(FORTUNE Magazine) – Bear with us for a moment as we review some news from February.

Item No. 1: President Bush proposes the biggest hike in defense spending since the Reagan years--$48 billion in 2002, rising an extra $123 billion by 2007.

Item No. 2: Defense manufacturer Northrop Grumman makes a $5.9 billion hostile play for auto-parts and electronics maker TRW.

Item No. 3: Integrated Defense Technologies goes public and becomes one of the hottest initial offerings in two years.

All this means one thing: It's time to dump big defense stocks.

While the outlook for the industry is certainly the brightest it's been in years, many of the stocks in the sector have accounted for that and then some. (For another look at the industry, see our story on the Carlyle Group, on page 104.) The share prices of four of the nation's largest military contractors--Lockheed Martin, Raytheon, Northrop Grumman, and General Dynamics--have surged more than 20% since Sept. 11. They are trading as high as 39 times 2002 earnings, and analysts predict that their earnings will grow at an annual rate of only 10% over the next few years. In order to justify these prices, however, the market needs to see growth somewhere in the vicinity of 20%. "The huge run-up in the stocks of the obvious beneficiaries of the defense buildup--Lockheed, Northrop, and General Dynamics--suggests earnings are right around the corner," says Lynn Yturri, manager of the One Group Equity Income fund. "That's just not the case."

That's because the land mines between here and a big payoff are numerous. While Bush will get the bulk of his proposed $48 billion military budget increase, the huge ramp-up in spending through 2007 isn't likely to occur. Once the budget is approved, $12 billion of the hike will go to personnel pay increases and health benefits. Only $13 billion is slated for the development and manufacture of weapons. Worse yet for the armsmakers, the government won't write checks for some time; contracts will be parceled out over months, caution analysts. And some manufacturers, such as shipbuilders, will be left out almost completely. "The average ship life is 30 years, so you need to buy ten ships a year to maintain our 300-ship navy," says Andrew Krepinevich, executive director of the Center for Strategic and Budgetary Assessments, a Washington, D.C., think tank. "The Navy is only going to buy five ships this year."

The military isn't looking for a large-scale Cold War buildup this time around. The battle against Afghanistan--and any potential skirmish with Iraq--is being fought mostly in the air and with new technologies. So while the government will increase orders for tactical aircraft such as the F-18 and Joint Strike Fighter, the future lies in unmanned aircraft drones like the Predator and the faster, higher-flying Global Hawk, which were used in Afghanistan. The problem is that because of industry consolidation, Lockheed Martin and company have gotten so large that those orders have little effect on earnings. For a $14 billion outfit (read: Northrop Grumman), a $100 million Global Hawk surveillance drone contract is peanuts, says Byron Callan, a defense and aerospace analyst at Merrill Lynch. For an investor, "that's like buying GE stock because of a TV show he likes on NBC."

Instead, investors will have better luck thinking small. Nimble players like Alliant Techsystems, L-3 Communications, and DRS Technologies could all grow earnings at an almost 20% clip over the next few years, says Steve Binder, a defense and aerospace analyst at Bear Stearns. "These companies will benefit because they participate in the communications area, the overall electronics upgrade, surveillance, and reconnaissance," he notes. Other firms to watch are Caci, ManTech, and Anteon--set to go public in mid-March--which provide systems integration and technology consulting for intelligence gathering.

But don't tell Wall Street that the military-expansion payoff will be smaller or take longer than many expect. Bankers, smelling a new mania, will once again crank up the IPO and M&A machines to meet investor interest in the area. Which brings us back to Integrated Defense Technologies. Its IPO was so hot that it went public well above the originally anticipated price and still shot up another 14% on its first day of trading. Deja vu, anyone?

REPORTER ASSOCIATES Julie Schlosser, Jessica Sung

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