Defense: An Undervalued Sector With Strong Dividends And Impressive Growth Prospects Even In A Bad Economy

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Includes: BA, GE, LMT, NOC, RTN, SPY
by: The Independent Investor

Wow, defense stocks sure are popular when Republicans are in office and the U.S. is fighting multiple wars overseas. Indeed, while the S&P 500 and its tracking exchanged traded fund, SPY, nearly doubled from 2004-2008, many defense stocks traded at huge premiums to today's prices as well.

The defense sector has always been a politicized sector to invest in. Still, given that many of the leading stocks in the defense sector, such as Northrop Grumman (NYSE:NOC), Lockheed Martin (NYSE:LMT), and Raytheon (NYSE:RTN), are trading the low end of these companies' historical valuation, it is interesting to see if defense spending really falls when wars end and Republicans aren't in control of Congress of the White House. Largely civilian contractors such as GE and Boeing (NYSE:BA) have also seen these companies' defense related business hold up as strong.

Many of these leading defense contractors have also continually reported strong earnings and have consistently raised these companies' dividend payouts by double digits for several years, and civilian contractors such a GE and Boeing have also benefited significantly from strong demand for military aircraft.

When Obama came into office in 2008 he did not have much flexibility in handling the War in Iraq, which was already drawing to a close. In Afghanistan, however, Obama significantly increased the U.S.'s troop presence by nearly 40,000 troops. Still, while the obvious total cost of the U.S. civilian and military presence in Iraq and Afghanistan is very high, percentage wise, the war in Afghanistan comprises less than 14% of defense spending, and military spending in Afghanistan is considered supplemental to the Senate's recently proposed defense budget for 2013 of $631 billion.

The reality is that while Republican and Democrats have controlled Congress and the White House over the last 12 years, the defense budget has continued to grow by around 3-4% a year.

dod budget

(2011 President Budget Document: Department of Defense Appropriation Acts FY 2001 - FY 2010, FY 2011)

While most leading defense contracts such as Northrop Grumman, Raytheon, and Lockheed-Martin are trading at 20-30% discounts to these companies' share prices during the Bush administration, the defense budget is actually nearly 30% higher today than it was in 2004 when Republicans controlled Congress and the White House, and the U.S. was the middle of the wars in Iraq and Afghanistan.

The argument that defense spending will fall significantly when the war in Afghanistan ends simply lacks historical support. The defense budget has steadily increased since the U.S. began drawing down troops in Iraq around the 2008-2009 period, and defense spending is significantly higher today that than what it was in 2006, in the middle of the war in Iraq.

Also, as we've seen in Europe, Korea, and elsewhere, an official end to combat operations does not frequently end the U.S.'s commitment to a country or region. Today, nearly 60 years after the war in Korea ended, the U.S. still has 40,000 troops in South Korea. In Europe, the U.S. also has around 40,000 troops.

Even if the U.S. continues to make progress in the War on Terror over the next decade, the U.S. will still have significant strategic and economic interest in the Middle East for many years. In addition to increasing the defense budget, private contractors working for groups such as Blackwater, now called XE, are also significant operators in U.S. combat zones today as well.

The U.S. already has plans to build a pipeline from central Asia through Afghanistan to supply natural gas to much of Eastern Asia, and Iraq may ultimately surpass Saudi Arabia in oil production over the coming decades. The proposed pipeline that would come from Central Asia and go through Afghanistan is also considered a national security issue, since Iran is attempting to be the leading provider of natural gas to Eastern Asia, and was the only government in the world to recognize the Taliban as a legitimate governing body. The U.S. embassy in Iraq is also the size of the Vatican, and is the biggest U.S. embassy in the world.

To conclude, while the defense budget will likely be much more focused on technology and modern forms of warfare in the future, defense spending is likely to continue to rise for decades to come even after the U.S. draws down its troops presence in Afghanistan. While Republicans often talk more hawkish on military issues, Democrats and Republicans have continually been committed to a significant and increasingly large defense budget and troop presence overseas for many decades.

While the growth outlook may continue to deteriorate in the near-term, many leading defense contractors in the U.S. are likely to see strong earnings for years to come.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.