Equity investors looking to profit from Japan’s move away from pacifism might find that easier said than done.

A gauge of defense stocks compiled by Goldman Sachs Group Inc. fell 12 percent this year through last week, trailing the Topix index’s 3.3 percent gain even as Prime Minister Shinzo Abe succeeded in passing controversial bills that expand the role of the military. The two Japanese companies that get the most revenue from defense ministry contracts — Mitsubishi Heavy Industries Ltd. and Kawasaki Heavy Industries Ltd. — also make 17 percent of their sales in other parts of Asia, where economic growth is slowing. They’ve lost $5.4 billion (¥648 billion) in market value this year.

Abe’s security push has become his most divisive policy, with thousands protesting in Tokyo and politicians scuffling in the Diet over the bills before they passed on Sept. 19. Still, Goldman Sachs’s Kathy Matsui is sticking with her bullish call on the shares, saying they’re a good bet over the longer term as regional strains make a bigger role for Japan’s military inevitable.

“Geopolitical tensions in the region are unlikely to disappear anytime soon,” said Matsui, vice chairman and chief equity Japan strategist at Goldman Sachs in Tokyo. “Clearly the U.S. wants Japan to contribute more to stability and peace.”

Abe has relaxed a long-held ban on arms exports, boosted the defense budget to a record and plans to start an agency to promote the development and acquisition of weapons. For Matsui, Japan’s focus on revamping the military and bolstering the defense industry is more than a fad that will disappear when he leaves office.

Goldman Sachs has been pushing defense stocks for more than a year, creating an index of 20 Japanese companies for investors to track in August 2014. In January, the bank picked defense as one of its top long-term themes for Japan investments.

Stock picking

Abe’s policy efforts haven’t been fruitful ground for stock pickers so far: Goldman’s index lagged the broader market by 8.2 percentage points through Friday since the Liberal Democratic Party won a landslide election victory in late 2012. That’s because emerging-market growth concerns are weighing on the gauge’s biggest members, such as Mitsubishi Heavy and Kawasaki Heavy, which rely more on industries other than defense, Matsui said.

The stocks are “selling off with the rest of the market,” said Matsui. “Being selective and picking up more of the pure plays in the basket is probably an interesting idea.”

Shimadzu Corp., an aircraft-equipment maker, and Japan Aviation Electronics Industry Ltd. gained more than twice as much as the Topix since Abe’s party came to power. Shinmaywa Industries Ltd., which provides and maintains rescue aircraft, is ahead by 45 points.

Japan has focused on its air forces, expanding bases in and around the Okinawan islands. Amid the territorial disputes with China and fraught ties with Russia, Japanese fighter jets scrambled against approaching foreign aircraft almost as many times in the year though March as at the peak of the Cold War.

With China steadily asserting itself throughout the region, including an island dispute with Japan in 2012 and maritime territorial clashes with Vietnam last year, Asian nations will need to boost military budgets in coming years, Matsui said.

More competitive

If Japanese companies “can jointly develop with other countries, exporting more and doing more together, that will allow the Japanese defense industry overall to become more competitive over time,” she said.

Abe met with Vietnamese Communist Party General Secretary Nguyen Phu Tron this month, agreeing to supply the Vietnamese coast guard with patrol boats and equipment. Asian and Oceanic nations, including Japan, spent $423 billion on defense last year, according to the Stockholm International Peace Research Institute. That was 5 percent more than 2013, the fastest growth among all regions except Africa, according to the figures, which are indexed to prices and exchange rates from 2011.

The defense ministry is asking for a record ¥5.09 trillion budget for the year through March 2017, according to a document obtained by Bloomberg. That would be 9.5 percent higher than the fiscal year that began before Abe took the reins.

Mitsubishi Heavy won 213 deals worth ¥263.2 billion from the Defense Ministry in the year through March, according to government figures. That’s 6.6 percent of the company’s revenue for the period. Kawasaki Heavy ranked second, with ¥191.3 billion of contracts, or 13 percent of total sales. Both firms stand to gain should they win the contract to helm a project to supply submarines to Australia, which the government says will be worth 50 billion Australian dollars ($36 billion) over its life. A decision is expected by the end of this year.

Broader economy

Shares of Mitsubishi Heavy lost 1.86 percent in Tokyo on Monday, while Kawasaki Heavy dropped 2.79 percent.

Some analysts say extra military spending could ripple through the broader economy. Japan spent 1 percent of last year’s GDP on defense, below the global average of 2.2 percent, according to the World Bank.

“Japan’s defense industry is shaped like a pyramid, with Kawasaki Heavy and Mitsubishi Heavy on top,” said Hiroyasu Nishikawa, an equity analyst at Iwai Cosmo Securities Co. in Tokyo. “With 2,500 companies in aerospace alone, the effects could gradually trickle down and become a plus to the domestic economic recovery.”

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