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The market thumbed its nose at Washington D.C. today as investors displayed their optimism despite being on the edge of the fiscal cliff (or, more accurately, fiscal slope) without an agreement from lawmakers. The Dow (INDEX: ^DJI ) and the broader S&P 500 (INDEX: ^GSPC ) gained 1.3% and 1.7%, respectively, on the last trading day of the year. For the full year, the S&P 500 rose 13.4% and returned 16%, inclusive of reinvested dividends -- a very decent result, particularly if one remembers the rather grim landscape investors faced at the beginning of the year.
One of the sectors that carries the greatest exposure to the fiscal cliff is defense. In 2013, an equal-weighted portfolio of General Dynamics (NYSE: GD ) , L-3 Communications (NYSE: LLL ) , Lockheed Martin, Northrop Grumman, and Raytheon squeaked past the S&P 500, with a 12-month return of 13.6% against 13.4% (17% inclusive of dividends -- the dividend yields in this group are higher than that of the index.) In fact, through Election Day, the group was ahead by 1.5 percentage points; however, once the market's focus shifted to the fiscal cliff, nearly all of that outperformance was erased.
This entire group looks interesting for a number of reasons First, the potential loss of revenue due to cuts in defense spending is well-known and must presumably be factored into share prices. Second, these stocks already look (on a rapid pass) to be trading at or slightly below fair value: three of them -- General Dynamics, Northrop and L-3 Communications are valued at less than 10 times earnings-per-share estimates for the next 12 months. Admittedly, these are low-growth -- and, in some cases, slowly contracting -- growth businesses, but they generate steady returns on equity in the mid- to high-teens and solid cashflows.
Finally, if uncertainty regarding any defense spending cuts drags on and the stocks' headline risk becomes more prominent, there is the distinct possibility that nervous hands will abandon the shares, driving prices below their intrinsic worth. For value-oriented investors, these are the hallmarks of an opportunity in the making. And speaking of value investors, it may be worth noting that Warren Buffett has bought General Dynamics in the past on behalf of Berkshire Hathaway (NYSE: BRK-B ) -- back in 1992 -- and that Berkshire owns a small position now. The defense industry is worth monitoring in 2013. Happy New Year and many value returns!
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