Defense Stocks vs. Mr. Market

Smart investors exploit the market for their benefit. However (and sometimes unfortunately), a smart and ultimately correct investment thesis can still produce lackluster results for investors. I wrote a piece a few months ago claiming the market substantially underpriced the defense industry as a whole. Since some time has passed, and with earnings season largely in the rearview mirror, I thought it would be interesting to see how some popular defense stocks have fared over the past months.

Perception -- How ya been??
Over the past three months, the S&P 500 returned 3.1%. During that same time frame, the major defense players generated the following returns:

Company

3-Month Total Return

United Technologies (NYSE: UTX  ) 6.5%
Boeing (NYSE: BA  )             10.0%
Lockheed Martin (NYSE: LMT  ) (2.1%)
General Dynamics (NYSE: GD  ) (3.0%)
Northrop Grumman (NYSE: NOC  ) 1.4%*
Raytheon (NYSE: RTN  ) (2.9%)
ITT              (1.0%)
Rockwell Collins (4.5%)
L-3 Communications (NYSE: LLL  ) 5.3%

Data from Capital IQ, a Standard & Poor's company.
*Adjusted to reflect spinoff of shipbuilding unit.

This slight overall underperformance makes sense, since nothing material really changed with the market's expectations for the defense arena. Investors widely accept and believe that the national defense budget will undergo its own scorched earth campaign, as Congress continues to gravitate toward austerity and the U.S. eventually winds down the bulk of its overseas operations (Iraq and Afghanistan). With these two major drags still in place, it seems perfectly reasonable that defense stocks largely underperformed the market during this period. However, as I argued in my first article, investors continue to let their doom-and-gloom expectations obscure the actual facts.

Performance -- How ya doing??
In fact, it appears largely fine. The most recent quarter and subsequent earnings announcements give a perfect window into the reality of major defense companies. Over the first quarter of 2011, it actually looks like those same major defense contractors did pretty well.

Company

Estimated EPS

Actual EPS

Backlog (Current)

Backlog 
(Last Year)

United Technologies $1.06 $1.13 $55,208 $55,667
Boeing $0.69 $0.79 $320,826 $315,558
Lockheed Martin $1.50 $1.52 $78,200 $77,200
General Dynamics $1.60 $1.66 $59,561 $66,545
Northrop Grumman $1.56 $1.82 $64,183 $69,186
Raytheon $1.10 $1.07 $34,551 $36,877
ITT $0.92 $0.67 $5,401 $6,300
Rockwell Collins $0.96 $0.97 $4,500 $4,500
L-3 Communications $1.85 $1.87 $11,091 $10,862

Data from Capital IQ, a Standard & Poor's company.
Estimate figure is median consensus of analyst estimates; actual figures reflect basic EPS.

Overall, these companies still seem pretty strong. The vast majority of them beat their earnings estimates (a few handily). Likewise, backlogs remained pretty steady, with outstanding orders staying relatively flat. This flies contrary to the conventional wisdom that these firms have bull's-eyes (military pun!) attached to their operations. If nothing else, I think this supports my thesis that a real disconnect currently exists between the actual business facts for these companies and their performance.

To quote Keynes
As the prescient economist John Maynard Keynes noted, "Markets can remain irrational longer than you can remain solvent." I might substitute "patient" for "solvent" here, but you get the picture. Unfortunately, this dynamic certainly appears at work for this sector. These businesses generally outperformed expectations and appear stable going forward, but their share prices continued their recent downward march (2nd military pun!). In this case, it seems like reality's taken a back seat to pessimism.

Even more unfortunately for investors, I expect this to continue into the future. With some recent positive developments in U.S. overseas operations, a troop drawdown certainly seems increasingly likely. The budget debate in Washington also seems to have intensified during this quarter. Despite this good news on both fronts, I still remain skeptical of the timetables investors have attached to either troop drawdowns or budget remedies. Remember, we have a presidential election on the horizon and a still-hamstrung economy. Combine that with our nation's famous legislative agility, and I think the same case for continued defense spending appears still valid.

Regardless of outcome, I'll keep my eyes peeled and you, the dear reader, informed as this saga plays out. You can also keep up to date with the latest developments surrounding these stocks by clicking here to add them to My Watchlist, the Fool's free stock monitoring service.

Fool editor and writer Andrew Tonner holds no position in any of the companies mentioned in this article. The Fool owns shares of General Dynamics, L-3 Communications Holdings, Lockheed Martin, Northrop Grumman, and Raytheon. Alpha Newsletter Account, LLC owns shares of L-3 Communications Holdings.

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