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Executive summary:

  • The world remains a violent and volatile place.
  • Worldwide defense spending has been on the rise.
  • Aerospace and defense companies are positioned to benefit.

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Those familiar with my writing know that I have a penchant for investing in sin stocks. War is the ultimate sin: it combines wrath, pride and greed, among others. Throughout recorded history, humans fought.

They are not about to stop.

The world remains a violent and volatile place

As the US and big European powers lower their defence spending or allow it to stagnate, China may very well maintain the prior decade's yearly military budget increases of about 12%. Chinese People's Liberation Army is already the world's largest military force, with the strength of approximately 2,285,000 personnel. With ballistic, cruise and anti-ship missiles as well as a recently-developed stealth fighter Chengdu J-20, China's military might is formidable. China also has conventional and nuclear-powered submarines, long-range radars, spy satellites and cyber and space weapons intended to interfere with US forces' communications, command and control systems. A new ballistic missile will enable China to strike US aircraft carriers up to 2000km (1240 miles) away. Realizing its growing strength, China has been asserting itself more and more aggressively in Asia, with latest events having taken place in East China Sea.

Russia is also reasserting itself after losing the cold war. It can now afford to better fund its defense (or offense) spending, thanks to resource-related wealth. Close collaboration between experienced Russian military and its inventive, forward-thinking defense technology design bureaus enables development of highly effective weapons. Russia is a leading designer and producer of tanks, infantry fighting vehicles, fighter aircraft, rocket-propelled grenades and advanced marine vessels. Those who think that Russia is low-tech will be sorely disappointed, as Russia now has laser-guided missiles and artillery rounds, unmanned aerial vehicles, a state-of-the-art air defense system and even its own satellite navigation system called GLONASS that easily rivals the GPS system. Of particular importance is Sukhoi PAK-FA, a 5th generation fighter aircraft that rivals the US-made F-22 and F-35.

North Korea shows no loss of resolve. Civil war in Syria rages on. Iran may be playing a cat and mouse game with the US so it could finish developing a nuclear weapon. Libya remains torn by post-war violence. Terrorism remains a huge problem worldwide.

World peace is far, far away.

Worldwide defense spending has been on the rise

Note that most sales were to the developing nations. Saudi Arabia alone had purchased tens of billions of dollars worth of weapons in recent years, most of these from the US. India and United Arab Emirates had also made multibillion-dollar arms purchases. The US has been, of late, the single largest weapons supplier.

Military spending in developing countries shows no signs of slowing down.

Aerospace and defense companies are positioned to benefit

Lockheed Martin Corporation (LMT) is one of the largest US defense contractors, and even though it makes a wide range of products, it is perhaps best-known for its F-22 Raptor and F-35 Joint Strike Fighter aircraft. There is no other company in the US (or in the world) that can build stealth fighters in volume similar to Lockheed Martin. The company has a long history of building advanced aircraft (Remember SR-71 Blackbird?) and has an institutional experience that is almost impossible to replicate. I think this gives Lockheed Martin a strong competitive advantage. Global participation of 8 countries (besides the US) in design and production of the F-35, and 3 additional countries considering the purchase, should drive the sales of F-35 aircraft for many years. According to the memorandum of understanding (page 88) between the US and global partners, the US alone plans to acquire 2,443 F-35s by year 2035. The global partners are scheduled to acquire an additional 730 F-35s. There is also a distinct possibility that the production of F-22 will be restarted at some point due to concerns related to the competing PAK-FA and J-20 twin-engine fighters and their possible advantages over F-35 in reliability and speed.

Lockheed Martin has had quite a run in 2013, presently selling for 17.7 times trailing earnings. This is not cheap and one may want to wait for a pullback, although it is not guaranteed. The dividend yield is decent at 3.3% and the dividend more than doubled in the last 4 years. The dividend payout ratio is about 50% and future dividend increases will probably approximate earnings growth. Of note, the company is diversifying from its defense business and, as part of that effort, recently made a $205M deal with Ocean Power Technologies (NASDAQ:OPTT) to produce the world's largest wave energy project off the coast of Victoria, Australia.

Raytheon Company (RTN) is the world's largest producer of guided missiles. Its Stinger missiles gave the Soviets quite a bit of trouble in Afghanistan. Its Sidewinder and Maverick missiles have been staples of US aircraft armament, and its Tomahawk and Patriot missiles are in a class of their own when it comes to world renown.

Overseas customers love Raytheon products. Recent interest and more interest in anti-tank missiles from Saudi Arabia is just one indication of this, for a combined sum of over $1 billion. Just previously, South Korea wanted some Patriot missiles to the tune of $400 million. And just before then, Saudi Arabia wanted about $6.8 billion worth of missiles and bombs from Raytheon and Boeing (NYSE:BA)!

Raytheon also makes air traffic management systems, which helps it get some revenues from the civilian sector; however, it no longer makes microwave ovens.

Raytheon has also been diversifying away from the domestic business, having had 27% of total sales in 2013 come from abroad. International bookings are expected to be in the 35% to 40% range of total bookings for 2014, and international sales for 2014 are expected to be around 30% of total sales.

Raytheon has had quite a run in 2013, presently selling for about 16 times trailing earnings. This is not cheap and one may want to wait for a pullback, which again is not guaranteed to happen. The dividend yield is smallish at 2.3% but an increase is expected in the next 2 months or so. The dividend nearly doubled in the last 5 years. The dividend payout ratio is about 36%, and the company can probably afford a significant increase soon.

General Dynamics Corporation (NYSE:GD) is perhaps best known for the M1 Abrams tank, which is the main battle tank of the US military. The company also makes the Stryker armored combat vehicle, the GAU-17 (minigun), submarines, surface ships and Gulfstream luxury business jets, among other products.

In my opinion, Gulfstream is the jewel of the company and provides nice diversification from the defense business. The Gulfstream division is also an excellent platform for growth. The market for private jets, especially in Asia, is quite healthy and Gulfstream jets are popular among the customers there. Just the G650 backlog is almost 4 years long. However, I have not found any Gulfstream aircraft called the "G6" as mentioned in the famous song.

General Dynamics sees international sales growing to account for 30% of revenue in 2014. Additionally, Gulfstream may soon come out with a supersonic business jet.

General Dynamics has had quite a run in 2013, presently selling for about 14.8 times trailing earnings. This is reasonably priced and one may consider taking a position around these price levels. The dividend yield is smallish at 2.16% but an increase is expected in the next 2 months or so. The dividend has increased by almost 50% in the last 5 years. The dividend payout ratio is about 25% and the company can afford a significant increase soon.

Source: War Profiteering: An Investor's Guide