Defense stocks to watch when military spending increases

  • By Daren Fonda,
  • Barron's
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The S&P 500 (.SPX) has staged a big comeback since the government shutdown on December 21, rallying 12.6% through Monday’s close. But a better bet has been companies that make money off the government—specifically aerospace and defense contractors.

The S&P Aerospace and Defense Select Industry Index has gained 16.7% since the shutdown started. And the sector looks poised for more outperformance, according to some analysts.

Barron’s has been bullish on defense companies. As we noted in a cover story in November, agreed-upon spending will increase revenue rapidly for companies such as Lockheed Martin (LMT), Northrop Grumman (NOC) , and Raytheon (RTN) through the end of the decade. China is developing a new hypersonic missile that could make today’s U.S. missile defenses obsolete. And President Donald Trump has signaled support for upgrading and expanding the military, from missile defenses to the Navy.

Ben Phillips, chief investment officer of EventShares, says he has recently added to shares of aerospace and defense contractors in the firm’s exchange-traded fund, U.S. Policy Alpha (PLCY).

“We’re buying on conviction that, over the next two years, defense spending will increase,” Phillips tells Barron’s.

The stocks look relatively cheap, he adds, trading at an average 12 to 16 times forward earnings and less than 11 times enterprise value/Ebitda (earnings before interest, taxes, depreciation, and amortization).

Congress must still approve a defense budget for fiscal 2020, and it is sure to be a battle. The Trump administration is likely to make a final budget request of nearly $750 billion for 2020, up 4.6% from the $717 billion appropriated for 2019. Congress may well approve less than that request. Democrats in control of the House are looking to cut military spending. And there will be plenty of fights over spending levels and individual defense programs—especially if Trump attempts to carve out funding for a border wall in a defense bill.

Nonetheless, analysts expect the Pentagon to prevail in funding its major programs. And even with some nips and tucks, defense contractors should continue receiving healthy levels of funding.

Phillips likes companies tied to increased missile defense spending. Trump has been a big supporter of missile programs, calling for more funding for space-based systems, partly in response to threats posed by North Korea, China, and other adversaries. While missile defense will be debated heavily in Congress—and may face cuts—many defense contractors should continue to benefit. Among them, according to Phillips, are Lockheed Martin, Raytheon, Northrop Grumman, and Aerojet Rocketdyne Holdings (AJRD).

The Navy is also requesting more funding to modernize and expand its fleet, aiming for a flotilla of 355 ships that would include smaller, lighter vessels and unmanned robotic warships. This is a multidecade plan that likely will be batted about Congress for years. But shipbuilding and high-tech weaponry development tend to generate bipartisan support in politicians’ home districts. And Trump has supported modernizing the Navy (at least as a campaign pledge). Stocks that would benefit include Huntington Ingalls Industries (HII), General Dynamics (GD), and BWX Technologies (BWXT), a leading supplier of nuclear components and equipment.

Two other areas that look appealing are companies involved in drone technology and the outsourcing of government workers, Phillips says. AeroVironment (AVAV), for instance, makes drones, tactical missile systems, and related technologies, and its sales have been rising as orders come in from the Pentagon and foreign governments. Analysts expect the company to generate $350 million in sales this year, up 18% from $296 million in 2018. One caveat: The stock is pricey at 50 times estimated 2019 earnings.

Also compelling, Phillips says, are companies benefiting from the government outsourcing of more national security and defense work to external personnel. Companies that stand to gain are CACI International (CACI), a big player in government network cybersecurity; consulting firms Accenture (ACN) and Booz Allen Hamilton (BAH); and Leidos Holdings (LDOS), a diversified government contractor.

None of these stocks have a straight shot up, of course. They all face headline risk as Trump and Congress battle over funding levels.

Investors who want a basket of defense stocks instead should consider an ETF such as iShares U.S. Aerospace & Defense ETF (ITA) or SPDR S&P Aerospace & Defense ETF (XAR). Both have done well this year, up 11.2% and 11.7%, respectively. Assuming the world doesn’t get any safer, these ETFs are likely to be good long-term bets.

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