One of the big political themes in the U.S. this year was President Obama's announced intention, outlined in the State of the Union address in January, to shift government fiscal allocation away from military spending and toward domestic infrastructure spending. This set up a dynamic between the two principal groups of companies (and their stocks) that would be impacted by the shift: government contractors and infrastructure companies.
Once Russia entered Crimea, however, the potential for the shift in fiscal allocation became politically improbable. This was underscored by the results of the midterm elections and the Republicans taking control of the Senate.
Stocks of the largest government contractors benefited from the Russian move into Crimea, but received an even bigger boost from the midterm election results. Those results have clearly paved the way for a reprieve from the potential shift in fiscal allocation, at least until after the next presidential election. Investors in government contractors will likely get a free ride until then as these companies will continue to be recipients of government largesse regardless of what happens in the private economy.
The year-to-date performance of all but one of the largest government contractors has indeed been stellar: Lockheed Martin (LMT) +28%, General Dynamics (GD) +50%, Raytheon (RTN) +18%, Northrop Grumman (NOC) +28%, Science Applications International (SAIC) +59% and CACI International (CACI) +21%. About half of these returns were achieved in the last three months as investors began to anticipate the outcome of the midterm elections. The only company in this group with a negative YTD performance is Boeing (BA), which is down 9%.
The global and domestic political situation has not been the only driver of the positive performance of this group, however. These companies have been buying back shares and reducing their outstanding floats in order to manage growth in earnings per share. Still, only two of them have been buying back stock with earnings as opposed to cheap debt capital: Lockheed and General Dynamics. As a result, of all the names mentioned, these two are likely best positioned to continue to perform regardless of private sector economic activity and what may happen to interest rates.
The share buyback plans that are being enhanced through debt will be negatively affected if the Federal Reserve carries through with an increase in the Fed funds rate next year, as it is indicating and markets believe. I do not believe the Fed will raise rates next year (I will address that and the trajectory for long-term rates in a separate column), but as this column is about defensive strategies, Lockheed and General Dynamics are the two best positioned to withstand rate hikes.
Boeing is an interesting situation. It too has been buying back shares this year with earnings, and quite aggressively, with a reduction in float of almost 5%. This is similar to the 6% reduction in float by General Dynamics this year, but investors have not responded in the same manner. I'm not quite sure why, but it could be because of Boeing's inventory build earlier in the year, which caused a near-term hit to earnings. Still, I would think investors would see through that.
All of the other companies mentioned are trading at record highs, while Boeing is about 14% below its peak, set this past January. As such, and given the fact that it has strong earnings, is buying back shares through earnings and is less sensitive to rising interest rates than most of the others, Boeing represents the best defensive and offensive play in the group.