(MONEY Magazine) – No one knows precisely what President Bush's "new kind of war" against terrorism will look like--as Defense Secretary Donald Rumsfeld soberly notes, our opponents "operate in the shadows and we have to deal with them in the shadows"--but one thing seems clear: The Sept. 11 terrorist assault on America has ended, at least for now, a protracted and prickly debate over defense spending.

Before the attacks, Congress was struggling to figure out how to pay for an increase in military spending without raiding the Social Security "lockbox" that both parties declared sacrosanct in the last election. After the attacks, newly unified lawmakers hustled to hike the defense budget to roughly $345 billion--Bush had originally asked for $325 billion--with little fretting over the financing. Supplemental spending will push the total even higher, and in today's atmosphere it seems that the military will get "everything it wants and more," says Christopher Hellman of the nonpartisan Center for Defense Information.

So too, it seems, will the defense contractors that supply the armed forces with everything from high-tech radar systems to guided missiles to unmanned surveillance planes. That's why defense shares soared after the markets reopened in September, even as the major stock indexes swooned. Raytheon, which makes missiles and other munitions that could be in heavy demand now that the U.S. has launched major strikes against Osama bin Laden and his pals, jumped 37% in the first two weeks of trading after Sept. 11; Northrop Grumman, big in radar and unmanned aircraft, rose 24%. Lockheed Martin, the aerospace giant, and tank and ship builder General Dynamics both saw percentage gains in the mid-teens. Shares in smaller stocks spiked as well, with encryption specialist L-3 Communications and munitions maker Alliant Techsystems rocketing 41% and 28%, respectively (see "A Second Line of Defense" on page 56).

Everybody wins--at least at first

Still, the ultimate impact on defense spending may be smaller than many investors think (more on this twist later). In the short run, however, all major defense contractors should benefit from the rush of new money. That's because after a decade of cutbacks and industry consolidation, there are only a handful of big contractors left, and each has its fingers in a diverse set of military-related businesses. Raytheon, best known for high-tech missiles like Tomahawks, also makes radar and night-vision systems. Lockheed deals not only in jets but also in satellites and software. Northrop Grumman makes ships in addition to electronic systems. General Dynamics, builder of ships and tanks, also specializes in secure communications. The only major contractor facing significant problems is Boeing--not because of any troubles in its defense businesses but because nearly two-thirds of its revenue comes from the struggling commercial airline sector.

While there's no doubt that virtually every company in the industry stands to benefit, two in particular could separate from the pack. Northrop Grumman is well positioned to benefit from an extra emphasis on electronics and information technology, which made up a third of its $7.6 billion in revenue last year. A decade ago, the company (then simply Northrop) was known mostly for its batwinged B-2 Stealth bomber. But during the post-Cold War slowdown in defense spending, it began to seem a tad profligate to spend as much as $2 billion on any bomber, even one invisible to radar, and George Bush the Elder capped the program at 20 bombers in 1992.

Seeing the handwriting on the wall, CEO Kent Kresa reoriented his stodgy company toward the electronics and info-tech systems that he expected would be in heavy demand as the military itself adjusted to a changed world. (As an executive in Northrop's Ventura division, Kresa had seen the promise of unmanned aeronautical vehicles as far back as the 1970s.) Now his moves look prescient. Even before Sept. 11, Defense Secretary Rumsfeld had been pushing the military to look beyond its reliance on Soviet-era attitudes and equipment, and the current crisis seems likely to accelerate his attempts at what he calls "military transformation."

Rumsfeld's approach fits Northrop's. Despite their recent run-up, shares are trading at 16.5 times estimated 2002 earnings, something of a discount to the average contractor's 18.2 P/E. Analyst Christopher Mecray at Deutsche Banc Alex. Brown suggests that Northrop should benefit markedly "from a low-level-conflict scenario that would require enhanced intelligence assets as well as possible new demand for electronic warfare products, unmanned aerial vehicles and airborne radars." (Sounds an awful lot like Afghanistan.) Of particular interest to the Pentagon: Northrop's Global Hawk, an unmanned surveillance plane that can gather crucial intelligence data while flying high above potential targets--without risking American lives.

