Defense Sector: Locked, Loaded and Ready to Go
Take what you’ve heard about the effects of a Barack Obama U.S. Presidency… and throw it away. The defense contractors are in the best spot that I have seen them in years, yet still-cautious investors are making all the wrong moves. The recent turmoil in the sector has led to some unbelievable valuations in the face of a global arms race, a continued surge in national security spending and regional conflicts that should continue to form opportunities for all of the major defense names.
Looking at a Year-to-Date comparison between the S&P 500 Index (SPY) and the SPADE Defense Index yields a difference of about 6%, in favor of the S&P. Why? Investors have historically flocked to the defense names because of their steady and weather-resistant revenue streams during hard times. We are actually in a war. Yes, in a war. Also, we get news every day of events like the Mumbai attacks, which should naturally support a defensive thesis, as it did post-9/11. As big-name contractors like General Dynamics (GD) and Raytheon (RTN) continue to produce estimate-topping earnings numbers, while raising guidance (despite big headwinds), the market has largely ignored their success… and I believe it’s time for a pop.
The U.S. Defense Budget - Why it WON’T be Taking a Hit
One of the primary reasons that investors are trading away from the defense sector is the uncertainty in the United States’ defense budget. The 2009 fiscal year budget for the Department of Defense (DoD) has already been signed in by President Bush at $615.5 billion, including stipends for Iraq and Afghanistan. Let’s hear from the two fears that stem from this budget:
1. Liberal Administration Change
One fear is that a Democrat in the White House will cause a major shift in our spending to the downside. We should take a minute to look back to the early 90s when we had the Persian Gulf War (now Iraq War) and the election of Bill Clinton (now Barack Obama). The defense budget was, again, in question during this period. Yet defense spending actually increased considerably. Not to mention that the defense industry has historically done better under a Democratic administration.
2. Out of Control Government Spending
Understandably, if we continue to spend ourselves out of a recession we will have to make cuts somewhere. Too many analysts automatically jumped at the chance to point the finger at the Defense Budget. Sure, some of the spending is extraneous. But the threat of national security and global 
turmoil makes this idea almost impossible. We may see more of a focus on repairs and maintenance (rather than new projects), but it’s already been rumored that the Department of Defense is attempting to add $60+ billion above the previous budget ceiling.
Politics and the Defense Industry
It’s a shame that we consider Republican administrations to be somehow more “war-minded.” Contrary to what most people believe, the Aerospace and Defense companies have historically outperformed more during Democratic presidencies than in Republican! What’s more, there really isn’t a safer place to be than in large-cap defense stocks during a recession. Defense outperformed the market during the last two recessions by more than 17% on average. In addition, this creditless environment strongly favors the companies that have their bookings guaranteed.
Rising Geo-Political Tensions - Global Arms Race Theory
It is my belief that as we continue through this globalized slowdown, we are going to see a global arms race. The stage has been set regionally, and it is only a matter of time before worlds collide. According to Merrill Lynch strategists Jose Rasco and Richard Bernstein: “Conflicts with Russia, Iceland, China, Venezuela, Iran, Afghanistan, Nicaragua, and piracy on the high seas are some examples of the regional difficulties that may require enhanced national security capabilities across the globe.”
Russia:
Seemingly on cue, soon after Barack Obama was elected to be the United States’ next president, Russian President Dmitry Medvedev made some fiery statements concerning Russia’s plans to disable the controversial missile defense shield that the United States has been building in Europe. While the U.S. works to build a networked missile defense system over Europe to protect its allies, Medvedev stated that Russia would be placing short-range Iskander missiles in Kaliningrad to “neutralize” a planned U.S. defense system.
Russia and Venezuela leaders have now made multiple pacts centered around energy policy. Venezuela is still a major supplier of crude oil to the United States, but it seems that a tighter tie between Russia and Venezuela, including a new consortium between two oil & gas giants, Russia’s “OAO Gazprom” and Venezuela’s “PDVSA,” could monopolize the oil and gas markets and create problems abroad. One thing is for sure, the Kremlin fully expects that recent events are turning the global environment in Russia’s favor.
