'Wars and Rumors of Wars' - Time to Look at Defense Stocks 16 comments
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With the prospect for “wars and rumors of wars” on an unsettling rise, now could be a good time to take a closer look at defense stocks.
The backdrop to 2009 thus far reminds me of that old New Testament line: “And ye shall hear of wars and rumors of wars.”
And in fact, “wars and rumors of wars” is a fair description of what we’re seeing now.
In the Middle East, we have Israel at war with Hamas. In China and Russia, simmering public tensions have the authorities deeply concerned. Ukraine, too, is wrapped up with Russia in a natural gas dispute that has (literally) left Europe in the cold.
In Iceland, protesters throw food and garbage at Parliament for lack of a better way to express their fury. In Pakistan, the national security adviser has just been fired over mounting tensions with India. And things got so bad in Greece at one point, the riot police ran out of tear gas.
Meanwhile, the more traditional bad apple countries – Iran, North Korea and so on – have remained uncharacteristically quiet. Can that last?
An Unwelcome Surprise
For now, the world is still deeply mired in economic concerns. Questions abound, like: Will deflation be vanquished? Will China and India grow fast enough to keep the good times on track? Can the oil producers maintain order in the face of collapsing revenue? In the name of emergency stimulus, will America spend far too much for its own good? Will it spend enough?
With all this on the plate, an outbreak of wider-scale war is probably the last thing on most leaders’ minds. But as they say, when it rains, it pours...
A serious, multi-country conflict (or the intensely real threat of one) would be considered a truly out-of-the-blue, “black swan” type surprise for the year 2009.
But if it comes to pass, it wouldn’t be quite the black swan (unexpected event) one might think. This is because economic turmoil and geopolitical turmoil have a natural link.
Playing the Nationalism Card
The linkage comes from the fact that when a country like Russia or China runs into difficulty, the leadership at the top finds itself in peril.
This goes doubly true for regimes that have made a sort of “prosperity bargain” with the public: “We deliver the economic goods, you ignore the unsavory aspects of our control.”
In conditions like the ones we face now – when the proverbial solid waste hits the proverbial oscillating wind device – the prosperity bargain begins to fray. If it frays badly enough, a new playbook is required.
One time-tested response is to play the nationalism card – i.e., turn public anger away from home affairs and towards an outside enemy.
This added dimension makes the threat of further “wars and rumors of wars” a bit too close for comfort.
Whither Defense Stocks?
All this pot-stirring could warrant a closer look at defense stocks.
The Philly Defense Index – loaded up with big, muscular names like Northrop Grumman (NOC), Lockheed Martin (LMT) and General Dynamics Corp (GD) – has held its own in the 2009 rally thus far.
Another reason to be interested in defense is the possibility of gravy from an ever-expanding Obama stimulus plan. As the White House and Congress plan to shovel huge amounts of money into the economy, one of the challenges they will face is deploying large amounts of cash quickly without wasting it. (To a large degree that will happen anyway, but that’s a different kettle of fish...)
Take California, for example – a state on the brink of, or perhaps deep in the thick of, fiscal peril.
Could the state that was the epicenter of the housing bubble (and bust) benefit from a marked revival of defense spending, considering what a boon the defense industry has been to California’s economy in the past?
Surely the thought has crossed a few minds.
Martin Feldstein, Chairman of the Council of Economic Advisers under President Reagan, has also argued in the Wall Street Journal that defense would be an ideal recipient of mass-stimulus spending. We’re due to spend the money anyway, Feldstein says... there is a shortage of time in which to make good decisions, and this is clearly an area that needs the cash. In sum, Feldstein concludes, a cool $30 billion a year or so should do the trick.
Nimble and High-Tech
I turned to my pal Zach Scheidt (retired hedge fund manager, trader extraordinaire and editor of Death Cross Trader) to get his take on what looks good in the defense space.
Zach’s advice, at least the way I heard it, boiled down to a focus on nimble and high-tech. As he has in the past, Zach pointed out that some of the mid- and small-cap names have greater potential to “move the needle” in terms of profit growth than the big, lumbering large caps do.
