Stock market valuations are usually wrong. Just because a company’s shares have risen significantly does not necessarily mean it is an attractive or sound business. It simply means it is popular among investors at that particular moment in time. Likewise, stocks that have fallen heavily in price are not necessarily low-quality companies. They are in fact just unpopular among the investment herd at a specific point in time.

Of course, there is some connection between a company’s intrinsic value and its share price. In many cases, though, this is very limited. Since investors are highly emotional beings, they nearly always overreact to good and bad financial performance. This means they routinely overestimate or underestimate company prospects, which provides so-called value investors with ongoing, and often significant, buying opportunities.

The share price performance of defence firm Chemring is a case in point.

When Questor first recommended its purchase in June 2019, the company’s share price had fallen by almost 75pc in the preceding nine years. While a decline in its market valuation was undoubtedly warranted – due to a disappointing financial performance, equipment failure and safety issues – investors overreacted and failed to identify that the company still had a solid balance sheet, a sound competitive position and long-term growth potential across key parts of its business.

As a result, the company’s share price has risen by 120pc since our original recommendation. It has outperformed the FTSE 100 index by 111 percentage points and beaten the FTSE 250 index by 116 percentage points. Yet, in Questor’s view, the stock market continues to undervalue the firm.

The prospects for the defence industry in which it operates have materially changed since Russia’s full-scale invasion of Ukraine in February 2022. In that year, just seven out of 30 NATO members met a target to spend 2pc of GDP on defence. This year, that figure is expected to rise to 18. And among Nato’s European members, the proportion of GDP spent on the military is forecast to increase from an average of 1.7pc in 2022 to 2pc in the current year.

This represents an increase of 18pc in just two years, with the overall rise likely to be even higher due to ongoing economic growth. Indeed, the prospect of falling inflation and interest rate cuts over the coming years means that the outlook for global economic growth is likely to improve. Given that military spending is closely linked to economic activity levels, this could act as a further catalyst for the defence industry. In addition, the prospect of a Trump presidency could further boost military spending among Nato members that have routinely missed the 2pc spending target.

As well as benefiting from an improving industry outlook, Chemring remains a high-quality business. Its net gearing ratio of just 4pc and net interest cover of 53 show that it has a solid financial platform. Meanwhile, a return on equity of more than 14pc last year, despite minimal debt levels, highlights its strong competitive position across a range of niche products.

Encouragingly, the company is on track to meet financial guidance for the current financial year in spite of unfavourable weather conditions at some of its manufacturing sites. Its order book now stands at almost £1bn, having increased by more than 50pc in the past 12 months. With a forecast improvement in profitability and strong cash flow, it has the financial capacity to not only invest for long-term growth but also to engage in a £50m share buyback programme.

This seems to be a sensible move while its shares continue to trade at an attractive level. They currently have a price-to-earnings ratio of around 18.8, which suggests they offer good value for money given the long-term growth prospects of the defence sector. 

Of course, Chemring does not offer the same scope for capital growth as it did at the time of our original tip. Then, it was grossly undervalued following several years of share price decline due to investors being overly pessimistic and failing to look beyond the firm’s short-term challenges. 

However, given that it still offers a margin of safety and remains a high-quality business with drastically improved growth potential as defence spending rises, it continues to merit long-term investment.

Questor says: buy

Ticker: CHG

Share price at close: 375p

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