Get Defensive With Defense

This article is part of our Rising Star Portfolios series.

I love defense companies because they enjoy high barriers to entry and are uncorrelated with the economy, making them -- like food and beverages -- great counter-cyclical assets. But I'm also choosy when it comes to buying them; most of the time you have to pay up. Except now, that is. Many defense contractors are trading at multiyear low prices and historically low multiples of earnings and free cash flow, giving us a potentially lucrative hunting ground.

This is because investors worry about overseas wars winding down and the huge effort by policymakers at home to rein in budgets by cutting defense, among other items. While there is certainly risk as combat levels slow, the global security system is anything but calm. Both North Korea and Iran seek nuclear capabilities, global terror attacks are unfortunately not a thing of the past, and just one incident could increase the public's willingness to fund defense programs. In addition, asymmetric attacks and electronic warfare are also on the rise. All of this means that we need to continue to spend money to defend both the nation and our interests abroad.

Defense spending as a percentage of GDP is also historically low, coming in at 4.8%, compared to peaks of 6.2% in 1986 and 10% or so in the 1960s. And while it won't set any speed records, growth has been surprisingly strong -- defense spending has grown at a 5.4% annual clip over the past 50 years.

This disconnect between needs and perception is giving us a fantastic opportunity to scoop up excellent companies at very good prices. And by very good, I mean very good. Defense contractors have historically traded between 5 and 10 times EBITDA and now stand around 6 times. Earnings and cash flow yields approach 10% for many of the companies. This is phenomenal value for solid assets, especially in an environment where cash yields little and there is more risk in the general economy than normal.  

This last point bears repeating. Although hemmed in by budgetary pressures, because most of defense contractors' revenue is from the government, the sector is remarkably stable. If the economy tanks, these companies won't be affected too much. Even some of our strongest consumer brands like Nike and Costco Wholesale are not nearly as immune to a downturn in the economy. In essence, the sector is not only good value, but a hedge against something bad happening with the economy. I'll take that bet.

What I'm looking at now
I'm all about value, and the industry is a rich picking ground right now for that. Companies that look interesting include Raytheon (NYSE: RTN  ) , VSE Corp. (Nasdaq: VSEC  ) , General Dynamics (NYSE: GD  ) , and perhaps even Alliant Techsystems (NYSE: ATK  ) . These companies are all cheap, and I'll delve more into them (and others) for one of my first recommendations.

My Foolish bottom line
I've spent many years studying the defense and aerospace industry and believe it's time to get excited about defense stocks. Investors are so wary they have forgotten that defense is an excellent area to invest. This is because:

  • There are huge barriers to entry.
  • Long product lifecycles mean high visibility of earnings and cash flow.
  • Defense programs are hard to cut.
  • Defense is counter-cyclical to the economy.
  • Unfortunately, the world is not a safe place.

You get the best deals in the stock market when no one wants to buy an industry. That's definitely the case today, and the companies above (and others) are worth a look. Look forward to more detail (and stock picks) as we continue this investing adventure!

This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. Click here to see all of our Rising Star analysts (and their portfolios).

Andrew Sullivan, CFA, owns shares of no companies listed above. Costco Wholesale and General Dynamics are Motley Fool Inside Value recommendations. Costco Wholesale and Nike are Motley Fool Stock Advisor picks. The Fool owns shares of Costco Wholesale. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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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