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As the protector of freedom and democracy in the world, the United States is always going to have a strong defense program. Even if one administration makes big cuts to the Pentagon, the next administration will reinstate them. If there’s one thing the government is good at, it’s spending money, and it will always spend generously on defense.
Remember, even in a political environment that is more dovish than hawkish, military contractors and defense companies donate lots of money to Congress.
That’s great news if you’re an investor, because over the long term, defense stocks are going to be winners. Interestingly, it doesn’t matter whether there’s a war on or not. In fact, during Gulf War I, the stocks just did modestly well, but took off after the war ended.
They were already in an uptrend when the terrorist attacks of Sept. 11, 2001 occurred, and they kept going for about six months before correcting. Then defense stocks began a six-year bull market, culminating in 200 when they fell with the rest of the market because of the financial crisis. Since then, most have outperformed the S&P 500.
Thus, we should be more alert for the defense sector being overvalued and experiencing a correction rather than whether or not we are at war. At the end of the day, these are legacy businesses that are always innovating, as technology requires upgrades to our existing military hardware.
Diversification Matters
The very best companies, however, do more than just military work. That provides investors with diversification, and that’s highly desirable in a generally overvalued market.
So which defense stock do you buy? I believe you should own at least one. I consider them to be as important to a portfolio as energy.
Raytheon (NYSE:RTN) is the least best in the sector, and has risen 204% compared to the S%P 500’s 194% since the trough in March of 2009. The company operates in four divisions: Defense Systems; Intelligence, Information, and Services; Missile Systems; and Space and Airborne Systems. This should clue investors in to how broad a sector “defense” is, since Raytheon offers intelligence, surveillance and reconnaissance, along with cybersecurity, logistics, mission support and engineering solutions.
Raytheon serves the DoD, the U.S. intelligence community, our Armed Forces, and Homeland Security. You have to love those broad government contracts.
RTN has a long-term EPS growth of only 9%, and pays a 2.3% yield. It trades at 15x earnings, so it’s a bit pricey.
Lockheed Martin (NYSE:LMT) has a 233% return since March of 2009. It operates in five segments: Aeronautics, Information Systems & Global Solutions, Missiles and Fire Control, Mission Systems and Training, and Space Systems. Some may not consider it a defense stock, but there’s no question that it is. It just is more diversified.
It trades at 17.5x estimates, on long-term growth estimates of 10.74% and a 3.1% yield. It’s also a bit pricey, but it throws off more free cash flow than RTN does.
Northrop Grumman (NYSE:NOC) is the hands-down winner as far as return goes, up 394% since the trough of 2009. I think its superior performance has to do with the fact that it is heavily into defense, and is well-diversified within that sector. It has an Aerospace Systems division that primarily deals with government agencies for use in military and science applications. It has an Electronic Systems segment that is used in everything having to do with aerospace and defense.
Information Systems and Technical Services segment provides logistics, modernization and sustainment support; and other advanced technology and engineering services, including space, missile defense, nuclear security, training and simulation.
NOC trades at 17x long-term estimates, in long-term growth of 8.1%, and pays 1.8% in dividends. It’s not quite the free-cash-flow generator NOC is.
I think NOC has shot past its fair value, trading at a PEG ratio of 1.7. LMT has a PEG ratio of 1.26. RTN comes in at a PEG of 1.32. However, LMT has the better balance sheet and free-cash-flow metrics.
ETFs for the Broad Swath
If you want to go broad instead of having to pick and choose the best company for your needs, that’s why ETFs exist. Look at PowerShares Aerospace and Defense (NYSE:PPA) or iShares Dow Jones Aerospace and Defense (NYSE:ITA). Both are fine choices, as they each hold all the major aerospace and defense firms, just in different volume.
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