Defense and Aerospace Sector: 'Irrational Dejection'?

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Includes: BA, GD, HON, LLL, LMT, MTCT, NOC, PPA
by: Scott Sacknoff

With the major U.S. market indexes all down for the fourth consecutive month, one might see this play on the Alan Greenspan speech in 1996 as an interesting choice of words. Back then, before the height of what has become known as the Internet bubble or the Tech bubble, the market seemed to favor all sectors and styles. Although some more than others, it was hard to identify an investment strategy that didn't work.

Today, we have the opposite, with nearly every equity sector and style seeing weakness driven by the serious economic issues in play at the moment: recession, inflation, the housing/ bank/ loan crisis, and a weak dollar. Recent conversations with money managers, and analysts that monitor the economy and Wall Street, have said that its possible that problems may be even worse than many people realize as capital for investment moves to the sidelines. Where the mood in the irrational exuberance days was 'everything is wonderful' (even in areas where it wasn't) today the mood is 'everything is horrific', even in places where it isn't.

Has Fear Replaced Logic?

How else am I to explain how the aerospace and defense sector, whose companies continue to report record earnings, record levels of cash on hand, historical share buybacks totaling in the billions of dollars (which will improve earnings per share over time), and a backlog that some firms are measuring not in months but years is falling in step with the rest of the market. To put this decline in perspective, according to the SPADE Defense Index, investors have driven the value of the sector down more than 17% from its November highs -- meaning that defense and aerospace companies are approaching bear market territory.

The FY09 defense budget was released by the White House in mid-February and it was pretty much where everyone thought it would be, if anything slightly stronger than what was expected. Before it was released, one might have expected a decline and perhaps a bump in the road for a sector that has outperformed the market for eight straight years. But once this worry came off the table, it becomes hard to understand how a sector whose trends have not changed since the benchmark SPADE Defense Index hit historic highs in November 2007 could decline by double digits without wondering if fear has replaced logic, and if it's just the pressure caused by the 'irrational dejection' of investors.

Is Now the Time to Buy?

This is definitely a question on a lot of investor's minds. What is important in choosing investments in this type of market is understanding the underlying trends driving longer-term performance so that you can determine which areas will perform or rebound quicker when investor sentiment improves. As stated before, the defense sector still has a number of underlying positive trends that bear consideration. Even as the defense budget shows flattening growth, the forecast is for at least $30 billion in new monies by FY2013.

On top of this are supplemental appropriations of nearly $8 billion per month for as long as we are in Iraq and Afghanistan at the current strength. For those worried about once the withdrawal begins, while there are questions about what will happen, it should be noted that new opportunities for contractors will arise as the U.S. military anticipates that it will maintain a presence in the region for some time. Combined with increased outsourcing of support, maintenance and operations to private contractors and greater involvement of firms as the military resets and invests in new technologies and hardware, many firms see successful days ahead.

In particular, summarizing the perspectives of several companies in speeches given during the Cowen & Co. Aerospace & Defense Investors Forum, even in light of the slowing defense budget, they see growing demand for trucks and vehicles, new aircraft systems, information sharing, persistent surveillance, enhanced situational awareness, navigation, advanced sensors, government services, and networked communications.

A More Complicated Investing Market

Determining which part of the defense sector was the 'hot' place to be and picking the individual companies that were poised to benefit appears to be a more difficult exercise going forward. Following 9-11, small- and mid-cap companies involved with defense IT and network centric warfare were favored as the defense community worked to develop systems that would enable better communications and intelligence collaboration and ensure that the gaps that could have prevented 9-11 were filled.

The invasion into Iraq changed that as resources shifted to the large companies supplying the equipment necessary for the war effort. Defense IT became a drag on the returns of the index even as the sector was collectively outperforming the broader market.

Now the answer isn't as clear. A case can be made that defense IT will rebound after we reduce our forces in Iraq as resources are freed up. A case can also be made that firms involved in any reset to replace equipment worn out over the past several years is the place to be. Still others will point to companies with exposure to the commercial aerospace market where new orders may slow but the backlog is at historic highs. In a market where things aren't as clear, funds offered by Powershares (AMEX: PPA) may gain favor.

But getting back to the original theme of this commentary, I believe that the sector likely sold off as investors sold good (those with significant gains) to pay for bad (those that had dropped and investors hoped were at the bottom). But with the defense sector down some 17% from its highs, I think we may start seeing investors increase their positions in aerospace and defense.

Lastly, a few thoughts on the highly publicized Air Force award to Northrop Grumman (NYSE:NOC) and EADS to build the next fleet of tankers. The up to $40 billion contract has caused an uproar among politicians and analysts as about half the work goes overseas instead of supporting the U.S. industrial base. One side will argue about U.S. jobs being lost, the other, that the goal should be to choose the proposal that best meets the military's needs at an appropriate cost. In the end, it is likely that, while this contract will go forward, Congress will consider new rules regarding how to include foreign subsidies and health care costs in bids relying on suppliers outside the United States. But there is something for all of us to ponder...doesn't the participation of our international partners in joint efforts imply that foreign governments are subsidizing our defense initiatives? If so, would that mean that DoD has more money to invest in R&D destined for U.S. firms? The issue is more complicated than one would initially think.