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A short list of war stocks to go long on
After a steep run-up following the 2001 terror attacks, defense stocks have returned to earth and now sport attractive valuations. Still, not all defense stocks are slam dunks.
By Jon D. Markman
Defense stocks dramatically underperformed the broad market over the first three months of this year, as investors apparently bet that a short war in Iraq would usher in a period of Pax Americana punctuated by the construction of a gourmet coffee shop on every Baghdad street corner.
While Pentagon contractor General Dynamics (GD, news, msgs) fell 30% over the first quarter, shares of Starbucks (SBUX, news, msgs) rose by the same amount.
Now that a quick-war scenario is cooling faster than an iced frappuccino, it looks like the prospects for defense stocks might be revving back up. In the past two weeks, Lockheed Martin (LMT, news, msgs) and L-3 Communications (LLL, news, msgs) have advanced more than 15% and appear poised to extend their gains; General Dynamics, Boeing (BA, news, msgs) and Raytheon (RTN, news, msgs) are still stuck in low gear in large part because of continued trouble at their commercial aviation divisions.
This nuanced response makes sense, as investors appear to be finally discriminating between successful contractors and those for whom troubles continue to lie ahead.
Look beyond the war news
Lets take Raytheon as an example of the latter. On Monday, the Pentagon said it had already fired 700 Tomahawk cruise missiles, which are made by a Raytheon unit in Arizona. Independent analysts believe that this number represents 25% of the U.S. inventory of these precision-guided weapons. One might naively think this represents an opportunity for Raytheon, since it would seem the company would be tapped to fire up the assembly line and deliver a few hundred more.
Theres just one problem. The program to build the latest Tomahawk Block 3 missiles ended in 1999. Raytheon cant make any more. Raytheon spokeswoman Jennifer Allen told me Monday the company is currently under contract to convert 467 older Block 2 Tomahawks into Block 3s -- essentially by adding GPS gear to its steering mechanism -- but the procedure takes a long time, as much as 12 months per missile.
The next cruise-missile program on Raytheons dance card is the Tactical Tomahawk, but the company has an order for only 167 of those and the final delivery date is two years out, in 2005.
The Tomahawk deficit shows why investing in the defense sector is all about long-term U.S. Department of Defense planning, not the immediate restocking of armaments. And those plans are still bullish for stronger defense contractors. The amount of money at stake for the entire group is mind-numbing. The president requested $53.4 billion for the Defense Department alone for the next six months if the war is swift and decisive. The presidents war sup -- the supplemental request for fighting in Iraq -- specifically requests $3.7 billion to replenish munitions. At the wartime spending pace of an estimated $400 million a week, its easy to see how the Pentagon could burn through that quickly. Lehman Bros. analysts estimate that this figure alone -- and mind you, the number may well rise -- should pay for a boost in demand for munitions to nearly a 10% annual run rate of growth for the 2003 fiscal year from 7%.
In other words, sustainable increases in military budgets already approved are expected to give defense companies growth in the high single-digits. A long conflict could potentially boost that figure into the low double-digits, which is much more than you can say is in the bank for virtually any other industry in the country.
Raytheon makes an imperfect defense play because its management continues to pay for a series of misguided decisions to diversify into civil engineering and commercial aviation a few years back. As a result, its shares have fallen to the mid-$20s from the $70s in the past two years. Now cheaper, but by no means a rock-bottom bargain, Raytheon could be one of the beneficiaries of a longer, costlier, uglier war, many investment managers are claiming, but other stocks are more interesting.
Defense names to watch
While defense stocks as a group became wildly overpriced as momentum plays in the wake of the Sept. 11 terror attacks, most have fallen now to the point that they are attractive to both growth and value investors. Strictly on a valuation basis, Lehman Bros. prefers L-3 Communications, makers of specialized avionics and satellite communications systems, and United Defense Industries (UDI, news, msgs), maker of the Bradley armored infantry vehicle, as well as assorted missile launchers and artillery systems. Both have price-to-sales ratios well below 1.0 and below their peers. However, its likely that if investors decide to take up this theme they will lift all boats, so to speak, and that means the more liquid stocks of Northrop Grumman (NOC, news, msgs) and Lockheed Martin will become the investment of choice for large funds.