Zach’s preference for high-tech made perfect sense to me, given the U.S. military’s severe shortage of manpower at the moment. We are spread so thin around the world these days, it seems a given that Uncle Sam would want to pay up for any possible tech edge that could help with the strain on the troop situation.
I also asked Zach if there were any defense names in particular on his radar screen. And since this is a guy who knows U.S. equities like the back of his hand, of course he said yes...
“One of the most interesting companies I am following in this industry,” Zach told me, “is a company called AeroVironment, Inc (AVAV).”
“One of the company’s most intriguing products is a small, un-manned airplane that can be carried onto the battlefield. If soldiers want to know what is over the next ridge or in the next valley, they can launch the plane by hand. Sophisticated cameras and radio equipment relay information to headquarters and the front line.”
“This type of technology,” Zach further explains, “shows how the current military is thinking outside the box when it comes to warfare. The rules are changing as tactics and constraints continue to evolve. And new systems and technology will play a major part in equipping the military for future missions.”
I asked Zach if he would consider AVAV a buy right now.
“Not just yet,” he said. “The stock is a bit expensive here, as investors are rightfully excited about the prospects and the share price has gotten ahead of itself. But a pullback in the coming weeks or months could provide a solid entry-point for this long-term winner in the defense space.”
One thing I’ve discovered, too, is just how valuable the input of the Taipan readership can be... do you have any interesting high-tech defense companies on your radar screen, or particular insights into how Uncle Sam might be deploying his defense cash? If so, we’d love to hear about ‘em.
Stock position: None.
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This article has 16 comments:
More likely its the first thing on their minds as its the most convenient way to get out of trouble and remain in power.
I'm more concerned with the maniacs in Washington than with those in Moscow or Beijing. While nationalism exists in other places it is not accompanied by the peculiar brand of nationalistic exceptionalism that is practiced in DC.
IMHO
Your conclusion is that the big defense stocks are too big and lumbering to buy and that the one small one you mentioned is too early to buy?
Is that right?
1. I can see absolutely nothing out there to suggest the possibility of a global conflict. Yes, I know all about 'Black Swans', but this one is in the 'death rays from Mars' camp.
2. Russia is an aggressive and disgruntled imperial power with deep-seated domestic problems, and if I were Ukrainian I would be deeply worried. But as anybody with experience of school playgrounds can attest, being a bully and resorting to physical force are two different things. The playboys who fund Putin will not want to put their Riviera lifestyles at risk, so Russia will continue to pressure its neighbours wherever it can without resorting to outright, large-scale war.
3. A study of Chinese history does not show this to be an empire with an appetite for long-distance military power projection. Sure, they can get quite tetchy when the Middle Kingdom's historical sphere of influence is perceived to have been invaded by interlopers or shows signs of wanting to go its own way, but that's a lot different from going to war with a distant major power - such as the US or India, both of which have been named as potential targets in 'mainstream' blogs I have read today.
4. The Middle East certainly has plenty of unfinished business which will inevitably lead to further regional conflict. Iran, Hezbollah, and the Arab street are clearly unhappy with what's going on in Gaza - as anybody should be if they have a shred of human decency - but Arab regimes (other than Syria) are content to see Hamas getting a caning, even if the outcome eventually falls short of what Israel would like. Is Iran really likely to fan the flames directly, as opposed to rhetorically or indirectly through Hezbollah? Unlikely at this point in time, given the apparent progress it's making on the nuclear front. Is Syria likely to act? Unlikely, given that their new up-market Russian SAMs are not yet operational and they have anyway been signalling a desire to come to a settlement with Israel.
5. India v. Pakistan? Possible, but neither India nor the United States want a failed state sandwiched between the former and Afghanistan. My bet would be that the current crisis will lead to further posturing before the Indian election, but nothing more. However, if the bad guys mount another successful 'spectacular' inside India within the next few months all bets are off.
