-time highs in due course, in my humble opinion.

It is worth noting that any signs of a slowdown or decline in revenue growth would see these gains quickly reversed. Supply chain disturbances have certainly weighed on revenue in the past, and sustained disruptions may cause a rethink of valuations.

All things considered, it is clear to me that QinetiQ Group share price still has a lot of upside potential. I will be paying close attention to this company.

What are defence stocks?

A defence stock is simply a share of a company that provides some form of security product or service to military or law enforcement.

Often, the first thing that comes to mind when thinking about defence companies is design and manufacturing. Whether it’s weapons, vehicles or materials, cutting-edge products are often at the forefront of thinking about military businesses from an investment perspective.

But defence companies in the UK are much broader than just manufacturing. Weapons, vehicles and materials are certainly part of the story, but UK defence companies also provide other important services.

Some provide intelligence services that help make operators more efficient and more effective. Others provide training services to equip military personnel with the skills they need to stay up with the latest technological advances. And some are involved in cybersecurity, which are an increasingly important part of national security.

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Top defence stocks in the UK

Here are the top five UK defence stocks in order of highest market cap:

BAE Systems

BAE Systems is the UK’s largest defence contractor by market cap. The majority of the company’s revenue comes from its exposure to fighter jet programmes—most notably the F-35 Lightning and the Eurofighter Typhoon. BAE’s customers include governments in the US, UK, Australia and Saudi Arabia.

Rolls-Royce Group

Rolls-Royce Group manufactures jet engines. While the majority of the company’s revenue comes from its civil aerospace division, it also has a strong business focusing on defence contracts. Its engines are used in naval vessels, military transport and aircraft.

QinetiQ

QinetiQ is a military tech company. Its offerings to customers include products and services. Its products include advanced materials, human protection systems, and military robots. Its services include testing, evaluation and training. QinetiQ has both civilian and military exposure.

Babcock International

Babcock International specialises in the construction and decommission of nuclear power plants and submarines. It also offers fleet management services for military vehicles, provides technical training, and maintenance support for military infrastructure. Babcock’s client base is diversified across the UK, Europe, Africa, North America and Australia.

Serco Group

Serco Group provides base and operations management for the armed forces. It also undertakes projects in ship modernisation and aircraft maintenance. Serco also analyses cyber activity, and delivers training, strategy and leadership programmes.

How to invest in defence stocks

Here are five things to think about before investing in defence shares:

The outlook for defence spending

Defence companies sell their products and services to governments. As a result, the available market for defence companies depends on the size of military budgets.

So investors should think about what the future looks like for national spending in this area—whether governments are likely to ramp up military spending, or whether they’re likely to be looking to cut back.

One thing worth noting is that countries in the NATO alliance—including the UK and the USA—have commitments to spend at least 2% of GDP on defence. So military budgets for NATO countries are likely to expand and contract in line with GDP.

Contracts

The primary advantage a defence company has over the competition comes from contracts. These can typically last for decades and they can be nearly impossible for a competitor to disrupt. Whether it’s a contract to supply fighter jets, to maintain ships or to provide training to military personnel, contracts are an extremely important part of a defence company’s competitive advantage.

When thinking about buying defence shares, it’s important to know what contracts a company has, how much they’re worth and when they expire. It’s also worth thinking about how difficult it might be for a government to switch to a different provider once the current contract expires.

Risks

Even if a company has a contract in place, it can still run into difficulties. For a manufacturing company, this can come from an increase in the cost of raw materials or disruption to its supply chain. Service companies are somewhat better protected against the threat of raw material increases, but they need to be innovative enough to stay at the leading edge of technological advancements.

Capital structure

As with several companies, investors in defence stocks need to be aware of how efficiently the company generates cash. Two good metrics to use for this are Return on Equity (ROE) and Return on Invested Capital (ROIC).

ROE is the company’s net income divided by its shareholder equity and multiplied by 100 to give a percentage. In general, a ROE >20 is good and >30 is very good.

ROIC is the company’s net income as a percentage of the assets that it uses in its operations. A ROIC >10 is generally good and >20 is very good.

Defence companies often benefit from customers contributing to R&D costs, allowing them to make stronger returns on equity and invested capital.

