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Overview

Late into the evening of January 1st, the House ratified a bill that would remedy some of the issues at the heart of the "Fiscal Cliff." This bill covered issues such as capital gains, dividend and income taxes. In my January 2nd article titled, "3 Large-Cap Dividend Stocks Set To Benefit From The Fiscal Cliff Deal", I talked about the dividend taxation and its implications for dividend-paying stocks. Yet an unresolved issue of the Fiscal Cliff is spending cuts. The Fiscal Cliff Bill that was just passed delayed the automatic spending cuts by two months. This is effectively kicking the can down the road, and investors have reason to be concerned about more political gridlock regarding sequestration and the potential consequences of allowing these automatic spending cuts to kick in.

Defense Spending

If Congress does not come to an agreement regarding sequestration, the automatic across the board cuts will kick in, with half of the cuts coming from Defense spending. This could decrease the defense budget by $55 billion this year. This could have potentially devastating repercussions not only to defense stocks, but also to our national security.

Defense Stocks

On December 9th, 2012 I wrote an article titled, "3 Defense Companies To Buy Ahead Of A Fiscal Cliff Compromise". The article talked about how negativity towards defense stocks presented a possible opportunity for investors if Congress came to a reasonable compromise on the Fiscal Cliff, especially concerning spending issues. However, since Congress has not yet come to an agreement on spending cuts, defense companies will likely be out of favor. If investing in defense stocks in the current environment, it would be advantageous to look to companies with sources of revenue from entities that are not the U.S. government, as the uncertainty over these revenues could expose the stocks to increased volatility. However, if Congress reaches a favorable deal on the sequestration cuts, defense names should outperform the market. In the article that I mentioned earlier, I talked about three main defense names that should benefit: General Dynamics (NYSE:GD), Raytheon (NYSE:RTN) and Northrop Grumman (NYSE:NOC). Of this group, General Dynamics has the lowest exposure to government expenditures as the U.S. government accounts for approximately 69% of revenue. All three of these names have good dividend yields of at least 2.85%. Additionally, earnings multiples are all reasonable, as each of these three companies trades for less than 11x 2013 earnings estimates.

Conclusion

The Aerospace and Defense sector will be one of the most watched in the first few months of this year. The sector will likely be driven by government policy, specifically relating to sequestration cuts. This could make the sector somewhat headline-driven in the near term. If Congress can come to a reasonable agreement on the sequestration cuts, this sector should benefit. Since Congress was able to come to an agreement, albeit at the last minute, the hope is that they will be able to reach another agreement to avoid sequestration.

Source: Sequestration And Defense Stocks