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The Case For Defense Stocks Against Increasing Uncertainty

Summary

Increasing uncertainty across global markets highlights the need for investors of all types to balance high growth opportunities with stable investments.

Defense stocks have increased since Trump's election, but there is still room for further growth.

With Trump likely to increase defense spending, defense contractors are poised to continue their outperformance.

Throughout global markets, 2016 and much of 2017 has been defined by uncertainty and volatility, confronted by pressing headwinds threatening g rowth prospects for the rest of 2017 and beyond.  Among these risk factors include events such as the election of Donald Trump and an unstable geopolitical environment.  As uncertainty on the horizon grows, investors of all types should take action to protect their portfolio from a possible market correction or dip in valuations.

Shares of defense companies have shot up since the election, but in my opinion there is still room to grow because the remainder of Trump’s presidency will likely see steady increases in defense spending.  Therefore, I think the defense contractor industry provides investors growth opportunities while minimizing potential downside.  The most notable defense companies are Lockheed Martin (NYSE:LMT), General Dynamics (NYSE:GD), Raytheon (NYSE:RTN), Huntington Ingalls (NYSE:HII), BAE Systems (OTCPK:OTCPK:BAESY), Northrop Grumman (NYSE:NOC), and Rockwell Collins (NYSE:COL) among others.  Another possible option is L3 Technologies (NYSE:LLL), which has a stable defense business, particularly in Satcom.  While the company has been laboring on the commercial side, it has more commercial sales than the aforementioned contractors, which suggests that a slowdown on that segment would be felt by the company more than other defense contractors.  However, L3’s stable cash flow and stellar capital returns certainly makes it a respectable option.  Boeing (NYSE:BA) and United Technologies (NYSE:UTX) have been excluded since these companies have larger commercial aerospace segments, and these are major performance drivers for the companies.

Generally speaking, companies that generate a large portion of their business with government entities are not the most glamorous Wall Street investments.  This is because governments have a reputation of being inefficient, bureaucratic, and prone to succumbing to preferential politics.  More importantly, the market size is dependent on how much money the government is allotted for military spending, which hinders growth rates irrespective of market share considerations.

With all of these factors considered, what’s the appeal of investing in a sector which makes money by selling products to assorted militaries across the globe?  During periods of surging global economic growth, such as the 1990s economic boom, I firmly agree that there are superior alternatives for outperforming the market.  The crucial aspect is having a diversified portfolio which will capture above-market returns during both bull and bear cycles.  The counter-cyclical nature of defense stocks does just this.  Things that drive down the rest of the market typically stimulate defense shares – which is a reason that defense outperformed other industries in the periods of stagnant economic growth of the last decade.

To this end, I believe that defense stocks are a better “conservative equity” choice than the conventional options, such as utilities and consumer staples, due to the companies’ unique market position.  Whereas the revenue of other companies is based on uncertain, commercial market-based spending, the revenue of defense contractors is dependent more upon fixed government spending.  This suggests an advantage, since government contractors are steadily paid over a longer period of time, thereby stabilizing top and bottom line results.

With the previously mentioned factors helping to mitigate risk, I believe that defense contractors are poised for further growth due to the unstable geopolitical environment.  As conflicts involving non-state actors have come to the foreground, it has created an unpredictable environment.  Although it is not the volatile dynamic tensions of the Cold War days, today’s geopolitical climate is marked by threats of terrorism, cyber attacks, and a number of regional and political conflicts.  The larger defense companies have the potential to reap the rewards from increased government spending on traditional products like aircrafts, while also benefiting from developing platforms like cyber security.

With the unstable geopolitical climate around the world and the Republicans controlling the White House, Senate, and the House (for only the second time since 1929), I believe that defense companies will continue to outperform in 2017 and beyond.  The sequester budget caps will likely be lifted during Trump’s presidency, which allows the U.S. government to increase funding for the DoD.  Should this occur, the DoD should see minor funding increases as shown in the chart below:

Source: http://comptroller.defense.gov/Portals/45/Documents/defbudget/fy2017/FY2017_Budget_Request_Overview_Book.pdf

I am not suggesting that defense contractors are poised for a massive boom; I merely think that the conditions are right for defense stocks to continue their historical outperformance because of the factors I have mentioned.  The industry certainly offers advantages from the perspective of a balanced portfolio.  Although it can be enticing to stack your portfolio with high growth tech companies, it would be smart to diversify risk by balancing your portfolio with one of the defense stocks mentioned in this article.