(FORTUNE Magazine) – Armsmakers just can't seem to hit their targets. Last year it was Boeing that missed its earnings and saw its stock go into a tailspin. Last summer it was Lockheed Martin. Then, on Oct. 12, highflying Raytheon dropped the biggest bombshell of all, announcing it would take a $668 million charge and miss both 1999 and 2000 earnings estimates by a wide margin. When its stock collapsed that day from $43 to $24, pulling the rest of the sector down with it, the message to investors seemed straight out of Dwight Eisenhower's farewell speech: Beware the military-industrial complex.

But have investors been too hasty in bidding a farewell to arms? Despite the impression of an industry in retreat, consider this simple, powerful fact: Defense spending is set to rise for the first time in 13 years. After tumbling from $82 billion to $44 billion between 1989 and 1998, Pentagon procurement outlays could rise to $75 billion by 2005 if President Clinton's latest budget request is any guide. (Both Congress and Republican presidential front-runner George W. Bush want even more.) That's a sustained upswing of 8% a year, and--let's hear it for oligopoly!--there's only a handful of contractors left to divide the spoils.

Yet investors have seemed to notice only the earnings blowups. All the major players except Boeing are dragging at multiyear lows. Defense stocks are trading at a 40% discount to the S&P 500 (on a P/E basis), compared with an average 15% to 20% discount over the past 20 years.

The earnings troubles stem from the Pentagon-approved consolidation sprees of a few years back, which turned defense firms into far-flung confederacies of businesses making everything from radar to rockets (Raytheon swallowed Hughes Electronics' and Texas Instruments' defense businesses; Lockheed gobbled up Martin Marietta and Loral; Boeing ate McDonnell Douglas). Now, to varying extents, the consolidators are showing all the symptoms of integration indigestion: surprise cost overruns, accounting errors, and a general breakdown of internal controls.

These are grave managerial sins, to be sure, but don't confuse them with signs of an industry whose basic economics are deteriorating. In fact the industry's operating margins have risen throughout the decade, from 6.5% to 10.1%. The problems are internal, says Merrill Lynch analyst Byron Callan--and eminently fixable. "This is the darkest part of the storm, before the light," concurs Pierre Chao, a defense analyst at Credit Suisse First Boston, adding that the war in Kosovo had the perverse effect of delaying contracts while the Pentagon focused on fighting. "It's a relatively unique opportunity to buy these stocks when they're washed out," he says.

So, where to buy in? Investing in the biggies--Lockheed and Raytheon--will require some patience. (Let's set aside Boeing, since it is more dependent on the commercial aircraft cycle.) Lockheed just shocked investors yet again when it slashed its earnings projections for next year, from $2.15 to $1.00 a share, and announced the resignation of its president, Peter Teets. Additionally, third-quarter earnings came down 32%, to $217 million, on revenues of $6.2 billion; it has been late with deliveries of its C130-J transport plane; and its Titan rockets keep blowing up or putting satellites into the wrong orbit. At Raytheon, an aggressive new management team set its sights far too high, gunning for 15% operating margins when all it could hit was the industry average of 11% to 12%. And it posted a loss of $169 million in the third quarter, on sales of $4.7 billion. "In retrospect," CEO Dan Burnham admitted to analysts, "we tried to do too much, too fast."

More negative surprises could pop up in the near term as both companies continue to poke around for soft spots in their operations. Yet when gains from streamlining at the two juggernauts finally do kick in, they could prove to be choice value stocks.

Raytheon looks the best positioned of the large caps because of its weaponry mix: Patriot missiles and other "smart" precision munitions favored in today's remote-control wars. Its shares have also been the most oversold, down an astonishing 62% from their July peak of $76. Meanwhile, CFO Frank Caine promises to get a better grip on financial reporting from Raytheon's crazy-quilt collection of businesses, by paring 75 accounting systems down to 25 and replacing quarterly business-unit reviews with monthly face-to-face meetings.

Lockheed Martin, too, is tightening its controls, announcing a reorganization that will centralize many business-unit functions such as finance and human resources. It's also belatedly getting around to dumping $1.8 billion of noncore businesses that it accumulated during its buying binge, including three environmental management companies. On the whole, though, Lockheed's $20 stock (down from $45 in May) is a dicier play than Raytheon's. Congress has stripped funding from its next-generation fighter, the F-22 Raptor. A $7 billion order of F-16s from the United Arab Emirates has stalled. And its pending acquisition of satellite communications company Comsat could prove another distraction.

For less patient capital, the best buys are to be found among mid-cap stocks that have been unfairly spanked for the transgressions of their larger siblings. General Dynamics, the $9 billion maker of tanks and nuclear subs, has been the top performer of the '90s, boasts one of the cleanest balance sheet in the business, and hasn't had an earnings miss. "It's the last man standing," notes DLJ analyst Joseph Nadol. Although the $55 stock is pricier than some--it's trading at 17.5 times this year's earnings estimates--Nadol expects it to hit $78; both he and Chao list General Dynamics as their top pick. Another potential bargain: L-3 Communications, a smaller and more focused newcomer, whose secure data-transfer systems are well poised for the expected boom in defense infotech. At $42, L-3's stock is 23% off its 52-week high.

Of course, there are new threats to watch out for too. The Pentagon's spending will likely be weighted toward development of new weapons rather than production of existing ones, which increases the chances of costly failures and overruns. And a newly muscular Europe could begin to exert downward pricing pressure as British Aerospace and France's Aerospatiale go on acquisition sprees of their own.

Now, if America's armsmakers could just start hitting their targets half as accurately as their missiles do...