This article is part of our Rising Star Portfolios series.
If, like me, you're an 8-year-old boy at heart, it's hard to imagine that missiles, tanks, and fighter jets could ever fall out of favor. Yet our allies across the pond in Britain are busy decommissioning warships, delaying weapons upgrades, and canning the development of some high-tech military vehicles. Here on U.S. soil, meanwhile, we're hearing rumors that cuts in defense spending are as certain as slop in the mess hall (or a bad-tasting MRE). These fears have weighed on defense stocks, sending the group down 8% since the beginning of the year.
I'd love to be buying a decommissioned battleship for the Un Portfolio, but I've only been given $17,000. Instead, I'm making a 6% allocation (3% each) to defense contractors ManTech International (Nasdaq: MANT ) and SAIC (NYSE: SAI ) . These unloved providers of classified tech support have exposure to several areas of defense spending that are actually growing, and their cheap valuations will compensate me fairly for the risks involved
Why not pick just one? Well, I like both businesses -- and given the all-or-nothing nature of winning government contracts, hedging my bets is a wise tactical move that even the Army could appreciate. Hooah!
Curious about the Five Rules checklist? I won't un-vest without it. Get the details here.
Like the Geek Squad -- with security clearance
Broadly speaking, the defense industry can be classified into two categories: (1) those who make stuff and (2) those who don't. The "stuff" in this sector gets all the attention, with good reason. Our inner 8-year-olds love these high-powered, expensive, and in some cases, downright sexy machines.
But in order for our numerous defense-related government agencies to do their jobs, they need more than tanks and jets; they must have secure, interoperable, and fail-proof networks. Large tech projects need to be highly engineered, tested, and proven before they go live. And each U.S. government and military presence abroad needs logistical and technical attention. All of this takes highly trained and expensive workers armed with special clearance. Imagine the Geek Squad fixing blue screens of death on a battlefield, and you've got a pretty good idea how ManTech and SAIC earn their cash.
True, IT support and systems testing is slightly less exciting than firing a missile from a fighter jet using coordinates from a satellite floating in space. But this is mission-critical, nuts-and-bolts work, and it gets done year-in and year-out. In other words, it's a classic example of un-vesting, and precisely why I prefer ManTech and SAIC to their "stuff making" competitors Lockheed Martin (NYSE: LMT ) and Boeing (NYSE: BA ) .
The BIG THREE reasons I'm buying
1. Fears of cuts in defense spending are overblown. The base U.S. defense budget is actually growing -- only a freeze in salaries, the closure of some bases, and dwindling spending in combat zones will lead to a decline. Over the past 50 years, defense spending has grown at a 5.6% annual clip, and it's still at a relative historical low as a percentage of GDP.
Source: Office of Management and Budget; years in red are estimates.
2. Exposure to growth markets. Both ManTech and SAIC are well-positioned to win new contracts in growing areas like homeland security, counterterrorism, and cybersecurity (the latter alone is expected to benefit from $17 billion in new funding over the next five years). Budget cuts or no, the guys and gals who sign the checks continue to support the modernization of tech systems and classified communications.
3. The price is right. Both ManTech and SAIC sport free cash flow yields higher than 8.5%, and have P/E ratios of less than 12. Cheap is all well and good, but it's not everything -- luckily, these companies also focus on the long term, don't have too much debt, and have wonderful reputations in their lines of business.
What's so "Un" about ManTech and SAIC?
So what challenges would declare war on the Un Portfolio's investment in defense?
- The U.S. national debt stands at $13.8 trillion, and people are actually starting to care. A slowdown in defense funding seems built into the companies' current share prices, but an unexpected severe pullback in the budget would make me reassess.
- There are fewer troops in Iraq and Afghanistan than there were in prior years. Americans are showing a general aversion to wars and combat, and that's not likely to change in the near future. I expect in-theater defense awards to decline, and that contract revenue will have to be recouped somewhere else.
- With the renewed focus on the federal wallet, it's no surprise that defense-contract dynamics are changing. Shorter contracts and fixed-price contracts (in which contractors, not the government, bear the risk of cost overruns), are becoming the norm. This will likely result in lower margins for defense contractors.
That's a buy
The market has good reason to be worried about defense contractors in general. Nonetheless, companies in this sector with world-class capabilities, the ability to integrate new technology and engineering into existing projects, and prudent leaders are still managing to win additional contracts and increase their revenue. Add excellent balance sheets and conservative capitalizations to the mix, and ManTech and SAIC stand at attention on a crowded battlefield. Finally, the stability of the defense industry should provide diversification -- and firepower! -- to the Un Port in the context of its current holdings.
Don't be a stranger lurking in camouflage; share your thoughts on the addition of ManTech and SAIC on the Un Portfolio's discussion board.