Portfolio protection in event of war

GEORGE Bush's determination to unseat Saddam Hussein has huge implications for stock market investors. Whether or not the US unleashes a new offensive against Iraq, some City experts are already putting their portfolios on a war footing.

War and its knock-on to the oil price would claim some obvious early victims. Airlines such as BA and tour operators such as First Choice would suffer. But what about the stock market winners?

It is a scenario that has not escaped arguably the UK's shrewdest fund manager. John Dodd, manager of the Artemis Smaller Companies unit trust, has loaded his portfolio with niche defence firms and oil exploration outfits.

Given that his fund has powered ahead 129% in three years when the FTSE All-Share fell 28%, beating rival funds and unit trusts from any sector, his backing of companies such as Premier Oil and defence group Chemring has been closely watched in the City.

'I'm not saying I think war is definitely on the cards,' says Dodd. 'But these stocks will still do well if people think there will be.'

The theory is that war would hit oil supplies and push up the price of crude. Because oil companies' profits are dependent on the oil price, the two tend to move in tandem. So the prices of BP and Shell could push higher. Smaller stocks are riskier but offer higher potential returns. The Artemis fund has filled up on Premier Oil and Ramco Energy.

However, tapping alternative oil supplies - in Russia and Nigeria for example – could limit a price rise. America has also been quietly stockpiling oil. It aims to store enough for about 100 days. And if war is averted, the release of this store could push down prices and oil share prices would follow.

Investors should tread warily with defence stocks: the UK's largest defence companies also have civilian exposure. BAE Systems makes parts for military aircraft but also owns 20% of civilian aeroplane maker Airbus. And the civils business would take a knock should war break out. Smiths Group is also split between making parts for civilian and military aircraft. Rolls-Royce makes engines for airlines and air forces.

'BAE is the closest of the two as a pure military play,' says John Middleton, an aerospace analyst at broker ABN Amro. Investors could look among smaller firms for a 'purer play'. Middleton says focus on firms that produce 'expendable' hardware: the military happily sends in and re-order missiles, but it is more reluctant to risk jets.

Meggitt, which makes cockpits and electronics systems, also makes chaff, decoys strewn out of jets to throw homing missiles off the scent. Chaff made by Chemring has already been used over Afghanistan and Iraq.

Ultra Electronics is a niche operator in navy sonar. Its selling point is that a large chunk of its orders are from the US.

Another play is Alvis, which makes armoured cars and recently bought tank builder Vickers. 'It's not the most exciting company in the world but it has very reliable earnings,' says Artemis' Dodd.

Chemring and Ultra are among the top ten holdings in Dodd's fund, as are Premier Oil and Ramco. He also holds Alvis.

Warship builder Vosper Thornycroft is another option, although it is moving more towards support services. Carl Stick, manager of the strong performing Rathbone Income and Special Situations funds, recently stocked up on Vosper and Smiths.

But conflict would clip the wings of the airline sector. Wary customers would stay away and higher oil prices would mean higher fuel costs - a combination that would hammer profits and stock prices. BA, already in the doldrums after 11 September, would be hit particularly hard because of its dependence on transatlantic traffic.

Long-haul tour operators such as First Choice and My Travel, airports operator BAA and hotel chains such as Hilton Group would also feel the pinch.

But budget airline shares could gain, as they did after 11 September, with holidaymakers preferring to stay closer to home. EasyJet rallied 60% in the sixth months after the stock market lows that followed the World Trade Centre attacks and Ryanair leapt 48%. That compares with a mere 17% rise in the FTSE 100.

There are also wider themes to follow. John Hatherly, head of global analysis at fund manager M&G, fears war could worsen the global recession. 'It could be the straw that breaks the camel's back,' he says. Move into safer share sectors, such as oil and gold, he advises. Other 'defensive' sectors include tobacco and food producers.

Khuram Chaudhry, strategist at Merrill Lynch, says consumer confidence would also be hit, knocking the shares of retailers and house-builders. But he warns against predicting events. He says: 'Stock markets are very good at pricing in economic data but haven't got a clue about politics.' History also tells a tale. Shares rallied after the Gulf War of 1990/91 before higher oil prices deepened the slump.