Winning on Defense

 | Aug 28, 2012 | 11:00 AM EDT
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Although I am lukewarm on the market at current levels over the near term, I am becoming more positive on the defense sector. There are three key reasons for this. First, stocks in this space sport historically cheap valuations. Second, I believe the fiscal cliff and the sequester mandating significant defense cuts will be pushed back past the end of the year. Kicking the can down the road is one of the few things legislatures in Western democracies do effectively. Third, despite the current Intrade odds and the consensus of the political punditry, it is becoming increasingly likely that the Republican nominee will win the upcoming presidential election. This should improve sentiment on the defense sector, as the focus should shift more to entitlement reform and cuts to other parts of the government budget rather than big defense cuts. I believe there are myriad reasons for this outcome in the November election:

  1. It is a tough environment for any incumbent to run in given over 8% unemployment and anemic economic growth.
  2. President Obama cannot run on his record with his two signature legislative accomplishments (Obamacare and the stimulus) remaining unpopular with the majority of the voting public.
  3. There are very few undecided voters, which means this will be a "base" election. Polls consistently show the challenger's party to be more enthusiastic about turning out.
  4. The Republican nominee has raised more money over the last few months than the president and husbanded it more wisely for the final push.
  5. The race is statistically tied, but historically any undecided voters consistently tend to break towards the challenger in the last week of the campaign.
  6. No president has won re-election with less of the popular vote than when he was originally voted into office. I can envision no scenario where the president exceeds his 52.6% mark of 2008.
  7. After the conventions, polls will shift to likely voters from registered voters, which will show more support on the margin for the challenger.
  8. Finally, the challenger is the taller candidate. Snicker if you want, but this has a better than 80% success rate in picking the winner of past American presidential elections -- a sad comment on American democracy if there ever was one.

With all that being said, this is not a forum for picking political winners and losers. This is a stock picking and market commentary site. So here are two cheap defense stocks that should do well in the coming months.

General Dynamics (GD) is one of the biggest players in the defense space. It makes combat vehicles, weapons systems, munitions and ships.

Four reasons General Dynamics has a solid risk/reward profile at just over $65 a share:

  • The stock sports a solid dividend yield of 3.1%. It has raised its dividend payouts at better than an 11% annual clip over the past five years.
  • GD is selling near the bottom of its five-year valuation range based on price/earnings, price/sales, price/cash flow and price/book ratios.
  • The company sports an A-rated balance sheet and is cheap on an absolute basis, selling at less than 9x forward earnings and 7x operating cash flow.
  • The company earns approximately a quarter of net income outside the defense markets.

Curtiss-Wright Corp. (CW) manufactures and overhauls precision components and systems for military and commercial customers. The company draws some 40% of revenue from defense appropriations.

Four reasons CW is a good value pick at $30 a share:

  • The company is a big player in surveillance and communications, parts of the defense budget that should emerge relatively unscathed.
  • The stock is selling at the very bottom of its five-year valuation range based on price/earnings, price/sales, price/cash flow and price/book ratios.
  • At 7x cash flow and less than 10x forward earnings, CW is cheap. The company should also benefit from Boeing's (BA) ramp up of Dreamliner production, where it makes more than $400,000 a plane.
  • The stock appears to have formed a nice technical bottom over the last few months at these levels (see chart).

Source: Yahoo!

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