A Meandering Journey Through Elections, Defense Spending And Defense Companies

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Includes: BA, GD, LMT, NOC, RTN, UTX
by: Patrick Gunn

Summary

A popular theme when elections come around is how each candidate will positively or negatively impact the defense sector.

By taking a look back at recent periods of defense spending, we can start to see trends which give us a better idea of what could happen in the future.

From what I have found, it appears to matter little who sits in the Oval Office. Geopolitical stability appears to impact defense spending much more.

I offer my own thoughts on defense spending and where I see more of the spending being allocated.

Defense and aerospace is a popular sector to invest in. The sector carries with it a wide moat, reliable customers, and macro trends that lead to market beating returns.

The defense sector also performs a little differently from the rest of the market. Periods of international turmoil and unrest are when defense and aerospace companies shine. Short of worldwide financial turmoil like we saw in 2008 there isn't much that takes down these behemoths.

A major chink in their explosive reactive armor is our own political system and the uncertainty that comes every year when the budget gets signed (hopefully) and every four years when we vote on our next president. Now that we are just months away from picking our next leader, investors are discussing what each choice would mean to the economy and more specifically the defense industry.

The first chart I want to share is going back to January 1st, 1992 and looking at the now six largest defense and aerospace companies. By market cap they are United Technologies (NYSE:UTX), Boeing (NYSE:BA), Lockheed Martin (NYSE:LMT), General Dynamics (NYSE:GD), Raytheon (NYSE:RTN) and Northrop Grumman (NYSE:NOC). The total US Defense Spending is included as well as the S&P 500 as a benchmark. The chart alone makes a strong case for an investment in the defense industry.

US Government Defense Spending Chart

US Government Defense Spending data by YCharts

The most remarkable thing I see is that since January 1st, 1992, defense spending has actually dropped by 10.6%. During that time, we had Bill Clinton (Democrat) from 1992-2000, George W. Bush (Republican) from 2000-2008 and Barack Obama (Democrat) who will end his tenure this year. We also had several conflicts, most notably Operation Enduring Freedom and Operation Iraqi Freedom.

As we all know (hopefully), it isn't the President who controls the budget. Congress has the purse strings, the President can only sign, refuse to sign, or veto the budget put in front of him (soon to be her maybe). Since 1991, there have been 13 Congresses including the current one. Seeing as how we have had two Democrats in the Oval Office and one Republican since 1992, I assumed mostly Democrats controlled Congress.

Click to enlarge

(Source: Data from infoplease.com and author generated spreadsheet.)

The Republicans have controlled Congress in seven of the last 13 terms, Democrats just three, and a shared control in the other three. So even with Republicans having control in the majority of the Congress's defense spending still went down by 10.6%. It is important to consider that no party had the 60-member majority in the Senate needed to essentially steamroll the other party. The closest we came was when the Democrats had 57 seats during the 103rd and 111th Congresses.

From 1995-2007, where Republicans controlled both chambers of Congress, defense spending actually increased by 91.8%.

US Government Defense Spending Chart

US Government Defense Spending data by YCharts

As you can see, the September 11th, 2001 terrorist attacks sent our defense spending into high gear, which skews our data. Even if the Democrats controlled Congress, defense spending likely would have shot up considerably. Keep in mind though that even with a 91.8% rise in spending during these 12 years, the overall spending from our sample is down 10.6%. Were it not for the longest period in American history of active combat, I wonder what defense spending would look like today. Safe to say it wouldn't be like this. We would probably see the sharp decline (seen in the below chart) during the Clinton years stabilize then hold.

So what about 1992-2001 where we had a pretty peaceful period?

US Government Defense Spending Chart

US Government Defense Spending data by YCharts

Under Bill Clinton defense spending tanked even with Republicans controlling three of the five Congresses. In the 104th Congress (1995), Republicans gained control of both chambers but we don't start to see a recovery in spending until 1997 with the 105th Congress. So how did our six companies perform during this time?

UTX Chart

UTX data by YCharts

To my surprise, UTX is the strongest performer and along with General Dynamics were the only two of the big six who outperformed the S&P 500. From January 1st 2001 to present day, things shift slightly.

US Government Defense Spending Chart

US Government Defense Spending data by YCharts

For this period, defense spending rose by 93.47% and Lockheed was the star. The rise in spending is clearly due to the wars fought in Iraq and Afghanistan. Even though spending rose by only 93%, the defense companies listed handily outperformed the S&P 500.

I would be remiss not to discuss the sequestration and what this has been doing to defense spending. Sequestration is the result of a political battle between Congress and the Executive Branch that resulted in broad cuts in spending across many sectors, which included the Department of Defense.

I won't go too deep into the background of the Sequester; you can use this link from CNBC to learn a little more if you like. The politics are the politics and I care little for whose fault it is or isn't, what interests me is how these six performed even after the Sequester went into effect.

