In his latest book A Gift to My Children, former Quantum Fund manager Jim Rogers gives his readers a little hint as to how he was able to return 4,200% in a 10 year span while the S&P returned little over 47% (1973-1983). He recounts a story of how, when he was experiencing his first successes on Wall Street, he was invited to a dinner of investment managers. Each of them had to give one stock recommendation over dinner. He recommended Lockheed (LMT), then Lockheed Corp.
Rogers was lambasted at the table for such a crazy pick, freshman investment manager he was. At the time in the mid 70's, Lockheed was bleeding profusely, defense spending was being cut all around, and Vietnam was winding down and ending. Rogers defended himself by reminding all at the table that defense spending could only be cut for so long, and that Lockheed, though bleeding money, was cutting off non-profitable portions of its business and focusing on new technologies.
In the '70s, LMT was hovering around a buck. In 1983, by the time Rogers closed out all his positions in the Quantum fund and left it to George Soros, President Reagan was increasing the defense budget and spending the USSR into the ground. Lockheed reached $12 that year.
Let's take this reasoning and look at the current situation. You have got four major defense companies, Lockheed Martin, Northrop Grumman (NOC), Boeing (BA), and Raytheon (RTN), all together accounting for a grand total of $115B in market cap. With the possible exception of Boeing, all are very top-heavy in federal money. Ever wonder why we're $16 trillion in debt? A lot of it went to these companies over the decades.
The US defense budget is unfathomably enormous. The US spends more on its military than every other country on the planet combined. The Pentagon's budget is the biggest since World War II in inflation-adjusted dollars, and we're not exactly fighting a world war these days. We don't even have a nuclear armed enemy on the other side of the world like we did in the '70s when the defense budget was small and Rogers' fund manager friends were mocking him for his Lockheed pick.
Europe is in a debt crisis the likes of which it cannot escape, and attention will turn to the dollar and US government debt whenever Europe either figures out what to do or gives up and defaults. Either way, the eye of the debt storm is on its way over here after ravaging Europe, and companies that rely heavily on business with the US government are going to have to start preparing their exit strategies if they want to weather the coming storm. In one sentence, there is only one way for the defense budget to go, and that's down.
Let's now turn to a little known player in the defense industry. Implant Sciences (IMSC) is a micro-cap (44.3MM) that manufactures and sells, among other things, explosive detection systems. Their stock is near an all time high (see chart below) but a look at their 10-Q is, in all honesty, not pretty. They have never turned a profit and they owe a grand total of $27,519,000 to DMRJ Group LLC, their chief creditor. So why is IMSC near its highs?
The silver lining is this: Unlike Northrop, Lockheed, or Boeing, Implant manufactures its own explosive detection systems. Their main market, at least right now, is international, recently completing a $6 million deal with India, a country that is admittedly poor, but whose defense industry is attracting heavy interest from local billionaires. Deals were also just made with Saudi Arabia, China and Africa. Implant's main competitors in terms of manufacturing these systems also happen to be outside the US. There is Safran SA (SAF), a French company, and Smiths (SMIN) a British company, both of which acquired their manufacturing capability through acquisitions in recent years.
Many see potential in the TSA's impending review and approval of Implant's systems. This would of course be a good thing and contribute significantly to the company's earnings, but seeking salvation with another US government agency is not, in my opinion, a long term strategy if we are to take Rogers' reasoning to its logical conclusion.
If we are to see this stock transform from micro-cap to serious player in the defense industry, we'll need to see a merger or takeover. The ingredients are there. Implant's market is outside the US. The big players do not manufacture what Implant does. Previous takeovers in this industry have worked for Safran and Smiths. If the boards of Lockheed, Northrop, and Boeing see what's coming in the US defense budget, they'll all want a stronger foothold in Implant's international markets to protect themselves. And finally, Implant Sciences is in debt. If they can't pay it off, they'll need someone else to acquire that debt.
Could this be why, despite it all, IMSC is nearing all time highs? Who knows, but look below and let's not forget how the big four in US defense companies were formed after all.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.