Cheap Stocks for 2014: The Best Buys in Defense Companies

Solid buys for the right price are still out there, if you know where to look.

Jan 11, 2014 at 11:32AM

It's that time of year again. There's a chill in the air, snow on the ground, and among investors, questions abound -- questions like: "What's the cheapest defense stock I can buy in 2014?"

File
Battleship USS Texas. Source: Wikimedia Commons.

I was recently asked that particular question. But as it turns out, it's a trick question -- because after a remarkable run-up in valuations over the course of 2013, there really are no cheap defense stocks left out there. Or at least, not very many.

Good news turns into bad news
Let me explain. Last week, if you recall, we took a look at valuations in the defense sector. However, we soon came to the disappointing realization that after turning in a very strong performance in 2013, there are very few true "value stocks" remaining among defense stocks. Huntington Ingalls (NYSE:HII) probably qualifies, based on its 20 P/E ratio, strong free cash flow, and industry-leading anticipated growth rate of 27%. But subpar, single-digit growth projections at defense contractors like General Dynamics (NYSE:GD), Lockheed Martin (NYSE:LMT), and Northrop Grumman (NYSE:NOC) appear to knock all of these companies out of contention as "bargain" candidates.

Thus, after crunching the numbers, I concluded that among traditional defense contractors, Huntington was really the only stock worth considering as a value investment.

Back to basics
Turns out, there's another good reason to consider Huntington a potential value candidate. Some years ago, I argued that defense contractors in America have a certain "natural valuation." Occasionally overvalued, occasionally undervalued, as a general rule, defense stocks tend to gravitate back toward a market cap equal to the value of their annual sales.

This argument was controversial at the time -- because of its timing. Most of these defense contractors had been circling the "equivalent-to-sales" valuation during the years of rapidly accelerating spending on defense, necessitated by the wars in Iraq and Afghanistan. It remained to be seen, however, whether these valuations would hold up in the post-war era.

Yet what do we see here, two years after the Iraq war's end, and on the eve of a U.S. exit from Afghanistan? Shares of Northrop Grumman and Lockheed Martin once again sell for 1.01 times sales each. Shares of General Dynamics cost 1.06 times sales. Raytheon's (NYSE:RTN) only a bit more expensive at 1.17 times sales.

Once again, this leaves Huntington Ingalls, and its 0.67 price-to-sales ratio, looking like "best in show."

Beyond the numbers
Aside from valuation, though, is there any other reason to prefer Huntington Ingalls over its defense contractor peers? I believe there is.

Consider, for example, Barack Obama's ballyhooed "pivot to Asia," in which the president promised to shift defense spending and reallocate military resources from Europe and the Middle East toward the Pacific. A de-emphasis on purchases of ground weapons needed to blunt a Soviet armored thrust into West Germany, or topple Middle East dictators, sounds like bad news for companies like General Dynamics, BAE Systems, and Textron, which make much of their bread and butter from building tanks and armored personnel carriers for the Army. It's probably neutral for Boeing and Lockheed Martin, whose fighter planes and bombers are just as useful in any setting.

A pivot to the Pacific really helps a company like Huntington Ingalls, though, whose whole raison d'etre is building warships to patrol the seas. Huntington's products run the gamut from Virginia-class nuclear attack submarines, to Arleigh Burke- and Zumwalt-class guided missile destroyers, to the USS Gerald R. Ford, America's newest nuclear-powered aircraft carrier. The company is absolutely crucial to building the newest generation of American warships -- Littoral Combat Ships excepted. As such, there's every reason to believe that even an ambitious target like "27% earnings growth" is not out of reach for Huntington -- even as spending elsewhere in the military trends down.

And there's also every reason to believe that even in a generally fully valued defense sector, Huntington Ingalls remains the one defense stock you can still buy in 2014. 

Oh, and one more thing
Did I mention that Huntington Ingalls pays a dividend, and has plenty of room to pay even more? A good dividend can mean the difference between an overvalued stock, and one that just might be worth buying after all -- because dividend stocks can make you rich. It's as simple as that. While they don't garner the notability of high-flying tech stocks, dividend-paying stocks are also less likely to crash and burn. And over the long term, the compounding effect of the quarterly payouts, as well as their growth, adds up faster than most investors imagine.

With this in mind, our analysts sat down to identify the absolute best of the best when it comes to rock-solid dividend stocks, drawing up a list in this free report of nine that fit the bill. To discover the identities of these companies before the rest of the market catches on, you can download this valuable free report by simply clicking here now.

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of General Dynamics, Lockheed Martin, Northrop Grumman, and Raytheon. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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