Defense Stock Issues
Brian Trumbore
President/Editor, StocksandNews.com

While I normally steer clear of commenting on individual stocks, I thought the following may be of interest to some of you with holdings in the defense industry.

The piece was written by Gopal Ratnam in the September 27 edition of Defense News, a publication that I read on a regular basis for its coverage of international affairs. The good folks have granted me permission to pass this story on to you. Personally, I do not own any defense issues at this time.

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Uncertainties about the upcoming U.S. presidential election and defense budgets are leading some Wall Street analysts to take a tougher look at defense stocks.

Some say the defense industry remains an attractive destination in an otherwise weak economy, while still others say such stocks offer good long-term value.

Major defense stocks already are trading at high prices compared with overall market indexes like the Standard & Poor's 500. The high prices reflect how investors are factoring in the good news about the sector - better profits and a modest increase in the U.S. defense budget - but from now on, prices are likely to decline on fears of uncertainty, warned David Strauss, an equities analyst at UBS Investment Research.

But Byron Callan of Merrill Lynch disagrees with Strauss.

"In an environment where earnings growth expectations for other stock market sectors are coming under question, the relative stability of defense earnings could support current or modestly higher prices," Callan said in an Aug. 27 note to clients. "The market capitalization of defense is still small, compared to other portions of the stock market."

The Electoral Impact

Though close examination of the defense industry is routine in presidential election years and during the annual Pentagon budget process, Callan and other analysts advise investors not to panic.

After Joseph Nadol met with several defense industry executives, the J.P. Morgan Securities analyst told clients in a Sept. 7 note that "the consensus opinion was that neither a Bush nor a Kerry win in November would lead to any substantial changes in the size of the defense budget in the near term."

Democratic candidate Sen. John Kerry has said he would reduce missile defense's $9 billion annual budget and use the money to add troops. But Nadol said the proposed cuts would be tempered by a Republican-led Congress.

Conventional wisdom holds that the defense industry flourishes under Republican administrations, but a recent UBS study showed that General Dynamics, Lockheed Martin, Northrop Grumman and Raytheon did better when a Democrat won the White House. Since 1972, the stocks of these four major Pentagon contractors have scored an average gain of 11 percent in the wake of a Republican victory, but 22 percent after a Democratic one. And election years are generally good times for the industry, overall, returning 15 percent for the period in question, the study found.

Predicting stock performance is a bit more complicated this election year, as the military services are trying to balance their modernization budgets against the need for more troops and rising maintenance costs. Some analysts fear that research and acquisition funds may be raided to boost the size of a military stretched by operations in Iraq and Afghanistan.

The military services have submitted their initial 2006 spending proposals to Pentagon budgeters; press reports indicate that the Navy reports indicate that the Navy intends to slash shipbuilding, while the Air Force means to trim its proposed purchases of tactical fighters. Changing threats, counterinsurgency operations and urban combat could send even more Navy and Air Force money to the Army, marking the biggest spending tilt toward the land force since 1947, Callan wrote.

Regardless of who wins in November, spending on research and purchases of new weapons could take a hit in 2006 and 2007, "which could result in low industry growth rates for a couple of years," Nadol said. But neither he nor Callan are advising investors to dump stocks in the sector.

Nadol predicts that once the presidential election is over, a $50 billion supplement would be added to the 2005 defense budget, which could ease the pressure on modernization and maintenance accounts.

The Long View

Long term, institutional investors are not perturbed by election- year uncertainties or short-term swings in industry performance, said one adviser to large institutional investors.

"It is true that the market hates nothing so much as uncertainty," the adviser said. "Yes, there is some uncertainty about who wins the election, but does anyone ever believe there would be a sea change in defense spending? That's a short-term attitude."

Equities analysts at Wall Street firms "get paid to think short- term," the adviser said. "But if you are the largest shareholder in Lockheed Martin, you can't get in and out of the stock anyway."

Most defense firms have spread their risk widely through several programs or through a combination of defense and commercial business, the adviser said.

"A big defense contractor like Raytheon has over 8,000 contracts," he said.

Beyond the big five defense companies, mid-sized firms that maintain and refurbish military equipment will see healthy business for many years, he said.

"We are going to spend a lot of money on our military for the foreseeable future," the adviser said. The current concerns among some investors "are short-term perturbations."

Reprinted with permission by Defense News / Army Times Publishing Company. Copyright 2004.

Brian Trumbore