Defense Sector Continues to Show Strength

Defense stocks continue to exhibit signs of strength highlighted by the recent 10% increase in its dividend by Lockheed Martin (LMT) and an upgrade of General Dynamics (GD) by Morgan Stanley.

Since the March lows in the market, the SPADE Defense Index has exhibited remarkable consistency, gaining between 4% and 12% in six of the last seven months (the only exception being a 0.85% decline in June). Overall, the sector rose more than 16% in the third-quarter and with recent gains is putting itself in position to challenge the S&P500 and outperform it for the 10th consecutive year.

Actions anticipated for the final quarter of the year have started to come to fruition and should drive the sector over the coming months. Recent news has indicated that future budgets should be in line with analyst expectations and leaks about the QDR (quadrennial defense review) regarding the future direction of the Defense Department have not revealed any surprises. Additionally, DoD released a new request for proposal for the $35 billion aerial tanker program and President Obama has reiterated, vigorously, his support for ongoing and expanded activity in Afghanistan. The final quarter should also see a number of new defense contracts let and the first test flight of Boeing’s 787, which will likely provide a substantial boost to the share prices of a number of suppliers to the program. Most importantly is the growing realization among sector analysts that the near-term budget for defense will remain relatively steady and not see the dramatic declines exhibited after prior defense spending peaks.

With defense companies much better prepared to handle this type of budget environment, many companies in the sector continue to see top line and bottom line growth while maintaining healthy margins; having expanded and diversified their operations over the past several years and built up their cash reserves. Investors for the most part have been divided equally into two camps -- those that exited the sector waiting to see how the companies would fare under a new budget environment and who are looking for a new entry point and those that have stayed the course and maintained shares as part of a diversified portfolio; happy with returns that have consistently tracked or bested the broader market and anticipating the next uptick.

One thing investors in this second group have on their side is that the sector has tracked the market this year even while the five major defense companies have all underperformed the sector benchmark. Both Raytheon (RTN) and Lockheed Martin remain negative for the year with Northrop Grumman (NOC) and General Dynamics positive but underperforming. Only Boeing (BA), whose share price has swung wildly in 2009 on various news items after a significant downturn in 2008, is ahead of the market. With mid-cap defense companies leading the gains so far, a rebound in the U.S. economy will have an impact on several of the largest aerospace suppliers and news, such as the 787 test flight, will provide additional attention on the sector.

The Powershares Aerospace & Defense ETF (PPA) continues to be the option of choice of many investors looking for a diversified way to play the sector or who are unsure how upcoming news will impact individual companies and want to hedge their investments in an individual company. In addition, recent conversations with several money managers have indicated that they have been using the ETF recently for end-of-the-year tax purposes while staying exposed to the sector (ex. selling Lockheed Martin, for example, and capturing the decline over the past year but buying the ETF to stay exposed).

Even in market conditions such as today, and looking back at its history of performance over the past twelve years, the defense sector at roughly 5% of U.S. GDP should be considered as a core element to any diversified U.S. equity portfolio. With fundamentals (P/E, P/S, PEG) remaining strong and the technicals showing the sector steadily above its 200-day moving average, the underlying data relied on by many professional investors continues to indicate that a movement upward is not out of the question. The run for 10 (consecutive years outperforming the market) is entering into the final quarter homestretch.

Comments

[ArtfulDodger:]

No doubt most people are still concerned about this fickle Ad. But GD in particular looks to be an excellent LT investment, one that will eventually pay the patient investor who accumulates carefully.

That is, unless this Ad turns crazy.

Good article. Thanks.

Oct 09 10:38 PM