Currently, automatic U.S. defense reductions are scheduled to begin on January 2, 2013. These cutbacks will eliminate $500 billion in the U.S. defense budget over the course of 10 years, and are estimated to ultimately cost 1 million defense workers their jobs. With these changes threatening so many U.S. jobs, defense contractors are required by state and federal laws to send warnings to their employees about their uncertain job status months before anyone is let go.
Lockheed Martin (LMT) and other companies are complying with these laws in such a way that political pressure is put on politicians to repeal the planned reductions, warning politicians that workers will be informed of the massive layoffs just prior to the November elections. There are many ways for investors to beat these defense cutbacks. In this article, I will focus on three companies which pay attractive dividends, yet do not derive their revenue from outdated government mandates. The three companies I have chosen are AstraZeneca (AZN), ConocoPhillips (COP), and BP (BP).
Even if the January cutbacks are deterred, the writing is on the wall that hard times are looming on the horizon for defense companies. Though Lockheed Martin (LMT) and other military contractors seem like compelling dividend plays, their businesses are based largely on unsustainable government spending. Dividends from companies that are not private-sector offshoots supported by discretionary government spending are a much better choice for income investors. Even investors who are dead-set on defense stock investing should take note and protect themselves by screening out firms who rely heavily upon business from military contracts.
The Case for Shrinking Military Budgets
First of all, it should be made clear that military spending makes for terrible GDP stimulus. The "D" in GDP stands for "domestic," a jurisdiction which misses of multiplier effects felt by local economies host to troop deployments based overseas in countries like Japan, Germany, Italy, among others. Spending defense money on the troops at home does not help the American economy much either. Many of these soldiers and their families live on-base, shop on-base in commissaries, and even buy gasoline on-base (procured from "budget surplus"). A fraction of this spending applied to other, less insular projects would result in a greater stimulus effect at lower cost. Therefore, there isn't much of a sensible argument for sparing military spending for its economic impact, domestic prosperity, jobs, or other sacred cows.
Furthermore, there is no geopolitical need for such a gargantuan military budget. The Cold War is over and the war in Afghanistan should have ended with the assassination of Osama Bin Laden. At this point, the war's most prominent beneficiaries are corrupt governments bodies in Pakistan and Afghanistan, who accept money from both the U.S. government and Al Qaeda simultaneously. Pundits warn against pulling out are playing the same trump card as those who warned against the U.S. withdrawal from Iraq or Vietnam.
Unfortunately, it seems like our military budgets have been cryogenically frozen in the Cold War era. Our government needs to come to terms with the reality of a post-cold war era, and its disconnect from reality is so absurd it could use a reality check from the comedy movie Austin Powers. Someone needs to thaw and debrief Washington: "The Cold War is over: we won."
Now for another dose of reality: The United States will ultimately be forced to dramatically slash military spending even more than it already has, which means defense stocks will see increasingly larger cuts. Consider the following facts about U.S. military spending:
The United States accounts for 44.4% of the world's military spending. The U.S. economy is too small to justify such a share with a GDP that is 19.8% of the world total and a population that is only 4.47% of the world's total. Just to be in line with the rest of the world, U.S. military spending would have to be reduced by 50% on a per-income basis. On a per-capita basis, unfathomable 90% cuts to the military budget would move the U.S.'s defense spending to the world average. Clearly, the United States has an oversized military budget for today's world.
There are many, many companies which pay attractive dividends yet do not derive their revenue from outdated government mandates. Consider the following stocks:
Integrated Oil & Gas
Integrated Oil & Gas
AstraZeneca, ConocoPhillips, and BP all pay higher dividend yields than their defense counterparts. These dividends are not in danger since each of these three firms pays out less than 60% of their earnings as dividends. Moreover, these stocks trade at cheaper price-to-earnings ratios than the defense stocks. These numbers capture how these stocks offer more income for cheaper valuations than many large cap defense stocks.
These alternative firms offer safer dividends on the basis of industry outlook, too. Selling drugs and fossil fuel products often involves consumption in the private sector. Government cost cutting will not reduce their revenues to the calamitous extent it would reduce the revenues of these defense stocks. None of these firms derive more than 80% of their budget from defense or other discretionary government spending, which makes them less of an austerity risk.
The role of the United States in the world is changing. The vestigial military spending of a Cold-War past and escapades as a global policeman are unsustainable in the present. When considering the responsibilities the U.S. has agreed to, such as promised entitlements and taking care of a an aging population, it is apparent that more funding will be yanked away from military funding and many military-focused aerospace contractors. Avoid these companies. Fortunately, there are many other stocks from other industries which pay even higher dividends. Consider them as alternatives to bets on prolonged heavy military spending.