(FORTUNE Magazine) – The Reagan Administration's defense buildup is falling victim to deficit cutters. The expected inflation-adjusted decline in military spending is bad news for investors in defense contractors that build ships, planes, and tanks. But it is great news, say Wall Streeters, for defense electronics companies. A growing part of the defense budget, explains Gary Reich, a security analyst at Wertheim & Co., will be used to upgrade existing ships and planes, stuffing them with the latest radars, jamming devices, military computers, and communications equipment. Eager to cash in, the big contractors have been on a quest to buy defense electronics makers, fueling a rise in stocks that look like takeover plays. Philip Friedman, a security analyst at Drexel Burnham Lambert, considers Loral Corp. a good investment, takeover or no takeover. The New York manufacturer of electronic warfare systems, whose earnings have climbed at a 23%-a-year clip for several years, is expected to land new contracts totaling $600 million to supply radar warning receivers for Air Force F-15 fighters. The receivers warn pilots when hostile radar is tracking them and issue instructions for dodging enemy missiles. Loral has been in an acquisitive mood of its own, shelling out $88 million last June to purchase the Rolm Mil-Spec military computer division of IBM. Peter Aseritis, defense analyst at E.F. Hutton, thinks the acquisition will pay off handsomely for Loral, contributing as much as 20% of the company's earnings during the next five years. Watkins-Johnson of Palo Alto, California, is an oft-mentioned takeover target. The company makes oscillators, amplifiers, and switches for satellites, missiles, and radar-jamming equipment. Caught at the end of one product cycle before another could kick in, Watkins's earnings plunged in the second quarter of 1985. But the setback was temporary, says Judith Comeau, a defense analyst at Goldman Sachs, who expects Watkins-Johnson's earnings to grow 15% a year for the next five years. Last year the military spent $17 billion on antisubmarine warfare, which security analyst Michael Lauer of Oppenheimer & Co. considers the last place economizers will strike. ''Advances in Soviet submarine technology virtually assure priority funding for antisubmarine warfare for years to come,'' he says. His favorite company in the field is Diagnostic/Retrieval Systems of Oakland, New Jersey, which designs and manufactures sonar signal processors for the U.S. Navy. The processors analyze signals picked up from hydrophones dropped in waters where enemy subs are believed to be lurking. Partly because of start-up costs on a new line of processors, Diagnostic/Retrieval reported a loss in the first half of its current fiscal year. But Lauer, who takes comfort from the company's hoard of cash and growing backlog of orders, thinks the stock will double in the next 12 months. Phillip Brannon, a defense electronics analyst at Merrill Lynch, is a fan of Electrospace Systems. The Richardson, Texas, company makes satellite communications gear as well as communications and data-processing equipment for 43 Boeing jetliners that would be used by the President and the armed forces as ''airborne command posts'' in the event of a nuclear war. With the company's founders holding 40% of the stock, Electrospace runs little risk of a hostile takeover. But Brannon thinks the company's 38%-a-year growth in earnings per share for the past five years makes the stock worth buying anyway.

CHART: COMPANY REVENUES NET STOCK PRICE RECENT latest four INCOME RANGE PRICE quarters in millions last 12 months P/E multiple 1 in millions Loral Corp. $599.1 $48.7 $28.00-$46.00 $44.25 21.7 Watkins-Johnson $232.6 $18.4 $21.125-$33.00 $32.00 16.5 Electrospace Systems $133.2 $12.6 $19.00-$25.25 $25.25 27.1 Diagnostic/Retrieval $34.4 $.5 $5.50-$9.50 $9.50 105.5 1Based on earnings for the latest four quarters, exclusive of nonrecurring item .