6. The US defence-industrial complex clearly benefits from certain types of conflict fought on its own terms in a controlled way. However, chastened in Iraq and faced by a much more important yet until recently neglected challenge in Afghanistan I would really wonder whether even the most hawkish of neo-cons has an appetite for further adventures. Whether A & D stocks are about to benefit from the hand-out gravy train or a budgetary pullback (from 2010, given that 2009 is already baked in) I have no idea.
The world is a dangerous place at the best of times, and this certainly isn't one of those. However, I would think that with some local exceptions the resurgence of nationalism to which politicians and the tabloid media often take recourse in difficult times is more likely to find voice in greater trade protectionism - including anti-competitive bail-outs and subsidies. We are already seeing a lot of this in public policy under the guise of saving jobs/the system/the world, and the sentiment is also showing up increasingly frequently at the grass-roots level (e.g., in SA posts and comments over the last few days).
On Jan 11 09:57 AM OldLimey wrote:
> It's interesting to me that the threat of significant wars (as opposed
> to local conflicts or insurrections) appears increasingly frequently
> in the financial blogosphere; by 'increasingly frequently' I mean
> that I am now seeing one or two such posts each day. The sources
> are usually American. I've lived for several deacdes in Europe, Asia,
> and the Middle East so my understanding of psyche in the American
> heartland (i.e., away from the coasts and amongst people with only
> limited exposure to the outside world) is far from deep. So let me
> add the thoughts of somebody from outside 'fortress America'.
>
Question...what if this worldwide recession-depression drags on a few years?
Doesn't that open the door from trade protectionism to flared up conflicts
or expanded terrorism?
World War II came about in many ways from the depression era frustrations.
Not saying it will...just saying hardship can lead to hostilities...
It will certainly increase the value of your gold though!
On Jan 11 06:16 PM Gold Barron wrote:
> Iran is next on the USA list.
1) Trying to anticipate war is no reason to be buying defense stocks. They will go up if the US suddenly gets involved in a conflict, but this is only because of the speculators. Enough people have the same misinformed point of view that it actually creates demand in the stocks. See #2 below.
2) The most profitable time for defense stocks is NOT when we go to war, it is when we are in sort of a cold-war mindset and do not have significant numbers of troops engaged anywhere. If we suddenly decide to send troops somewhere, then this takes up resources. When you need money to fund day-to-day troop operations, your not going to spend money developing the next generation aircraft carrier, fighter jet, or submarine. I remember right after 9/11 a lot of the programs we had got shut down because money had to be used to fund troops on the ground.
3) During times of war, the only companies that benefit are the ones that make the supplies troops need on a day-to-day basis, or ones that have some emerging technology that the military thinks could be a 'game-changer'. The larger companies don't see any added benefit.
4) Defense contracts can often span 5 years of more. So in many cases the work that will be performed while Obama is in office has already been negotiated by the Bush administration. It may be several years before the new administration gets a chance to increase/decrease funding levels. In these cases, going to war is the worst thing for the industry. No significant new contracts are awarded, and the funding we already have is put in jeapardy.
The Israeli/Palestinian proxy war has been going on for decades.
Pakistan has been unstable for decades.
Russia has been making threats and extorting neighbors for decades.
Riots in Greece and Iceland (pop. 300k) are too insignificant to note.
Iran and the US have been threatening each other for decades.
More likely, the US military will need to buy new vehicles and weapons to replace those trashed or given to other governments in the two wars going on right now. These domestically manufactured items will fit nicely with the Obama administration's spend-to-stimulate-eco... platform, but don't expect them to be talked about much.
The Iraq / Afghanistan wars will eventually be lost in that the democratically-elected governments we propped up in those countries will be overthrown by theocratic Islamists as soon as we leave. The public in those places just don't believe in democracy. We might even see a Hamas-like party win an election in one of these countries during the next election while we are still deployed there. Won't that be unsettling?
This experience, plus the national debt / inflation / entitlement problem will probably result in the diversion of funds away from defense in the long term and towards things like Medicare.
So short-term I see an earnings boost for defence, followed by a long gradual decline.
On Jan 11 06:16 PM Gold Barron wrote:
> Iran is next on the USA list.