Financial health

Lastly, investors thinking about buying shares in defence companies need to be aware of the company’s financial health. Two important metrics to consider here are Interest Coverage and Debt to EBITDA.

Interest Coverage measures the amount of interest that a company pays on its debt (found on the ‘interest expense’ line of the income statement) as a proportion of its operating income.

Net Debt to EBITDA measures the company’s short-term and long-term debt with cash subtracted as a proportion of the company’s earnings before non-cash charges (depreciation and amortization).

As a rule, it’s better for both numbers to be low. But more significant is how these numbers compare (a) to the company in previous years and (b) to the company’s competitors.

In general, it’s better to see a company reducing the amount of its operating earnings it spends on interest payments and the amount of debt it has relative to its cash earnings. And it’s also good to see that a company is in a strong position relative to its competitors in both cases.

Are defence shares right for you?

Investing in defence stocks can get pretty technical pretty quickly, and it can be easy to get blinded by the science. Naturally, military-grade technology is often at the cutting edge of innovation and can be inherently complicated and difficult to understand. The economics of businesses, however, can be fairly straightforward.

Defence companies that enjoy strong relationships with customers that have huge budgets can be an attractive proposition from an investment perspective. And there are plenty of accessible features for investors to fasten on to. Thinking about how long a company’s contract lasts, how strong its balance sheet is, and what sort of things might threaten its business can give investors a great way into investing in defence shares.

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The Qinetiq share price tumbles on trading update

In the words of management, the company has achieved “strong underlying operating performance” and “continued strategic momentum”. Looking at the initial numbers, I’m inclined to agree. Defence order intake reached £700m, roughly 25% higher than the first half of its 2021 fiscal year (from April 2020 to April 2021). This is largely thanks to securing new contracts with the US Army, the Australian Department of Defence, and the UK Ministry of Defence. As a result, revenue growth is estimated to be around 5% for its 2022 fiscal year.

Five percent hardly sound particularly exciting. But given that the defence industry average revenue growth rate is around 3.2%, that’s not bad, in my opinion. So why did the Qinetiq share price fall?

Despite the firm’s efforts to emphasise its progress, it seems investors were less than pleased to hear that supply chain disruptions are creating problems. The company is trying to find a quick solution. But it has warned that the situation may create a one-time £15m expense. Comparing that with last year’s operating income of £119m shows a potential 13% decline in underlying earnings. And to add fuel to the fire, the mission shift out of Afghanistan has resulted in operating profit margins coming in at the lower end of previously issued guidance, placing the margin around 11%.

Needless to say, that’s not good news. So, seeing such a sharp decline in the Qinetiq share price is hardly surprising.

Taking a step back

As frustrating as the situation is, supply chain disruptions are ultimately a short-term problem. And the adverse effects could be easily reversed in the future. How? Qinetiq’s US operations have been something of a disruptive force. And management is actively pursuing its goal of doubling the size of this division over the next five years through a mixture of both organic and acquisitive growth.

Meanwhile, the firm’s ability to continue securing new contracts worldwide serves as supporting evidence that demand isn’t going away. And with an estimated $20bn addressable market size, the long-term growth opportunities for Qinetiq and its share price seem plentiful. At least, that’s what I think.

The bottom line

All things considered, if I were a shareholder, I wouldn’t be too concerned about this trading update. However, is this a buying opportunity for me? Well, I’m not so sure. It’s hard to make an informed decision about the future of the Qinetiq share price without more data. And CEO Steve Wadey wasn’t particularly generous with details on the earnings call.

The company is planning to release its interim results on 11 November. So for now, I’m going to keep this business on my watchlist until I know more.

The news release spoke of a “strong underlying operating performance,” and an “excellent order intake at £700m, 25% higher than the first half of FY21.” But that didn’t protect the shares from the latest curse of supply chain problems.

The company said: “We are experiencing technical and supply chain issues on a large complex programme, which, if unmitigated, could result in the need for a one-off write down to our short-term guidance.” QinetiQ went on to say that it’s working towards “mitigating this risk to less than £15m.”

For a company with turnover last year of £1,278m, and a pre-tax profit of £124.7m, that doesn’t seem like too big a horror story to me. But these days, any mention of supply chain issues seems almost certain to send shareholders rushing for the exit. So has the reaction been overdone, and does it give me a buying opportunity for my Stocks and Shares ISA?

