Defense Sector Stocks Continue to Surge

by: Scott Sacknoff

So was the FY-2011 Defense budget a good one or a bad one? Well, let the markets do the talking.

Since the announcement of the budget on February 1st, the SPADE Defense Index rose by 4.46% in February and another 4% in the first days of March -- 240 basis points better than the broader markets.

How the defense sector will perform in an era of constrained budget environments is something that many investors are mulling. A recent Morgan Stanley poll showed that investors remain divided on whether the sector will beat, lag, or track the S&P500.

I’ve recently been reading some analyses from analysts and bloggers who’ve formed their own opinions, albeit in some cases by misinterpreting facts. As an example, one thought the sector was in trouble because China was annoyed with U.S. arms sales to Taiwan. Broader economic issues aside, this is not a negative for the defense sector. The deal is worth billions to U.S. defense firms and China is essentially prohibited from buying U.S. defense products under rules controlling the export of missiles and parts so there is little lost business there. Additionally, an angry China, philosophically, adds to the need for continued U.S. defense spending.

Similarly, those that refer to stock performance in the aftermath of Vietnam and the Cold War are drawing on facts comparing apples to oranges. In the aforementioned timeframes, post-war reductions in defense spending led to a significant decline in defense companies. It is a fact that none will deny. Today’s situation however is much different and there is no corresponding historical period with which to compare it to. Perhaps World War II or Korea, but the economy and the operations of companies involved in defense are substantially different (ie. GM and Ford were large defense contractors back then).

The main difference, and what makes today’s environment unique, is two-fold. First, the pullout from Iraq and Afghanistan in the next 18 months will not lead to a cessation of global hostilities and an era of peace. The end of the Cold War led to a brief period where the U.S. did not know who its primary adversary was or would be and spending reductions were possible because of this. Many said that the declines went too far and put the U.S. at risk. In fact, defense spending began to rise the year before 9/11 and accelerated from there.

The second difference is that strategic changes to the defense budget have been taking place more slowly than in the past. The switch from budgets associated with a war to a post-war environment have been known for the past few years. This compares to the shift from the Cold War cessation or the pullout from Vietnam where changes occurred in months reducing the time companies had to adapt.

Today, the inevitable peak year spending profile and impact thereof has been studied by defense sector strategists for the past several years and plans to expand into adjacent markets, increase operations efficiencies, raise capital, increase cash-on-hand, and identify possible acquisition targets have made today’s defense companies healthier and in a much better position going forward than they have been in past cycles.

Combined with an uptick in the business cycles for adjacent markets in commercial and business aviation, satellite communications, and homeland/national security as well as the expansion of firms into non-defense government agencies and the opportunities for continued growth remain possible.

Although a decline in war spending is scheduled for FY-2012, much of the decline goes towards operational items supporting the overseas effort such as fuel, soldier support (food, water, etc.), health care, bonuses for combat salaries, etc. By FY-2015 defense spending levels are forecast to rebound to FY-2009 levels providing new opportunities for defense companies and investors alike.

Compared to investing in a war-cycle, identifying the winners and losers will take a better understanidng of the market and the companies’ operations. ETF products, such as the Powershares Aerospace & Defense (NYSE: PPA) that tracks the SPADE Defense Index, can diversify the risk and provide exposure to the mid- and small-cap companies that are anticipated to benefit under the Obama administration’s plans. Investors of individual stocks as they recognize that additional due diligence over the next few years is required to identify the winners in the sector, are likely to consider a core/satellite plan to reduce risk while remaining exposed.

Regardless of whether an investor looks to the ETF, a core-satellite option, or individual securities such as Lockheed Martin (NYSE:LMT) or General Dynamics (NYSE:GD), when compared to the broader markets, there are a number of reasons how the defense sector can continue to remain in favor.

Disclosure: Author is manager of the SPADE Defense Index