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Buy defense for the long term, not a short war
Even after its impressive run-up, the defense sector remains poised for consistent growth. Here are the stocks you should consider buying now.
By Michael Brush
With the country threatening Iraq and defense stocks down sharply, many investors are whispering that its time to scoop up shares of the weapons makers.
Its hard to decide whether their thinking is more flawed or crass. But at least it gets them to the right place to make money. For this really is a good time to own defense stocks.
Ironically, a brief war with Iraq wont directly boost these companies because its unlikely to use enough weapons and equipment to make a difference. But take a step back and look at the big picture, and youll notice Washington, D.C., is gearing up for the biggest military shopping spree in almost 20 years.
The binge will increase spending on weapons by a massive 35% over the next five years to counteract years of defense cuts under President Clinton.
This should translate to an average of 10% to 15% in annual earnings growth for big-name defense contractors such as General Dynamics (GD, news, msgs) and Northrop Grumman (NOC, news, msgs), as well as for lesser-known companies such as Engineered Support Systems (EASI, news, msgs), Moog (MOG.A, news, msgs) and others well get to in a moment.
Replenishment and refurbishment
The procurement budget has been massively underfunded, and you can only eat your seed corn for so long, says Andy Laperriere, who tracks defense spending at the Washington, D.C.,-based International Strategy and Investment.
Regardless of whether we have a war with Iraq, we need to refurbish our armed forces, says aerospace and defense analyst Paul Nisbet of JSA Research. We need to replenish spare parts and ordnance, whose inventories have been worked way down over the years.
This source of demand, plus new worries about security in the age of terrorism, help explain why defense spending is slated to reach $451 billion by 2007, from $334 billion in 2002. Those are levels not seen since the Reagan military-spending bonanza in the 1980s. Much of the increase is for procurement and research and development, which directly benefits defense contractors.
Volatility ahead
Despite the writing on the wall about the long-term trends, many investors will be selling defense stocks, and potentially heightening volatility, over the next few months for two reasons.
First, if war breaks out with Iraq, defense shares could move lower because they often fall after a conflict begins and traders move out. Next, some investors will sell defense shares whenever signs of economic strength crop up. Theyll be freeing up funds to buy more cyclical stocks with better exposure to economic growth.
In either case, long-term investors should take advantage of the weakness to buy defense companies, JSAs Nisbet is telling his clients. Defense spending goes through long cycles, and we are just at the beginning, he says. Unless there is a regime change in Washington, we will see a long period of strong defense spending.
Indeed, defense-spending cycles are so long -- about 10 years -- that investors tend to forget the lessons learned the last time around. As a veteran defense analyst who has watched the sector for more than four decades, Nisbet is a good person to fill you in on the pitfalls. Basically, Wall Street worries too much about valuations and how long the strength in defense shares can last.
Investors often underestimate the power behind the momentum that gets this thing going, says Nisbet. So analysts are continually saying: These stocks are overbought and overpriced. And sure enough, five years later, they have doubled. What other group can you look at that is likely to have double-digit earnings growth for the next five years? There are darn few.
Michael Kennedy, a portfolio manager at American Express AXP Stock fund (INSTX), is one buy-side analyst who doesnt plan to abandon positions in defense plays Lockheed Martin (LMT, news, msgs), Northrup Grumman and Raytheon to raise money for growth stocks. I am a believer of the economic recovery, but I think the recovery will be very slow and muted because of consumer weakness, he says. Besides, these are growth stocks, too. These trends are very identifiable and they wont go away.
Heres a brief look at some of the major defense spending themes and which companies will benefit.
A lighter, more mobile military
To fight in the new regional conflicts and counter-terrorist strikes ahead, the military is turning from bulky arms like the 155-millimeter howitzer to lighter, remote-controlled weaponry. Its a transformation that promises decades of fresh, tech-rich spending initiatives from the Pentagon.
But dont get fooled into thinking the shift to high-tech gadgetry means investors have to figure out a new generation of tech firms and start-ups that have been strangers to defense work. Most of the new business will be grabbed by the old names.
After all, they know the ropes at the Defense Department, and they can develop or buy the technologies they need. Outsiders may have the know-how, but newcomers tend to get frustrated with the drawn-out government bidding process and back away, says Jon Kutler, president of Quarterdeck Investment Partners, an investment bank that specializes in aerospace and defense.