US Government Defense Spending Chart

US Government Defense Spending data by YCharts

From January 1st, 2010 to present day, we can see what the Sequester did to defense spending. Dropping by 15%, didn't seem to have much effect on the six largest defense companies. Once again, Lockheed outperformed all others. UTX was the sole laggard compared to the S&P, which surprised me given their past performance.

So how did these companies do so well even with their funding being threatened? Turns out they are pretty good at preparing for these types of things and are swift operators when bad things happen. Let's look at just the top three performers during this period.

LMT Total Employees (Annual) Chart

LMT Total Employees (Annual) data by YCharts

Each of those three cut employees, cut capital expenditures (besides RTN), increased gross margins and increased EPS. This all makes sense as contracts dry up from lack of defense spending so do their need for employees. Defense companies, like other contract dependent organizations, have fluctuating employee counts based on contract awards. The Department of Defense is also taking drastic measures to reduce their weapon platforms, which funnels more money into fewer projects, which also benefits companies like Lockheed with their F-35, which is replacing a myriad of planes.

There is much more that we could discuss on Sequestration, though relating it to investing may be a challenge. If you want to know more about that subject, or anything about government budgets, the Congressional Budget Office is the best resource. Here is where they cover Sequestration.

My Thoughts

One thing I hadn't mentioned yet is the complexity of defense spending. There is the base budget and of course money is funneled into defense through separate bills, spending measures and siphoning off from other programs. Not every dollar in defense spending goes towards contractors either; a large chunk is eaten up by personnel costs, healthcare and retirement for the service members. A good breakdown from 2000-2014 is provided by the CBO and can be found here.

It seems pretty clear to me that it doesn't matter a whole lot who wins the presidency, or even who controls Congress. What seems to matter is the current state of the world. If bombs are being dropped and guns fired, defense contractors benefit. There could be an interesting discussion about the likelihood of the United States to enter into conflicts based on if there is a Republican or Democrat in office, but that is mostly worthless to us as investors.

Before I put money into this sector, I'd ask myself if I see the world returning to a more peaceful state, possibly similar to 1992-2001, or if current unrest in Iraq, Syria, Ukraine and Northern Africa will persist. Opinions will vary and that is great. My own opinion is that threats such as ISIS, al-shabab, Hezbollah, Iran, North Korea, Russian aggression in the Crimea and Chinese pushes into the contested South China Sea will not go away.

The only thing I see changing is how we confront these challenges and what companies will benefit as a result. I do expect spending in Anti-Access/Area Denial (A2AD) to increase as wars progress into less kinetic "in your face" conflicts and are increasingly fought with more precise technology from great distances. I expect companies who specialize in these types of weapons and technologies to do very well over the next several decades.

Our weapons are making ground wars mostly futile much like the machine gun made horseback cavalry charges worthless. What good is a tank when one soldier armed with a shoulder fired rocket can kill that tank before the tank even knows he or she is there? What good is the soldier when a satellite can spot them and launch a drone to kill them? Since basically Operation Desert Storm, we have seen the value of traditional military forces drop.

Saddam Hussein possessed a massive military that was well armed with tanks and heavy weapons. He was no match for the F-117 Nighthawk, which picked apart his air defenses and army in a matter of days without being detected. Our own ground forces were there to mop up and that ground war was over in 100 hours. The Abrams tank was killing Iraqi T-72 tanks (those that weren't picked off by A-10 Warthogs) before the Iraqis even knew they were there.

Even in Afghanistan, it was pretty common to just call in an air strike when contact was made with the enemy. The Taliban knew this so they'd try to break it off after just a few minutes. Turns out that you can't outrun an A-10, which is tracking your location thanks to you being tracked by a blimp hanging above a FOB, which has positive identification of you and is literally pointing a laser at your vehicle for the pilot to lock-in on and waste you with a 30mm Vulcan cannon.

The one thorn in our side was IEDs, but we started carrying frequency jammers to cut off the link between the trigger man and the bomb. So they started using pressure plates, which we countered with vehicles armed with ground-penetrating radar and mine rollers. What I'm basically getting at is that ground warfare is being rendered mostly obsolete by technology. Yes that will always have a place in defense spending because without boots being placed on the ground control cannot be truly established, but the days of smashing opposing armies into each other are all but gone.

With terror attacks still taking place and traditional nation-states becoming more aggressive, I don't see defense spending being cut much no matter who gets the job in the Oval Office. Until peace prevails, the defense and aerospace contractors will remain a market-beating sector in the investment world. There are many ways this data can be interpreted and if we were to introduce politics into it, I'm sure great points could be made on any side. Personally, I try to avoid political discussions especially if they call out certain politicians by name. Every four years, I'm reminded of a song from The Who titled "We Won't Get Fooled Again." One line stands out, "Meet the new boss, same as the old boss."

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Disclosure: I am/we are long RTN.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.