Get on Defense

 | Oct 26, 2011 | 12:00 PM EDT  | Comments
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For what seems to be an eternity, defense-related stocks, as a group, have been trading at single-digit earnings multiple, a wide discount to the overall market. This industry used to be viewed as a consistent grower in any economic environment, but investors and analysts abandoned them out of fear that government spending cutbacks with impact defense budgets. While defense spending may indeed be curtailed to a certain extent, a government that can print money is likely going to make sure that its national security needs are fulfilled. After all, without national security, you can forget about having a worthwhile economy.

This morning, defense contractors Lockheed Martin (LMT) and Northrup Grumman (NG) both announced that 2011 profits would come in higher than expected. Lockheed's third-quarter profits increased by 25%. Yet, despite the good news, investors can still pick up shares of Lockheed for $78, 10x its current earnings. In addition, the company will pay you $4 per share a year, equivalent to a 5.1% annual dividend yield.

Investors still remain concerned that Lockheed's biggest program, the $380 billion F-35 Joint Strike Fighter (which is the most expensive weapon in the Pentagon's history) will face further scrutiny as the Defense Department looks to cut $450 billion in spending over the next decade. But the reality is that $450 billion in cuts over the next decade can be achieved without making any significant cuts in the F-35 project. More so, demand for the F-35 is very strong.

The reality is that with 85% of Lockheed's revenue coming from the U.S. military, it will likely have to accept a few cuts here and there. But because company's products are so vital to the defense of the U.S., it's highly unlikely that it will lose any significant portion of the military's business. So the simple thesis is that Lockheed is a high quality company that recently boosted its dividend and is aggressively buying back shares. In these uncertain times, the shares provide an excellent shelter for conservative portfolios while offering exceptional long-term growth backstopped by a dividend that has been paid for more than 20 years.

At Raytheon (RTN), concerns over defense budget spending have produced a share price of $44 or 8x earnings and a yield of 4%. The company sports a backlog of more than $30 billion. This will likely continue to grow, driven by projects that include cyber security software and missile systems, which are represent strategic importance in today's world.

If you examine the stock price charts of names such as Raytheon, Lockheed and General Dynamics (GD), you will observe the resilience of this industry over time. In addition, over the past decade, the average annual price-to-earnings ratios (P/E) for most of these companies have ranged from 13 to 18. Today, the average is 8x to 10x earnings. To me, the uncertainty about defense spending is over discounted in the valuation of defense stocks. As earnings continue to show signs of resilience, you can expect a multiple expansion, which at normalized levels suggests a 40% to 75% upside from current price levels. Along with the bond-like dividend yields, the defense sector could be one of best performing industries over the next several years. Having said that, the downside protection looks very well protected at current prices.

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