Friday, February 15, 2013

Contrarian Alert: Defense Stocks Offer Yield and Value

It has long been axiomatic among the investment community that timing the purchase of defense stocks can be largely based on public opinion.

When the general populace thinks that the U.S. needs to beef up national security, money starts to flow to the big defense contractors like Lockheed Martin, General Dynamics and Raytheon. In the aftermath of 9/11, for example, defense stocks went on a multi-year tear, with returns in many cases nearly double the broader market indices.

On the other hand, when a war-weary public has lost its enthusiasm for huge defense outlays, defense budgets get slashed, and the contractors suffer as well. The most obvious example here is the post-Vietnam war years.

source:  Huffington Post
So now, with the U.S. largely out of Iraq, and starting the process to withdraw from Afghanistan, is now the time to exit the defense industry stocks - particularly with fiscal budget pressures?

Barclays defense analyst Carter Copeland doesn't think so.

I went to go hear Carter yesterday, and found him largely bullish on the group.

Carter agrees that, yes, the public is now generally in favor of cutting the growth in defense spending.  He even showed a chart during his presentation which indicated that the most recent Gallup poll data showed that nearly 50% of the American public thinks that the government is spending too much on national defense, which is near the highs over the past 50 years.

However, Carter argues that simply selling the stocks is too simplistic.

He pointed out that most of the large cap defense stocks are trading at a 30% discount to the overall market valuation - a fairly sizable haircut basic on history. The free cash flow yield on many of these stocks is in the double digits, making the stocks among the cheapest on this metric in the market.

Carter's team ran numerous financial models for the group.  They assuming declining revenues for at least the next five years, and moderate pressures on margins.  What they found was that the stocks could still produce decent returns, assuming the companies use their free cash flow for dividend increases and share buybacks.

Carter has "buys" on most of his stocks, but he is particularly excited about the prospects for General Dynamics.  Trading at less than 10x earnings, and offering a 3.1% dividend yield, he figures that GD offers investors a +30% price upside by the end of 2014, without assuming any multiple increase.  In addition, he is very impressed by the new management team at GD, and their focus on adding shareholder value.

Buying defense stocks here is, in my opinion, a contrarian investors dream. As their low valuations attest, the group is being largely shunned, since we have all learned to not buy defense stocks when looking at multi-year reductions in defense spending.

But they might just work.

And then there's this: When I returned to the office yesterday, I saw the following article on Salon. com. The article pointed out that for all of the talk about defense cuts and sequestration, defense spending remains at extremely high levels:

...In other words, despite America closing out the longest continuous era of war in its history and one of the biggest national security buildups ever, sequestration means Pentagon spending would still only face the smallest post-war reduction in more than a half century.

The result, says Ronald Reagan’s former assistant Secretary of Defense Larry Korb, would be a defense budget leaving the United States “still spending more than the next 14 nations in the world combined, most of whom are allies.” In historical terms, he says, “spending would still be higher in inflation-adjusted dollars than the Cold War average.” This, despite the fact that we are facing a threat that most agree is no bigger or more existential than that of the nuclear armed Soviet Union....