Three Real Defensive Stocks

Readers often ask us why we continue to recommend investing in the defense industry. Actually, we hold three defense stocks in our Growth Portfolio: Northrop Grumman (NOC), Raytheon (RTN), and CACI International(CACI).

Admittedly, the defense industry depends on government contracts, and casual observers might wonder if these will soon start to shrink. Given the extraordinarily high deficits the government is running up these days – including massive sending on entitlement programs, healthcare, corporate bailouts, and economic stimulus - surely even the most profligate politician will be combing the budget looking for areas where some savings can be made. Defense would seem to be a prime candidate for cutbacks, especially since the war in Iraq looks past its peak.

However, defense stocks have a lot more going for them than meets the eye! Here's why...

THE DECADE OF TURMOIL

As we keep pointing out, today's investment climate is both stranger and more precarious than the one most investors cut their teeth on. Look at the previous four decades and you'll see why.

In the 1980s and 1990s, when the baby boomer generation started investing, stocks ruled supreme. Those were the decades of low inflation and reliable growth. It was the climate which all the long-term, buy-hold-and-diversify investors see as the normal state of affairs.

However, we cannot forget that things were quite different in the 1970s. That period was marked by high inflation, with the result that the top performing assets were gold, oil, and other commodities.

So far the 2000s have proven to be even stranger than the 1970s. Instead of inflation or growth, the dominant theme has been deflation. Consequently, stocks have been trumped by gold and zero coupon bonds.

Our point is that the last 40 years disprove the theories of Roger Ibbotson, Jeremy Siegel, and the like who look at long-term averages for stocks, bonds, and cash and project steady returns along the historical mean. Those theories ignore the fact that markets are seldom “normal.” What good are long-term returns if in the short-term you get whacked?

We don't know for sure what comes next, but we doubt it will be a return to the golden age of late 20th century. Accepting that financial markets are volatile and undergo large swings in direction, it makes far better sense to hedge against the most likely risks at the moment, while you seek returns from the strongest trends currently unfolding.

Our two top hedges continue to be gold and zero coupon bonds. Zero coupons protect you from deflation. Gold protects you from most financial threats, including both deflation, inflation, and one other which people are now starting to discuss (here's where we get back to defense stocks)...

THE RISK THAT WON'T GO AWAY

The U.S. dollar has lost a lot of ground versus the euro recently, prompting nations around the world to start demanding something to replace the dollar – whether gold, new reserve currency a basket of currencies, drawing rights, etc. They'd like to hold something in their treasury that will retain value better. Yet, it will take more than just a rising euro to dethrone the dollar.

You see, the dollar holds supreme as the world's reserve currency for one main reason. Oil is priced in dollars. As long as that's true and oil remains the world's most important commodity, the dollar will play an important role on the global stage. The dollar will survive despite fears of inflation, deflation, or any other turbulence.

Of course, you might wonder why oil is priced in dollars, especially since the U.S. doesn't export oil. Right now, oil-rich nations lose money every time the dollar falls. Why don't they start demanding to be paid in their own currencies or a basket of currencies, or even gold? (If they were paid in gold, their income would have risen four-fold over the past ten years.)

The simple answer is that Saudi Arabia, the world's largest oil producer, insists on pricing oil in dollars. They will not risk damaging the U.S. by changing this policy. In fact, they seem reluctant to make any major decision without U.S. approval. (We've even heard that some Saudi planes won't fly without first receiving a clearance code from the U.S. authorities.) The U.S. essentially controls Saudi Arabia through its control of the kingdom's defense, and the Saudis need us.

For instance, we recently came across an article regarding trouble on the Yemen-Saudi border. Apparently, Yemeni Shias have launched a rebellion and hope to drag the minority Saudi Shias into the dispute. In this effort they are joined by al Qaeda (ironically, since al Qaeda are Sunnis). The story isn't getting much attention, possibly because security and sovereignty violations are all too common in the Middle East.

Nonetheless, the story highlights how much the Saudis depend on the U.S. for defense – and how much we need to protect Saudi Arabia. A disruption in Saudi oil production would be a disaster for the world economy.

Bottom line, the U.S. needs to keep the oil flowing, which means we need to defend Saudi Arabia at all costs. In turn, the Saudis will make sure the dollar remains the world's reserve currency. We should be glad of this, because it means we pay less for imported goods and materials.

However, it also means the U.S. must maintain an overwhelming defense capability. So you can count on defense manufacturers staying profitable for a very long time.

If we had to pick a favorite defense stock, it would be Raytheon, which depends less on high end programs and has a lot of advanced technology. CACI makes much of the software the Defense Dept. needs (you can't get a job there without ultra-high security clearance). That gives the company major franchise value.

You don't necessarily have to buy our top three defense stocks. Nor do you need to weight defense as strongly as gold or zero coupon bonds. But making defense a component of your portfolio will protect you against the real chance of economic and geopolitical turmoil.

Comments

[Steve in Gr...:]

Thanks, Dr. Leeb. The world is getting more dangerous due to the lack of a global power willing to impose discipline on the resource-rich, culturally-medieval Middle East.

But please help me with the zero-coupon bond argument. I can understand having bought zeroes yielding double-digits at the end of the Carter years when inflation was high in anticipation of Volcker killing inflation and dropping interest rates.

But the EDV you recommended in your 8/5 note is yielding 4.4%. Are you expecting long term yields to drop from here?

Sep 15 10:57 AM

[trick:]

I do agree on the rationale for defense investing, especially as the Govt may see war as a way of boosting the economy and tension between countries escalate during this period of financial stress and a potential currency crisis.

I am long RTN based on my bottom up stock picking criteria, without incorporating these views. The outlook for earnings continues to improve whilst the negative sentiment towards the sector created an opportunity in the stock price.

Sep 15 05:28 PM

[gato:]

Your take on the dollar, oil and Saudi Arabia etc, is insightful and clearly stated. Most of all, it makes sense, a rear thing on blogs at this site.
The selection of stocks in the "defense" sector (a politically correct term) but a misnomer (with me) where a more descriptive name would be war stocks. This would at the very least give "the politically dumb and insensitive Americans" an idea of what they were buying..and those that have ounce of morality in their hearts could act accordingly.
But, as "investment recommendations" , you are right on. ("to know what a horse will do, you have to know what a horse has done") So, a peek into the history of the IOUS of A, will shows, Americans will allow their government to "hood-wink" them into attacking other countries when the right "spin" is applied. And, now, that we have "a peace seeking president"...I find, there is very little to differentiate him from the previous war-criminal ..we get a sort'a.. "Bush light"... a more understanding family man. This helps us feel better about ourselves, as he (with "a little" help from the fed..'an..(Ahem!..excuse my language)..Goldman Sachs! ) they systematically turns the dollar into confetti, where at least it can be used for a useful purpose.
So, now, as we mortgage (yet again!) our future generations of (gullible) youths, to give their lives to protect oil fields or whatever new political philosophy in vogue. We face both moral and economic bankruptcy, with the prospect of having to defend hills of sand, for what?
Deus, tem misericordia de nos!
gato

Sep 16 12:29 PM