Large-Cap Defense Stocks Poised For Strong Movement

What better place to be defensive when the markets are selling off than the defense industry? While the defense sector has underperformed the market, losing 10% since the sell-off began on July 19, compared to a 6.4% decline for the S&P 500, large cap defense names actually beat the S&P 500, losing only 4.8%. Small and mid-cap defense names meanwhile, lost 11.5%, according to Goldman Sachs’ Richard Safran.

While he is “neutral” on the sector as a whole, it does offer a low volatility play for those expecting the current market turmoil to continue, the analyst told clients in a note. Fears of slowing economic growth in the U.S. should not dampen investor sentiment, since the defense stocks are driven by budget cycles, not economic ones, Mr. Safran said.

As for the deteriorating credit environment, he notes that these companies’ balance sheets are heavy with cash (the top ten global defense contractors have US$39-billion) and they have minimal debt. The cash makes all-cash M&A deals much easier, particularly given the fact that 17 small and mid-cap defense names in Goldman’s basket have a total market cap of just US$17-billion.

The second quarter was solid for defense names and Mr. Safran expects strong earnings will continue in the second half of 2007. While their results beat expectations by 10% on average, upside full-year revisions only climbed 4%. This conservatism suggest more upside surprises are ahead, the analyst predicted.

Contractors L-3 Communications Holdings Inc. (LLL) and Lockheed Martin Corp. (LMT) are Goldman’s buy-rated large cap defense stocks, while the firm also likes neutral-rated General Dynamics Corp. (GD).

LLL vs. GD vs. LMT 1-yr chart:

Comments

[Quaker]

"What better place to be defensive when the markets are selling off than the defense industry?'

How about cash.