A team from General Dynamics and General Motors (GM, news, msgs), for example, is developing more-agile combat vehicles. Boeing (BA, news, msgs) is the prime contractor for the Future Combat System vehicles, which will roll out later this decade. Other firms that stand to benefit include Engineered Support Systems, which makes battlefield and logistics gear, including biohazard shelters and surveillance gear, and FLIR Systems (FLIR, news, msgs), which specializes in night-vision technology.
Theres a growing emphasis, of course, on so-called smart weapons. An example: remotely-operated, satellite-guided missiles that can hit targets with pinpoint accuracy. These smart weapons accounted for just 10% of the firepower used in the Gulf War, but 40% of that deployed in Afghanistan. In the next war, it will be 80%, says Nisbet. Besides the missiles, the armed forces need secure communications gear to link it all together. Defense contractors that will benefit here include -- you guessed it -- big, existing contractors such as Northrop Grumman, Raytheon and Lockheed Martin.
For all the talk about drones operated by remote control, we only have a handful of unmanned aerial vehicles like the Global Hawk, which is made by Northrop Grumman. But the money is pouring in, and they are going to proliferate over time, says Nisbet. He says Northrop Grumman will get the lions share of the spending. Mercury Computer Systems (MRCY, news, msgs) should benefit as well since it makes parts of the navigation systems.
Big-ticket items
With all the focus on the high-tech gadgetry, you might think that a move away from ships and planes would be coming. Not so, says Nisbet. The government plans to double shipbuilding over the next five years, for example, in a spending plan that includes the launch of a new family of warships called the DD-X. Thatll be a big plus for General Dynamics and Northrop Grumman, two of the prime shipbuilding contractors.
More-advanced planes such as the F-22, the Joint Strike Fighter and the C-17 cargo aircraft will be rolling out for years, a boost for Lockheed Martin and Boeing. Meanwhile, partners like Moog, EDO Corp. (EDO, news, msgs) and DRS Technologies (DRS, news, msgs) will benefit because they make electronic components and parts used in planes, boats and other military gear, says Nisbet.
Missile defense
Despite claims for years that it would be impossible, defense specialists have successfully tested Star Wars-style missile intercepts like those first proposed by President Reagan.
Using radar guidance from ships and satellites, researchers have shot down missiles moving at 15,000 miles per hour -- pretty impressive. Detractors say the tests still dont imitate what would happen in a real-world strike, and some defense analysts think this program could get cut back.
But as long as it looks as if North Korea and Iraq may have the ability to launch nuclear or chemical strikes on the United States and the current administration is in office, spending on missile defense will continue, says Nisbet. It is a reality as long as we dont have a change in the White House.
The country now spends about $8 billion a year on missile defense research, around twice as much as a few years ago. Companies picking up the contracts are Boeing, Raytheon, Lockheed Martin, TRW Inc. (TRW, news, msgs) and Orbital Sciences (ORB, news, msgs), which produces the missiles used as targets and the booster systems used by defense missiles.
Homeland Security
Since U.S. enemies have successfully brought a battle to U.S. soil -- and will likely do so again -- a defense-sector portfolio could also include the likes of OSI Systems (OSIS, news, msgs) and American Science and Engineering (ASE, news, msgs), which make equipment used to scan luggage and cargo containers at ports. The potential market is big because systems still only scan about 2% of the cargo moving into this country, says Brian Ruttenbur, who follows the group for Morgan Keegan, the Memphis brokerage.
Other homeland defense companies include Identix (IDNX, news, msgs), which makes fingerprint and facial recognition technology, CompuDyne (CDCY, news, msgs) which makes blastproof doors and windows, and SureBeam (SURE, news, msgs), which makes food sterilization systems used by the military, says Scott Larson, an assistant professor at National-Louis University in Evanston, Ill., who follows defense stocks. Many of these stocks have come down recently as long-awaited contracts have been delayed.
What if the expected increases in spending never materialize? Thats a risk for all of the defense-related stocks. Suppose a foray into Iraq spreads through the region and alienates our allies there so much that they cut off purchases from U.S. defense companies. Or what if world peace breaks out following some horrifying turn of events in a conflict -- like full-scale nuclear battle?
These scenarios may sound farfetched. But in war, as in the markets and life, its often the unexpected that gets you.
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