QinetiQ share price performance

Well, firstly, I need to put the QinetiQ share price fall into perspective. Essentially, what’s happened is that Thursday’s drop has wiped out the stock’s progress over the previous year. We’re now looking at a 12-month rise of just 4%, from the 20% gain the shares were at the day before.

Over five years, QinetiQ shares have gained 27%, a bit ahead of the FTSE 250’s 22%. Oh, and the FTSE 100 has managed just 2.8% in the same timescale. So we’re looking at a higher growth index, and a stock that’s above the index average. And that’s after Thursday’s surprise one-day slump.

But back to the trading update. To illustrate how it doesn’t seem to be too worried about the current problem, the company told us it’s maintaining its medium- to long-term guidance. QinetiQ is still targeting “mid-single digit percentage compound annual organic revenue growth over the next 5 years.” And maybe some extra growth should strategic acquisition opportunities come up.

Healthy cash situation

Operating cash flow was said to be good. And at 30 September, the balance sheet boasted approximately £140m in net cash. Never mind companies struggling to recover from the pandemic crisis under increased debt loads, this is what I like to see.

What’s the risk? Well, how often have we heard one warning like this and then been hit by further bad news later? Perhaps there are more supply chain problems hiding round the corner, ready to pounce on us as soon as we let down our guard.

I think suspicions like that could well explain the scale of Thursday’s QinetiQ share price drop. But isn’t this a good time to buy, when pessimism is high and shares are low? I think so.

70% growth

On 20 May, the group produced strong annual revenue numbers, delivering its fifth year of growth. Since 2016, it’s grown its revenue by 70%. During FY21 profit rose 14%, revenue 19% and earnings per share (EPS) increased 11%. Best of all, its orders rose 18% for its largest order intake in a decade. QinetiQ also reinstated its dividend.

Its tech capabilities reach across automation, AI, and robotics. As a recent example, QinetiQ transformed existing military vehicles into electrified hybrid tanks. This reduces the need for fuel in far-flung places and improves stealth. This is also helping with its ESG goals.

What does the future look like?

The company now has its sights set on growing another 70% in the next five years, with a particular focus on boosting its US presence. The US defence market is extensive but quite outdated and wants to modernise, so there’s a big opportunity there.

The company acquired MTEQ in December 2019. This is a leading US provider of advanced sensing solutions, giving military personnel an advantage in the field. QinetiQ hopes this acquisition will help it transition into a leader in robotics, autonomy and advanced sensing. But to reach its goals, the company plans still more acquisitions.

QinetiQ financials

QinetiQ is a £1.8bn company with a price-to-earnings ratio (P/E) of 15 and EPS are 21p. It also offers a dividend yield of 2%. In the past five years, the company share price has risen 41%, so it’s been a slow and steady increase, but there’s also been extreme volatility along the way. The QinetiQ share price is currently 14% below its pre-Covid highs.

It tends to fluctuate based on company news and to trundle along in between. I believe its share price will suffer if it doesn’t achieve the lofty targets it has set. On the other hand, if it can meet its growth targets then it stands to offer shareholders considerable upside.

The world is still a volatile and geopolitically sensitive place. I think this means there will be plenty of money being ploughed into defence in the coming years. Yet to achieve its ambitious goals, QinetiQ is going to need to win bigger, longer-length contracts and competition is fierce.

According to Statista, the global robotics industry is forecast to grow at a compound annual growth rate (CAGR) of 26% until 2025. Tech stocks, particularly in robotics and AI, were a big deal in 2020, but many have been over-hyped. With a P/E of 15, I don’t think that’s the case with QinetiQ.

Overall I think QinetiQ looks a good company. So would I buy? I’m tempted, as I like its prospects and dividend yield. But I already have shares in BAE, so to keep diversified I don’t plan to add another defence business to my Stocks and Shares ISA today. Nevertheless, I’ll keep it on my watch list.

The QinetiQ Group share price rose above 349p per share at one point in mid-week trade. While it’s settled back a tad, the FTSE 250 company remains 9% higher on the day at 348p.

