Investing Using Government Math

by: Scott Sacknoff

Let's say the headlines announce that the Department of Defense budget goes down by $50 billion. That's bad, right?

Not necessarily.

In government math, the change in the budget isn't the same thing as a decline in spending. The budget can go down but the total spent goes up. Confused? You're likely not the only one.

Think of it this way. You budget $1000 for a new flat screen TV to watch the Super Bowl on. When you get to Best Buy (NYSE:BBY) there's a sale and you only spend $800. So you saved $200. You actually spent $800 but that's not what you are focused on.

The government budget is much the same. Each year, DoD sends to the Congress and the White House its estimate for spending over the next five years. If Congress and the White House decide they should spend a bit less on defense to focus on deficit reduction (which is what is happening) then the actual will come in below the forecast -- hence a decline even if the actual is still an increase.

Back in late November, the Office of Management and Budget (OMB) stated that after the +/- $50 billion annual cuts, DoD would see a budget that actually rose from 2014-2017; although at lower than previously planned levels and at levels that were around the rate of inflation.

2013 $523.3B (down 1%)
2014 up 1.8% $533.0B
2015 up 2.3% $545.5B
2016 up 1.9%, $555.9B
2017 up 2.2% $567.9B

So what does all this mean for the defense companies like Lockheed Martin (NYSE:LMT), General Dynamics (NYSE:GD), Raytheon (NYSE:RTN), L3 Communication Holdings (NYSE:LLL), Northrop Grumman (NYSE:NOC), SAIC (SAI), etc?

The truth is...the devil will be in the details. Simply looking at the planned reductions in spending or the top-line figure won't provide clear answers.

You have to add in budget growth, subtract inflation, add savings due to reduced troop levels, and then factor in amounts reallocated from one program to another as the agency seeks to define its new military doctrines. Even when looking at reductions in the number of planes in a program such as the F-35, it doesn't necessarily mean what you initially think it does. Decreasing the number of planes to purchase through 2025 is a negative, however production of the 'missing' planes wouldn't impact revenue by the prime contractor (in this case Lockheed Martin) for many years in the future; by which time, an increase in the number could enter the budget.

So what is an investor to do if they feel identifying the winners and losers is too complicated at this point in time?

If you believe that the net impact of the defense budget declines will be manageable with international growth, commercial aerospace, and other business activities enhancing companies' top and bottom lines and the fundamentals and dividends are just too good to pass up, then an ETF, such as the Powershares Aerospace & Defense ETF (PPA) provides a diversified option to get exposure to the sector, especially in the growth areas of cybersecurity, UAVs (unmanned vehicles), and C4ISR.

Disclosure: The author manages the SPADE Defense Index (NYSE: DXS) which the Powershares Aerospace & Defense ETF (NYSE: PPA) is designed to track.