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Defense and homeland security companies continued to outperform the broader market in 2006 as the benchmark SPADE Defense Index [AMEX: DXS] gained 19.33% and marked the seventh consecutive year it has outperformed the S&P500. It is a remarkable run that has seen the sector generate alpha over the broader markets not just for seven years running but in 20 of the last 26 quarters. This past year saw the sector outperform the broader markets by 571 basis point. And since 2000, the Index has gained a whopping 113.86% compared with a 3.47% LOSS by the S&P 500.

With the Index currently as all-time highs and after having set new intraday highs 40 times in 2006 on top of 25 in 2005, the question for investors is when will this run end? The answer may be, no time soon. CNBC called defense one of their 'Seven for 07'. The New York Times on December 26th said, 'Defense Stocks Likely to Outperform in 2007', Merrill Lynch called it a top 10 play and Investor's Business Daily asked on 7Dec06, “...with global tensions high...where else would you want to be?".

With the Defense budget scheduled to grow by nearly $30 billion in FY07 and supplemental spending forecast to add between an initial $110-$130 Billion and with some analysts speculating this could rise to $170 Billion by the end of the year, it looks like there is some legs left in this rally.

Fears about a Democratic Congress reigning in defense spending are likely overblown as the party is interested in capturing the White House in 2008 and any support for reducing spending on defense or homeland security would hurt this effort.

Perhaps most surprising is a review of the top performers in 2006. Sixteen companies (of the 58 in the Index) posted gains in excess of 30% and the 12 largest constituents all posted gains of 10% or more with 10 of the 12 posting gains of 20%+. Returns generated by the large-cap infrastructure prime contractors were: Lockheed Martin (NYSE: LMT) 44.70%; General Dynamics (NYSE: GD) 30.38%; Raytheon (NYSE: RTN) 31.51%, Boeing (NYSE: BA) 26.48%, and Northrop Grumman (NYSE: NOC) 12.63% -- but there were not necessarily the best performers. Five of the top ten were companies who purchase satellites and use them for commercial purposes or who commercially utilize government systems. Top of the list was DirecTV which gained 76.63%. So while satellite radio stocks performed poorly in 2006, their larger cap brethren were providing substantial returns.

The Index's Top 10 for 2006 was:

1. DirecTV (NASDAQ:DTV) - 76.63%
2. Garmin (NASDAQ:GRMN) - 67.78%
3. Ladish (NASDAQ:LDSH) - 65.91%
4. Precision Castparts (NYSE:PCP) - 51.09%
5. Lockheed Martin (LMT) - 44.70%
6. Orbital Sciences (NYSE:ORB) - 43.61%
7. Trimble Navigation (NASDAQ:TRMB) - 42.94%
8. FLIR (NASDAQ:FLIR) - 42.54%
9. Essex (NASDAQ:KEYW) - 40.23% (being acquired by Northrop Grumman)
10. Echostar Communications (NASDAQ:DISH) - 39.92%

The drivers in 2007 continue to be much of the same that we've seen in past years with performance gains attributed to five factors:

1. Across-the-board increases in government spending
2. Rising budgets for defense and homeland security
3. Supplemental spending to cover the estimated $7 billion monthly cost of the wars in Iraq and Afghanistan
4. An ongoing rebound in the commercial aircraft manufacturing business
5. Continued expansion of the space and satellite market

So how do investors participate?
The easiest way is obviously to find an ETF such as the Powershares Aerospace & Defense ETF (AMEX: PPA) which tracks the SPADE Defense Index and provides exposure to 58 companies including the recent additions of SAIC (SAI) and Stanley Inc (SXE).

For those interested in a contrarian play, 2006 results revealed that defense information technology and homeland security/biometrics firms were out of favor as the Defense Department shifted some of their focus to the ongoing operation in Iraq. With an increased Congressional focus on border security in 2007 and DoD restrategizing its plan for Iraq, both elements could rebound. Other investors may continue to choose one of the large cap prime contractors and hope the company rises with the sector.

Disclaimer: The SPADE Defense Index is a registered trademark of the ISBC. The ISBC makes no representation regarding the advisability of investing in any product based on the SPADE Defense Index.

About the Author
Scott Sacknoff is the manager of the SPADE Defense Index, a modified cap-weighted index designed to benchmark the performance of companies involved with defense, homeland security, and space. The Index methodology and constituents can be found at www.spadeindex.com along with historical issues of the 'SPADE Investor' newsletter.

Source: Defense Sector Bests the S&P 500 for a Seventh Consecutive Year