Upgrading forecasts again

QinetiQ has performed quite robustly despite the pressures created by Covid-19. And the company’s update today shows that trading momentum has remained bubbly in recent months.

In fact, thanks to a “strong performance” during the fourth quarter of last year, QinetiQ said it expects full-year results “to be above our previous guidance and above market consensus expectations” for the period to March 2021.

This is not the first time the FTSE 250 firm has upgraded guidance in recent months. In its November half-year release QinetiQ said that revenues would rise by low double-digits for the full year. And they’d rise by low-to-mid single-digits on an organic basis. 

But today QinetiQ predicted it would deliver “high teens percentage revenue growth [and] high single-digit percentage revenue growth on an organic basis.” Furthermore, the UK defence share said that it expected underlying operating profit “to be modestly ahead” of that delivered in the first half. As a consequence full-year profit is tipped to clock in at £147m.

A FTSE 250 overachiever

QinetiQ explained that strong trading has been underpinned by “overachievement across the EMEA Services portfolio”. It explained that this helped to offset Covid-19 disruptions at its Global Products unit, which affected its Target Systems and United States operations.

QinetiQ also said that the sale of three businesses earlier in the year would help its full year. It added that this non-trading gain will be offset by “a goodwill impairment in our German business due to a more challenging business environment.”

In other news QinetiQ said that “good” operating cash flow helped it end the year with a strong balance sheet. This should show net cash of around £150m on 31 March, it added.

A bright future

QinetiQ is maintaining its goals for the medium-to-long term. And the FTSE 250 firm affirmed its target of “mid single-digit percentage compound annual organic revenue growth over the next five years.” It added that strategic acquisitions should further bolster this expected growth.

The engineer has retained its operating profit margin target of between 12% and 13%, too, it said. But it added that “increased investment [in] our digital transformation programme and the evolution of our business mix” would cause margins to fall around 100 basis points in the near term. The business has earmarked between £90m and £120m for the next two years as well.

After that, the share price kept on rising too, and it looked like I might have picked a good one. But that came to an abrupt end in February when Covid-19 arrived. In 2020 so far, QinetiQ shares are down 22%, in line with the FTSE 250. But how is business actually doing?

According to a first-half trading update Wednesday, the company enjoyed a strong second-half performance. The firm said “Our focus on recovery delivered good revenue and profit performance during the second quarter resulting in us finishing close to our original targets, despite Covid-19 impact in the first quarter“.

Dividends are back

Cash performance was also described as strong, and QinetiQ says it is now focusing on driving sustainable growth. The company suspended its 2019 final dividend when the lockdown began. But it’s really only been delayed, as QinetiQ is set to pay an extra 4.4p dividend as a replacement.

QinetiQ shares are now on forward price-to-earnings multiples of around 14, which is approaching the FTSE 250 average. It’s a company with defensive investment characteristics, a record of solid cash generation, and what I see as excellent long-term dividend prospects. I rate it a buy, at a bargain price today.

FTSE 250 winner

Investment firm 3i Infrastructure (LSE: 3IN) is unusual among FTSE 250 stocks in 2020. Its share price has held up. Well, it’s down 2% since the start of the year, which is perhaps not technically winning. But compared to an index that has lost a fifth of its value, I say it’s a winner.

3i puts its cash in infrastructure assets, and its performance in this Covid-19 year looks resilient. I’m really not surprised the shares have trounced the FTSE 250 so far.

In an interim update Wednesday, the company said: “Most portfolio companies have met or exceeded the expectations we set at the start of the period“.

Some valuations will still suffer from the pandemic effects. But total portfolio income and non-income cash reached £47m, not far down from £57m in the same period last year. Liquidity looks very strong, with a cash balance of £361m at 29 September. The firm also still has its full revolving credit facility of £300m available.

Income attraction

I’m looking for dividends, and 3i’s has been progressive in recent years. The company says it is on track to pay its planned 9.8p per share, for a rise of 6.5% on last year. For a FTSE 250 growth stock, that’s impressive.

We have an investment firm concentrating on what I think are attractive assets. It’s generating cash strongly, and its dividends are growing faster than inflation. The forecast yield for this year stands at 3.4%. There are bigger ones out there, but the strongly progressive outlook for 3i’s dividend attracts me. I’d buy.