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Personal Finance > Investing
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Playing defense
graphic October 19, 2001: 5:46 p.m. ET

Investing in arms stocks requires some serious strategic thinking.
By David Futrelle and Nick Pachetti, with Pablo Galarza
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  • Defense: Stock by stock
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    NEW YORK (CNNmoney) - 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," said 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.

    Everybody wins - at least at first

    Still, the ultimate impact on defense spending may be smaller than many investors think. 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.

      graphic STARTING TO MOVE  
        Gain since Sept. 10
  • Raytheon: up 42%
  • Northrop Grumman: up 25%
  • Lockheed Martin: up 21%
  • General Dynamics: up 11%
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    But 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.

    Still, there's no doubt that virtually every company in the industry stands to benefit in the short run - and 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, Northrop (NOC: up $0.96 to $103.96, Research, Estimates) 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.

    General Dynamics doesn't play into this theme of high-tech and transformation. But 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. And as the largest maker of naval vessels and tanks, General Dynamics will surely benefit.

    Its marine systems division accounted for 34 percent 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 percent of the parent company's revenue and 44 percent 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 (GD: down $2.29 to $83.71, Research, Estimates) 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.

    Other Questions

    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.

    But as the military campaign unfolds, numerous complexities that have been pushed under the rug will re-emerge. Hellman, of the Center for Defense Information, acknowledges that 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?

    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.

    Given this record - and the run-ups in most defense names - it might make sense for investors to consider none other than struggling Boeing (BA: down $2.90 to $34.78, Research, Estimates) 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 said, "you're getting Boeing's commercial business for free." graphic

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    Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer. Morningstar: © 2018 Morningstar, Inc. All Rights Reserved. Factset: FactSet Research Systems Inc. 2018. All rights reserved. Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor's Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2018 and/or its affiliates.

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