The Great Defense-Stock Comeback

 | Mar 01, 2013 | 10:00 AM EST  | Comments
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Stock quotes in this article:

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rtn

Imagine you're a market commentator three years in the future. Someone asks you to explain why defense stocks rose 50% over the three years from 2013 through 2015, surprising almost everyone.

Your chronology begins with March 1, 2013, the day the sequester was implemented. Under its terms, federal spending was cut $85 billion from planned levels in the 2013 fiscal year. Defense spending bore half the brunt, or $42.5 billion.

There was much gnashing of teeth, even though the cut was only 6%-7% of the total defense budget.  It was still enough to slice defense companies' profits in half.

Yet the stocks didn't follow the profits down. Why not? For one simple reason. Investors saw this problem coming a mile away.  

That's why, back in March 2013 began, Northrop Grumman (NOC), Raytheon (RTN) and Lockheed-Martin (LMT) all traded at 9x earnings. General Dynamics (GD) (which also owns the Gulfstream executive jet business) traded at 11x. 

Once their profits fell, most of these stocks were still trading at earnings multiples in the high teens. Then, in 2014, earnings began to rise.

They rose partly because of cost cutting by the defense companies and partly because of heightened military tension. In the Middle East, Hezbollah and Israel clashed across the Lebanon border and Iran sent massive aid to Hezbollah, including (according to unconfirmed reports) soldiers. 

The U.S. decided it would be timely to conduct some naval exercises in the region, and Iran responded by lining up heavy artillery along the edges of the Straits of Hormuz. An uneasy standoff ensued. 

Meanwhile, China and Japan exchanged increasingly heated words over who had sovereignty over the Senkaku Islands. The U.S. said it would not allow its ally, Japan, to be bullied.

The Republican Party, which had grown in strength during the 2014 midterm elections, vowed to save defense from further cuts and, indeed, to seek selective increases in defense spending. Democrats publicly fulminated, but privately went along with most of the hawks' plans. 

Then in 2015, the Congressional Budget Office projected that an improving U.S. economy meant the budget could be in balanced as soon as 2017. The pressure to cut defense spending became less intense.

Of course, the good tone of the overall stock market helped, too. The S&P 500  was up more than 30% in 2013 through 2015. But the rise in the defense stocks outpaced the rise in the S&P. 

Now, let's switch back from the future to the present.

Everything I said above is, of course, speculation. It is subject to dozens of uncertainties and things may or may not unfold as I've outlined. But something like the scenario I've described is likely. Come back in 34 months and we will see how close I came. 

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