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Aerospace and defense contractors are facing very interesting times. As we all know, social unrest has been on the rise since 2009. There was the Arab Spring, populist uprisings in Egypt and Libya, and ongoing conflicts in Iraq, Iran and Afghanistan to name a few. And this list is nowhere near complete. More recently there has been much reporting on the Strait of Hormuz, and generally increasing middle-eastern tensions led by Iran's nuclear ambitions and Israel's "the best defense is a good offense" stance. I'm not taking sides on any of this, just pointing out that the world is an increasingly unstable place.

While social discord ebbs and flows, the size and scope of conflicts tend to rise as economic conditions deteriorate. If this relationship continues to hold, ongoing economic deterioration could provide a growth opportunity for defense contractors.

On top of this, the few economies on the planet that are still growing, such as India, Russia and China, are also increasingly asserting their military strength.

By "asserting," of course we mean spending. But India, Russia and China combined still spend only 40% of what we spend here in the US on defense. In other words, despite the number, size and scope of military conflicts across the globe, aerospace and defense firms ultimately still face the constraints of the US defense budget. And if the past decade of defense spending growth has you thinking that reductions can't happen, chew on this: from 1987-1999, defense spending dropped from over 28% of GDP to 16% of GDP.

The macro theme is dependent on two countervailing forces: the amount of global conflict and the willingness to spend on them. Our belief that conflicts will increase while spending remains stagnant provides little clarity on the industry outlook. However, it doesn't prevent us from measuring the relative potential of companies within it.

Lockheed Martin (LMT) is one of the titans of aerospace and defense. With annual revenue of $46.5 billion, growing every year over the last decade (save for a small 1.25% revenue drop in 2008), LMT is a company that grows in lockstep with US defense spending. With net margins of 6.59% that beat the industry median of 6.11%, a substantial 4.47% dividend, and projected 5-year EPS growth of 8.41%, LMT appears well-positioned. And with a PE ratio just north of 11, this seems to be a company that would impress value investors.

John Shapiro of Chieftain Capital apparently isn't impressed, however, as he recently sold 630 thousand shares. Mr. Shapiro isn't buying the bullish macro theme, and has chosen a cyclical approach that altogether moves away from aerospace and defense.

But not all of his peers have followed him in exiting the industry. Others have been moving into more attractive defense-themed companies, such as General Dynamics (GD). With projected 5-year EPS growth of 9.2%, investors expect more growth from GD than from LMT.

This may be one reason that Warren Buffett has been scaling into GD for a while, increasing Berkshire Hathaway's position by 27% over the last quarter.

In addition to the projected growth and "soft" positioning that Buffett seeks in acquisitions (talented management, defensible market position, etc.) there are specific financial attributes that signify an attractive company. Namely, he looks for book value, valuation and earnings quality.

While the book value is in line with industry standards, valuation is a different matter altogether. GD has a PE of 10.4 and its forward PE is below 10. It also has price to sales, cash flow, and free cash flow ratios significantly below industry and sector averages.

To Buffett, earnings quality also matters. This means two things. First, the business must be stable. One way to measure stability is in the standard deviation of quarterly earnings. GD has the second lowest standard deviation of quarterly earnings relative to peers over the last 16 quarters. Second, the income statement has to be "clean." As we've all learned over the past 15 years, earnings are subject to manipulation. To cut through all the accounting gimmicks, Buffett prefers companies where the business income (which omits unusual items) is as close as possible to operating profit (which includes unusual items). In this regard, GD has a very clean income statement. After such attracting valuations, having stable and trustworthy financials is just the icing on Berkshire's cake.

Overall we also like General Dynamics better because it is slightly cheaper than Lockheed Martin with similar growth characteristics. We wouldn't initiate a long-only position in GD at this point but we think buying GD and hedging the industry risk by selling LMT would produce positive returns over the next couple of years.

Note: This article is written by David Gimpel and edited by Meena Krishnamsetty.

Source: Why General Dynamics Is A Better Investment Than Lockheed Martin