Five Reasons to Invest in Defense
Although November ended on an upbeat, overall the month was brutal for stocks and the defense sector was no different. The sector has not been trading on fundamentals or the realization that defense sector revenues and earnings are relatively independent of recession, instead following the broader markets (see chart).
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But while the defense sector is undervalued at these levels, the same can be said about other sectors as well. So the question becomes, when you put money back into the market, and when the market trades on fundamentals, why defense?
1. The Department of Defense Budget: It looks like the FY-2009 and FY-2010 budgets will come in at the current levels or as much as $50 billion higher -- at least this is what defense leaders are proposing and the Bush White House is advocating.
2. Boeing (BA): The company has been a major source of weakness for the sector with its stock price down more than half during 2008. The company’s rebound following the strike settlement was short-lived as the broader stock market shortly thereafter retested its lows. Although next quarter’s earnings for many commercial aerospace companies should be down year-over-year (reflecting the strike), it is likely already priced in. The first test flight of the 787, and subsequent 2009 milestones including the delivery of the first planes, should provide positive news to boost stocks higher. Low oil prices have stabilized airline expenses and reduced the risk the recession would have if airlines delayed delivery of new aircraft orders.
3. Defense Procurement Changes: It's been suggested that the Obama administration will focus on monitoring program costs better; shifting procurement to more fixed cost contracts; and restructuring some delivery timetables on large programs -- each of which is not necessarily a negative and could benefit firms by improving margins and creating more (albeit smaller) programs to compete for.
4. Security Needs: The coordinated terrorist attacks in Mumbai, India shows how lucky the U.S. has been since 2001 in thwarting new attacks. The forgotten part of the defense sector is that which focuses on collecting and analyzing intelligence to determine threats and stop them before they can be executed. The attacks in India serve to remind us of the importance of defense spending. One can expect India’s government to increase resources to protect its citizenry. In addition, the nation was already seen as a major new export market with tens of billions in proposed acquisitions for new fighter jets and other equipment anticipated over the next few years. With U.S. C4ISR skills unmatched in size, scope, and capabilities, (with the possible exception of Israel), new opportunities in India may open up in this market as well.
5. The Obama Defense Team: While military officials and officers were wary of the agenda under an Obama administration before the election, they appear to be increasingly receptive to what they are hearing now. The expected retention of Robert Gates as Secretary of Defense, the appointment of Sen. Hillary Clinton for Secretary of State, and retired Marine Corps General James Jones as national security adviser have been greeted with relief at the Pentagon. Clinton is seen as a defense moderate to hawk and her membership on the Senate Armed Services Committee has given her close ties to the military community. Jones was the Supreme Allied Commander at NATO and a Marine commandant. After last week’s meeting with Obama, Admiral Michael Mullen, the Chairman of the Joint Chief of Staff said he came away with a very positive feeling. Regarding the proposed 16-month timeline for withdrawing from Iraq, both Secretary Gates, Adm. Mullen, and General David Petraeus, all said they were not troubled by the timeline especially in light that the Iraqi parliament passed an agreement with the U.S. military to leave the country by 2011.
Lastly: The positives in the defense sector at this time seem to outweigh the negatives however we are in a market that tends to discount fundamentals and reacts to negative news in the broader markets. And there will be negative news -- dismal revenues/earnings from non-defense aerospace activities due to the strike at Boeing are likely -- but we still have not yet seen any indication that defense budget declines will affect revenues and earnings over the next several quarters, and there will be limited impact on defense sales due to an economy in recession.
Outside factors are likely to continue to be in control -- whether upside [a Santa Claus rally that offsets some of 2008’s performance, economic news better than the long recession forecasts, or the BRIC nations providing stability and hence growth to Western exporters (China’s CSI 300 is up 17% since November 4th, Brazil’s Bovespa is up 15% since October 27th, and Russia’s RTS is up 23% since October 24) or downside [addition financial, banking, automotive sector issues; news indicating a deepening recession in the U.S. and abroad, etc.]
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