Large Cap Defense Stocks: Option Traders See Limited Downside

Includes: GD, LLL, LMT, NOC
by: Joe Kunkle

A trend emerged yesterday as I was going through my nightly scans to find unusual options activity; four of the largest Defense/Aerospace firms all traded around 6 times average daily put volume. Now, most would go on to assume that this is a bad sign, but the puts were all being sold at the bid, opening put sellers.

Institutional traders will often sell puts at a level that is seen as major support, unlikely for shares to trade below, looking to collect the premium from the transaction, and if shares do break below the strike price, the trader is willing to take delivery of a large block of shares as a long position.

After a bit more research I noticed that all of these stocks are trading less than 10X forward earnings, offer above average dividend yields, and have under-performed the market the past 3 months.

The four stocks are General Dynamics (NYSE:GD), L-3 Communications (NYSE:LLL), Lockheed Martin (NYSE:LMT), and Northrop Grumman (NYSE:NOC).

The spreadsheet below provides some of the major valuation metrics showing that all these stocks are extremely cheap compared to the market, and compared to industry peers. At less than 10X earnings and 6X EV/EBITDA there is the potential for a good amount of upside in shares strictly on valuation.

I would prefer General Dynamics as the top play of these four, trading as cheap of the others with better growth and margins, and also down 20.5% the past 3 quarters. Shares also found support at the 50% Fibonacci retracement.

Here is a view of the four companies and the valuation metrics:

Large Cap Defense Stocks Valuation Metrics

Defense stocks have underperformed due to worst case scenarios being priced in for potential budget cuts, some believing there could be up to 30% cuts in the defense spending budget. However, defense spending usually is a tough area to cut as the post 9/11 era still has people living in fear, and cuts to the defense budget and military spending could bring about a lot of criticism, something the Government would be best to avoid as elections come around.

Also, many of these firms are big players in the Aerospace Industry, the only sector showing major growth in Industrials based on recent economic data.

Now, let's look at a breakdown of the options activity today to see exactly what the traders were doing that alerted my scans:

1) General Dynamics traded 5,182 puts, 7X daily average, and 87% hitting the bid, as more than 4,500 September $55 puts were sold for $0.30 with shares at $62.70.

2) L-3 Communications traded 2,590 puts, 4X daily average, and 75% hitting the bid, as more than 2,300 September $65 puts were sold at the $0.30 bid with shares at $74.50.

3) Lockheed Martin traded 3,698 puts, 6X daily average, and 70% hitting the bid, as more than 3,400 September $70 puts were sold for $0.60 with shares at $75.50.

4) Northrop Grumman traded 2,175 puts, 5X daily average, as one block of 2,150 September $55 puts was sold for $0.70 with shares at $59.07.

The action is indicating that shares are unlikely to show much more downside in the next 2 months and could start to close the gap with the under-performance compared to the market. It is not upside out of the money call buying that implies Defense stocks are going to be the next hot group to move higher, but it is a vote of confidence.

With options there are various ways to position for how the "smart money" is positioning in these stocks:

You can sell cash secured puts, following this action, but making sure you have enough cash to take delivery of shares if shares were to move below your strike price come expiration.

You can sell vertical put spreads for a net credit, a semi-bullish play in options that leaves room for error, and requires less margin.

You can buy the underlying equities and average in if shares were to head lower, as the longer term picture is a bullish one.

There are various ways to trade these stocks based on the action that is occurring in the options market, where the smart money plays.

It is a trend worth noting as we look to gain an edge in the markets, and is also a great place to hide if the S&P breaks back below the 1,090 level

Disclosure: Currently No Positions in the Above Mentioned Stocks