Old soldiers...

Despite all the talk about high-tech and transformation, however, it turns out that much of the new money pouring into the Pentagon will pay for old-school, big-ticket stuff like aircraft carriers, tanks and submarines--all of which should play to the strengths of General Dynamics, the largest maker of naval vessels and tanks. Its marine systems division accounted for 34% of the company's $10 billion in revenue last year. Demand for subs, which can be used for launching missiles and gathering intelligence, should rise significantly. And if, as many expect, General Dynamics acquires Newport News Shipbuilding--the last of the military shipmakers--it will be in a sweet spot, becoming the Navy's sole supplier of subs and aircraft carriers.

As if that weren't enough, General Dynamics could also see increased revenue from the most unlikely of sources: its business jet sector. Back in 1999, CEO Nicholas Chabraja diversified his company when he acquired Gulfstream Aerospace. Last year Gulfstream accounted for 29% of the parent company's revenue and 44% of its operating earnings. Those numbers could get a significant boost if, as some analysts expect, sales for corporate jets increase as executives forgo travel via commercial carriers. In addition, General Dynamics has what's considered hands-down the best management in the industry, as well as strong cash flow. Even after its recent rise, it's trading at 17.2 times estimated 2002 earnings.

The long march

Whether the old or the new kinds of weaponry win out, the real question to ask is how much spending will increase long term. Right now, selling Congress on the idea of more bucks for the military seems about as hard as peddling flags on the Fourth of July. Defense bulls like Paul Nisbet of JSA Research expect spending to hit $400 billion by 2003: "We replaced virtually none of our combat aircraft the past eight years and barely made enough new planes to cover attrition," he says. "The administration is using this wake-up call to gain the public support necessary for some heavy defense increases."

But as the military campaign unfolds, numerous complexities that have been pushed under the rug will re-emerge. Sure, says Hellman of the Center for Defense Information, debate over military spending "evaporated on Sept. 11, but the issues driving that debate haven't gone away." Those include not only the total cost of increased outlays for defense but the broader question of whether it makes sense to shell out many tens of billions on planes, ships and tanks essentially designed to fight the last century's wars. Does our military need both Lockheed's new F-22 Raptor jet fighter and the planned Joint Strike Fighter, which is expected to cost at least $200 billion over almost 30 years? Will a national missile defense system--even if it could be made to work--protect us against a nuclear device inside a terrorist's backpack?

History's lessons

With these and other questions still in the air, some wonder if defense stocks--many of which have seen considerable moves upward since early 2000--are not already fully valued, and thus unlikely to see much further upside unless "Enduring Freedom" becomes "Everlasting Entanglement." Douglas Eby of Torray fund recently dumped his shares of General Dynamics, Northrop and Raytheon, plowing the proceeds into beaten-down financials like American Express and AIG. "We just felt there was better value outside the defense sector," he explains.

Skeptics have history on their side. Research from SG Cowen analyst Cai von Rumohr on the performance of defense stocks since the Soviet invasion of Afghanistan in 1979 comes to the not exactly shocking conclusion that they tend to outperform the market in periods of military conflict, with the stocks rising anywhere from 17% during the Persian Gulf War to 74% in the wake of the Afghanistan invasion. But these gains aren't always lasting. Defense stocks lost a quarter of their value once the shock of the Afghanistan invasion wore off and fell sharply after the end of the Kosovo campaign in 1999.

Given this record--and the run-ups in most defense names--it might make sense for investors to consider none other than struggling Boeing as a contrarian play. Sure, its commercial jet business is in a deep funk, but its sales of surveillance aircraft and C-40 transports are expected to increase substantially in coming months. James McAleese, a defense industry lawyer and analyst, calculates that Boeing's military business is by itself worth $29 to $30 a share--about six bucks less than the company's recent stock price. "Basically," McAleese says, "you're getting Boeing's commercial business for free."

--DAVID FUTRELLE AND NICK PACHETTI, WITH PABLO GALARZA