Paul Nisbet, veteran aerospace and defense analyst at JSA Research in Rhode Island, likes those four as well, but adds General Dynamics to his list. He believes it is the cheapest of the group and has been unduly punished for setbacks at its Gulfstream business jet division.
As a more speculative play, he also put Boeing on his buy list last week as it declined to seven-year lows, suggesting new shareholders are paying nothing for its commercial airliner business.
What could go wrong this time? First, the trading patterns for all these stocks are awful and suggest a secular decline. Though technical patterns are less than half the story, nearly all have made lower highs and lower lows in the past year. If the war does end quickly, after all, then the theme of a recovering economy is likely to quickly overshadow the theme of defense spending. Shares of companies like Northrop Grumman are probably not going to outpace the shares of economically sensitive companies like chipmaker Intel (INTC, news, msgs) or chemical maker Du Pont (DD, news, msgs) in that scenario, as the desire to hide in safe moderate-growth stocks is overwhelmed by the desire to speculate on high-growth stocks. And then theres the morality issue. If the public, and money managers, shift from appreciation to repugnance with the war, their hearts and emotions may temper investment enthusiasm and logic.
Safian bullish on growth no matter the war's outcome
One analyst who thinks that all growth stocks are already undervalued enough, no matter what happens in the war, is the indefatigable Ken Safian. A private fund manager, researcher and observer of equities whose career spans back to the bull and bear phases of the Vietnam War in the early 1960s, he told me last week that he believes virtually all possible bad news is already discounted into stocks and that therefore prices are likely much closer to a trough than a peak.
Safian shares my distaste for the construction and management of the S&P 500 Index ($INX), but he has gone much further and actually created his own rival index. His traditional growth index, available only to his Safian Investment Research subscribers for the past two decades, holds stocks in proportion to their sector weights in the U.S. economy. The list rarely changes. That contrasts with the S&Ps index, which holds stocks in proportion to their sectors market capitalization and changes rather frequently with shifts in market momentum.
Investors who believe the market is currently overvalued based on historical price-to-earnings ratios of the S&P 500, Safian declares, are out to lunch. Based on proprietary metrics that roughly relate stocks earnings yield to the T-bill yield, he claims that valuations for the average non-cyclical growth company, e.g. drug-makers and food makers, have not been so attractive since the late 1950s and are lower than at every major trough in the past 40 years. The bottom line is that the market is not as expensive as people think it is, and it has discounted worse things to come, he said. If much worse things come, then we need to reappraise whether prices were fully discounted today. But for now, I dont think the downside danger is extreme.
Safian, who was highly skeptical on stocks during the late 1990s, sees the potential for a 10% to 15% move up from here over the rest of the year, and for large swings within the range of those highs and the October 2002 lows. In the expected economic scenario, he likes the prospects for industrial companies with a technological edge. He singles out tractor maker Caterpillar (CAT, news, msgs) as a potential strong long position because it has made strides with a new, low-pollution diesel engine and has little significant price competition from overseas. He also likes Praxair (PX, news, msgs) and Air Products and Chemicals (APD, news, msgs), which provide specialty gasses to industry.
Fine Print
To learn more about the Tomahawk program, visit this page. To learn about the next-generation cruise missile that Lockheed Martin is developing, the Joint Air-to-Surface Standoff Missile, or JASSM, visit this page. One interesting thing about Tomahawks is that they travel so far that they carry a lot more fuel than warhead. The bomb itself is only 1,000 pounds. To learn more about the Gulfstream line of business jets from General Dynamics, click here. To learn more about Safian Investment Research, visit its Web site. Readers were mixed on my negative assessment of Hewlett-Packard (HPQ, news, msgs) last week. Said an anonymous HP bull: Just read your column and I must say it is the most biased by far that I have ever had the opportunity to review. Please tell me in a factual reason why the stock should not rise to its former level and even higher. Said John Quarles, a bear: I enjoyed reading your article; it's taken the investment community way too long to recognize the issues you outlined. HPQ is dead (unless) it can invent the next new thing. This hasn't happened in any of their business, even in their crown-jewel Intellectual Property Group. Digital cameras is a great example of a lost opportunity, where HPQ was an early leader, and is now an also-ran. I expect the same with printers.
Jon D. Markman is senior investment strategist and portfolio manager at Pinnacle Investment Advisors. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at supermodels@jonmark.com. At the time of publication, his fund held no positions in any of the named securities, but positions can change at any time.
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