War, War, What Is It Good For? Defense Industry Stocks

Includes: COL, GD, HEI, LMT, MMM, PCP
by: Erik Dellith

Facing a Democratic Congress for the first time, President George W. Bush asked skeptical lawmakers to give his new Iraq war plan a chance. His appeal has met a cool reception and it is obvious the hugely unpopular war has become Bush's Achilles heel. There has been, however, a clear winner: the defense industry.

In the wake of Sept. 11, the government has beefed up military spending to boost national security and finance wars in Afghanistan and Iraq. National defense consumption expenditures and gross investment spending climbed more than 30 percent between 2000 and 2005, according to government statistics (the figures for full-year 2006 are not yet available). During this time, the government's investment in aircrafts and vehicles has more than doubled, while figures for investment in missiles and electronics & software have climbed approximately 52 percent and 41 percent, respectively.

Investors interested in gaining exposure to defense stocks will have plenty to choose from.

Out of the nearly 8,900 companies currently in the Reuters.com stock universe, 70 are found in the aerospace & defense industry. Many of these companies have fared well thanks to the increase in government spending. Over the last five years, earnings per share [EPS] in this industry have grown at an average annual rate of more than 31 percent - nearly double the pace of EPS growth for the S&P 500. This earnings growth has also been reflected in share prices. Although industry-wide EPS growth has eased over the last year, the trailing 12-month [TTM] figure, at nearly 21 percent, remains relatively solid when stacked up against the S&P 500's EPS growth of just under 24 percent.

This earnings growth is also reflected in stock prices. The AMEX Defense stock index [DFI] was created in September 2001 with a base value of 500. The index now stands around 1,253.

We started our search in the aerospace & defense industry with the seven companies that recently cleared at least one Reuters Select stock screen. (Click here for an Excel sheet comparing these companies.) We then omitted foreign-domiciled companies. This shortened our list to six names.

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While the AMEX Defense index focuses on widely held and highly capitalized companies, we are not so strict in our search criteria. Still, investors looking for larger companies should note that Lockheed Martin Corp. (NYSE:LMT) and Rockwell Collins, Inc. (NYSE:COL) are two such large-cap names that are not only components of the AMEX Defense index, but also recently appeared on Reuters Select stock screens.

If you want to further narrow the list, one approach is to focus on aspects of corporate quality. For example, we filtered the list of six names to find companies that have above-average return on investment [ROI] over two time periods: the trailing 12 months [TTM] and over the last five years. This shortened our list to three names.

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Investors more concerned with valuation might want to start their search with Lockheed Martin, the only company here to appear on a value screen. The Relative Value screen focuses on companies that are reasonably valued. It requires that stocks have price to earnings [P/E], P/Sales, and P/Cash Flow ratios that are no more than 10 percent above the industry averages, such as Lockheed Martin.

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Defense spending will likely remain unusually high for the near future as the war in Iraq drags on and related companies should continue to reap the benefits. But investors beware: Nothing is certain, and all bets may be off if the United States decides it no longer has the stomach for a prolonged engagement.

Disclosure: At the time of publication, Erik Dellith did not directly own shares of any company mentioned in this article. He may be an owner, albeit indirectly, as an investor in a mutual fund or an Exchange Traded Fund.

Note: This is independent investment and analysis from the Reuters.com investment channel, and is not connected with Reuters News. The opinions and views expressed herein are those of the author and are not endorsed by Reuters.com.