Rest of World:
Not to dwell on the extraordinary political moves in each nation around the world, let’s give a quick summary of more trends that are rising up across the globe. We see nations like China and North Korea attempting to expand their horizons to other areas of the globe, signing contracts with the likes of Cuba and Venezuela to control Latin America. Nicaragua started some problems of their own with an election on November 9th that is being disputed as fraudulent. Iran is trying to completely monopolize the oil market by seizing control of the Strait of Hormuz, a channel through which over 20% of the world’s oil is shipped. Afghanistan continues to spiral down the path of no return. India is in shambles after a terrorist attack on Mumbai, its business capital. Pirates remain in control of the African coast, killing many trade routes. Iceland’s economic crash caused a potential alliance-shift away from the U.S. toward Russia. And all the while, the United States is attempting to impose sanctions on other nations’ nuclear weapons capabilities.
The point here is that although we are hearing more about the financial crisis than anything else on the front page of the Wall Street Journal, it is in fact this global tension and geopolitical movement that will be bucking the long term trend. At any rate, it’s safe to be in defense names as more conflicts arise.
What To Look For in 2009
1. Defense Technology
I love the long-term prospects behind the C3ISR Index (Command, Control, Communications, Intelligence, Surveillance and Reconnaissance), which tracks defense technology. These are the companies providing the essentials that support our troops, increase the safety of our nation’s military forces and reduce conflict. Out of the group, you are best with staying large-cap with Lockheed Martin (LMT) in the event that global hardships continue.
2. Maintenance and Repair
A major trend in the coming years is bound to be the focus on maintenance over replacement. Many companies are less reliant on booking new projects that put a noticeable dent in the United States’ DoD budget; any company with an information technology unit will, by default, have an extraordinary amount of support work to do ’round the clock'. Whether it’s General Dynamics and their repairs to the Abrams Tanks, or United Technologies’ (UTX) multiple consumer-based and maintenance-intensive businesses… you’ll be safe sticking with those repair specialists.
The defense sector is locked, loaded and ready to go at these ultra-low levels. With Lockheed Martin, General Dynamics, Northrop Grumman (NOC) and L3 Communications (LLL) all trading at multiples under 10 times earnings (and their competitors not much more expensive), we are bound to see some upward capitulation in these companies. When you are staring down a global arms race, rising international tension and dirt-cheap valuations… it’s hard not to start buying these inexpensive companies.
Disclosure: The mutual fund that the author is associated with is long GD.
Related Articles
|
Top Rated Comment Streams:
-
1.Hedged In661
- 2.
-
3.Smarty_Pants399
-
4.cos1000289
-
5.axelrod608288
- Free E-Newsletters
- About Seeking Alpha
- About Us
- Contact Us
- What's New
- Readers Feedback
- Advertise With Us
- Contributors
- Contribute an Article
- Feature Your Book
- Our Contributors
- Anonymous Contributions
- Dispute an Article?
- Legal
- Terms of Use
- Privacy
- Copyright
This article has 3 comments:
-
Clamdigger
-
2 Comments
Dec 01 12:08 PM-
tshk1221
-
38 Comments
Dec 05 06:05 PM1. Without them and without the safe shield from them, we can't even sleep well one night and survive one day, constantly bombarded with attacks from foreign countries. Let's not forget that Russia including other hostile countries are always eyeing us for our weaknesses, economical and political, to top down our country.
2. Defense industry companies' balance sheets are one of the healthiest and most rock-solid out of all US industries. Very little or no debt. Very long surviving history since early 1900's. Strong and stable revenues and cash flow streams since they deal with Uncle Sam.
3. Valuations are very good now at net cap rates of 10% - 13%. The best chance of your life time has come to own a piece of these great defense companies of US at the most affordable prices.
4. If you own one of these companies, you don't need to own MSFT or CSCO because these defense companies are the world's most advanced and ultimate tech stock you can own.
5. One of the great candidates for eternal holding since they have to exist eternally to protect the US!!
-
Jim Regan
-
5 Comments
My Website
Dec 18 02:13 PM