Yahoo Finance How Global Conflict Can Boost Your Portfolio
When the world goes to war, should you fortify your portfolio with defense stocks? Technically, we might not be in a world war, but little by little, the globe is becoming a chaotic jumble of military conflicts.
Some conflicts are burning slowly, like that in Ukraine; others, such as those across the Middle East, are raging. Either way, governments around the world are seeing the need to arm up, if only to head off unwanted excursions from neighboring countries.
If spending does pick up, it could bring in some huge profits for those companies manufacturing the latest high-tech weaponry, smart bombs and warplanes. Specifically, it's companies such as Lockheed Martin Corp. (LMT), Northrup Grumman Corp. (NOC), Raytheon Co. (RTN), General Dynamics Corp. (GD) and Boeing Co. (BA) that should profit.
Such stocks have already done well over the past couple of years despite U.S. military spending cutbacks. In the last 24 months, each of those stocks, except Boeing, substantially outperformed the broad market, gaining between 46 percent and 79 percent, excluding dividends, versus 18 percent for the Standard & Poor's 500 index.
Not bad, given Uncle Sam's spending has steadily declined since 2011. In 2010, the U.S. spent $843 billion, versus $738 last year, according to data from the St. Louis Federal Reserve. None of that takes inflation into account.
Still, there are reasons to be more optimistic for the group to continue its rally. Some contractors are seeing "urgent need demand" due to conflicts in Eastern Europe, the Middle East and Asia, Goldman Sachs says in a recent report. That means near-term revenue should be robust, at a minimum. It could be even better than that.
"Across the Middle East there's a sense that it's time to buy weapons, in the aftermath of the [Iran] nuclear deal," says Mark Moyar, a visiting scholar at the Foreign Policy Initiative, a nonpartisan think tank, and author of "Strategic Failure: How President Obama's Drone Warfare, Defense Cuts, and Military Amateurism Have Imperiled America."
"I think there is going to be a spending surge," Moyar adds.
That's overseas. But the real money to be made in the defense business is when America starts buying.
"[U.S.] defense spending has only one way to go and that's up," says Mike Rocco, who covers industrial firms for PNC Wealth Capital Advisors in Philadelphia. "Government funds will be made available; I don't see the world going back the way it was."
That actually emphasizes the key to this group doing well: government spending. Private citizens and corporations don't typically purchase missile systems or stealth bombers. That same factor also means there is less competition. You really don't buy the latest and greatest military equipment from your enemies. There are also relatively few countries that make sufficiently advanced arms.
In addition, Rocco says, there really isn't a currency risk -- the U.S. is still by far the biggest buyer of such equipment. On top of that, there isn't going to be a problem from cheap imports from emerging markets. That's not something that can be said about other industries.
While investors are nervous about the global economy, defense stocks have become a safe haven. "We think investors are rotating into defense stocks due to the uncertain global economy, which we expect will continue," states a recent report from S&P Capital IQ, the New York-based financial information firm. If it does continue, that means more buyers for the stocks.
That said, S&P Capital IQ brings up a legitimate concern. "Even though there aren't that many large-scale contractors and the risk is that you don't win," says Jim Corridore, aerospace and defense equity analyst at S&P Capital IQ. "There is lot of execution risk for the large contractors."
For instance, a recent report stated that risks to Northrup Grumman stock "include the potential for large cuts in military budgets, and failure to perform well on existing contracts or to win new contracts." The same report also adds that management has "cited delays in new awards to budget uncertainty." S&P Capital rates Northrup Grumman stock a "hold."
Raytheon is also rated a "hold" by S&P Capital IQ, but the research analyst seems a lot more optimistic. "Risks to our recommendation and target price include the potential for major new wins of military contracts, and better performance on existing contracts than we are expecting."
For Boeing, which S&P Capital IQ rates as a "buy," the blessing is also the curse. The company is something of a hybrid commercial aircraft manufacturer and defense contractor. "We remain concerned about a drag from defense as U.S. defense spending slows," but overseas business, commercial buyers and cost controls will help moderate that problem, according to the report.
Indeed, the defense business does seem to be feast or famine -- you win a big contract or you don't. But PNC's Rocco seems to be on to something. Even if Northrup doesn't win the highly anticipated Long Range Strike Bomber project, "it will still be an outstanding company," he says. "If they do, it could turn them into a growth vehicle." Northrup is competing against a teamed bid from Boeing and Lockheed Martin.
Based on the analytical process that PNC employs to select stocks, Rocco likes defense stocks. "Cash earnings, cash flow metrics and returns on invested capital are better than growth stocks. If you own them, then keep them. And if you don't, then buy them."
In addition to all the stocks mentioned already, investors should also consider the various funds that track the group -- the Fidelity Select Defense & Aerospace mutual fund (FSDAX), plus three exchange-traded funds: iShares US Aerospace & Defense (ITA), SPDR S&P Aerospace & Defense ETF (XAR) and PowerShares Aerospace & Defense ETF (PPA).
Buying a basket of stocks in the field might miss the home run of an outstanding individual company, but it also helps spread the risk.
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