In an Insecure World, Play Defense
As U.S. military spending continues to rise, so should the shares of big Pentagon contractors.
Michael Sivy

(MONEY Magazine) - When you're trying to decide which areas of the stock market look most promising, consider where our society is putting its resources. Right now a disproportionate share is going to the military.

It's not just a question of paying for Afghanistan and Iraq. Since 9/11 the U.S. military has been undergoing fundamental changes.

The goal: to reduce the need for sheer numbers of troops by relying on more powerful traditional weaponry and 21st-century technology. That transformation would have taken years even before the invasion of Iraq.

But as threats have multiplied since major combat operations in Iraq ended in May 2003, it's become clear that revamping the U.S. military could take a decade or longer. "The United States is a nation engaged in what will be a long war," Defense Secretary Donald Rumsfeld wrote earlier this year.

As disheartening as Rumsfeld's prediction may be, what's going on in the armed forces has made defense stocks more attractive than usual. Typically, the shares of major defense contractors are not as dynamic as other growth stocks. The main rationale for owning them is that they're a good counterweight to shares such as those of consumer products and tech companies that rise and fall on the economy's ups and downs.

Lately, though, defense has been on a roll. Since May 2003, shares of Boeing, General Dynamics, Lockheed, Northrop Grumman and Raytheon have gained at least 48% from their lows--and in some cases far more--compared with 39% for the S&P 500. And I think they have further to go, for three reasons.

Share Prices Are Reasonable

Most of the major defense contractors are trading at average price/earnings ratios. The one exception is Boeing, which still gets 40% of its sales from commercial aircraft and has been riding a boom in that business. At $73, Boeing stock now trades at 21 times this year's estimated earnings. That's just too pricey a multiple.

The other four big contractors, however, trade at less than 17 times estimated 2006 earnings and are projected to increase their earnings 10% or more annually over the next five years (see the table at left). They also pay dividends of 1.3% to 2.1% a year. That means you can reasonably expect average total returns of at least 11% going forward. And if the economy falters unexpectedly at some point over the next few years, defense stocks are likely to hold up better than traditional growth stocks because they depend on military spending trends that are set far in advance.

Margins Should Get Fatter

Spending on the latest communications equipment and new kinds of weaponry such as airborne lasers and small pilotless aircraft should grow faster than that for traditional equipment. As product mixes shift to higher-margin gadgetry, single-digit increases in revenue will likely be able to support double-digit earnings gains.

Spending Will Keep Rising

The budget proposals for the coming year that President Bush sent to Congress in February call for a 4.8% increase in military spending to $439 billion. That's quite a hefty gain, double the rate of inflation, but it understates the full scale of the current military buildup. The budget includes a hefty $84 billion for new weaponry and $73 billion for research and development. Not included in the budget are separate appropriations totaling $120 billion to pay for operations in Afghanistan and Iraq.

Congress may trim some of these proposals, but probably not by much. World conditions and political considerations prevent that. Besides, what senator wants to vote against more high-paying defense jobs in his or her state? That's unfortunate. Strictly from an economic standpoint, there are better things to spend the money on than weapons. But that's no reason to avoid including defense stocks in a diversified portfolio. Top of page

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.