2 stocks with terrifying pension deficits

Who doesn't enjoy a scary tale on Halloween? Well, investors in defence giant BAE Systems(LSE: BA) and global security specialist G4S(LSE: GFS) might not want to read on. Both are near the top of the league when it comes to which listed UK companies have the largest pension deficits relative to their market capitalisations (40% and 17% respectively).

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Large pension liabilities can be a serious headache for board members but they can be even worse for business owners. So, is it time for holders to look for opportunities elsewhere?

What's not to like?

At face value, there's much to like about both companies. BAE's recent trading update was upbeat, suggesting that the outlook for 2016 remained unchanged with earnings per share expected to be roughly 5-10% higher than last year. After a torrid 18 months, G4S also pleased the market when it reported a 5.1% rise in revenue and 13% increase in earnings in its latest set of results. Although, admittedly, some of the recent performance may be down to the post-referendum bounce experienced by markets, these developments have done their share prices no harm at all. BAE is up 16% since June. Shares in G4S have climbed by 35%.

The future for both companies also looks positive when events across the pond are taken into account. Regardless of who wins next month's US election, both Trump and Clinton are likely to be sympathetic to the idea of increasing defence and security spending further, especially in the wake of recent terrorist incidents. Should Trump somehow get the keys to the White House and implement his policies on immigration, private security companies like G4S could benefit substantially.

Finally, there's the attractive valuations and dividends on offer. Shares in BAE and G4S both currently trade on reasonable forecast price-to-earnings (P/E) ratios of around 13. The former's shares come with a forecast yield of just over 4%, easily covered by earnings. Holders of G4S can expect to receive a yield of just below 4.5%, again easily covered. Or can they?

Dark clouds ahead

Thanks to a combination of falling bond yields and low interest rates, many of the strategies pursued by pension funds simply aren't working. Unless both companies prioritise tackling their deficits, this could mean that many employees won't get the pension they were hoping for. To rectify this, BAE and G4S will need to think hard about how the cash on their books is utilised.

As investors in supermarkets and mining companies will attest, dividends are often the first things to be sacrificed by a business in a crisis. This may be acceptable if you intend to retain the shares for many years; not so good if you have a large holding and rely on the income those shares generate. As far as G4S and BAE are concerned, the size of the yields they offer may also blind investors to the fact that neither is growing particularly fast (increases of just 1.24% for G4S and 2.3% for BAE in 2016).

Sadly, cutting their dividends may not be enough. These companies may also need to reduce their capital expenditure, thus impacting on growth prospects. If the situation becomes truly desperate, parts of either business could be sold and/or their pension funds may adopt less risk-averse strategies (which could backfire if markets slump).

The question for investors is whether it's worth sticking around to find out.

Too much trouble?

Whether BAE and G4S are able to plug their pension deficits without resorting to drastic measures remains to be seen. Despite the possibility of their share prices rising further in the near future, I'm inclined to suggest that investors should move on, at least until there's clear evidence that this issue is being addressed in a meaningful way.

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Paul Summers has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.