NEW YORK (MONEY) - It's a sad comment on the times in which we live, but the federal budget that President Bush sent to Congress on Monday signals further gains for defense stocks. Prime beneficiaries include General Dynamics and Northrop Grumman, both of which are on the Sivy 70 list.

The proposed budget would make many of the President's first-term tax cuts permanent, which could cost a projected $1.4 trillion over 10 years. The budget would also trim more than 100 government programs.

The biggest proposed increases are in military spending, which would rise 4.8 percent to $439 billion. Moreover, this figure does not include sizable spending on new weapons systems or specific appropriations for maintaining troops in Afghanistan and Iraq.

All told, spending on the military could rise at three times the rate of inflation. The prime beneficiaries of the Administration's spending priorities will likely be the leading defense companies.

Among new weapons programs, General Dynamics (Research) and Northrop Grumman (Research) are expected to receive multibillion-dollar contracts for Navy destroyers and attack submarines.

Both companies are also likely to profit from high-tech initiatives. Northrop, for instance, is a leader in airborne laser technology, which would allow high-flying airplanes to destroy targets with a beam of intense light.

Such substantial projects would likely improve profit margins at the companies, allowing earnings to move up faster than revenues.

Both stocks have been rising slowly but steadily for more than two years. And their near-term outlooks remain quite positive.

In the past two weeks, both companies reported strong fourth-quarter earnings. General Dynamics' profits were up 21 percent, or 3 cents a share above consensus estimates. Northrop's earnings from continuing operations gained 24 percent, also topping analysts' targets.

Nonetheless, expectations remain quite moderate. Earnings for both companies are projected to grow just a bit more than 10 percent annually over the next five years. And both stocks yield around 1.5 percent. That's essentially an average total return projection at a time when military spending looks more robust than much of the rest of the economy.

Finally, the shares are priced conservatively. Both stocks trade at less than 15 times projected earnings for the current year. I'd expect any surprises to be on the upside.

Sivy on Stocks resources:

Sivy 70: America's best stocks

Guide to Growth

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