Rising Star Buy: Cheap Defense Stocks

This article is part of our Rising Star Portfolios series.

When a sector is beaten down, I get interested.

When a sector is beaten down and nothing has fundamentally changed, I get really interested.

I believe that's the case in the defense industry.

Why so bullish?
In the banking industry, there are beaten-down stocks because of uncertainty around balance sheets, foreclosures, and stability.

In the health-care industry, there are beaten-down stocks because of worries that regulation will change the fundamental profit drivers of the industry.

In the defense industry, there are beaten-down stocks because of worries over defense cuts.

I've been trolling around in each of these sectors (click here for my calls in the banking space), but I'm focusing on the defense industry today, because defense offers us a chance to buy into an industry that's more stable than the market's pricing. Companies are trading at historically low multiples, and even though the pie may get smaller because of cuts by the U.S. Department of Defense, I'm betting the currently envisioned extent of those cuts is an overreaction.

There are five large defense companies trading for earnings multiples of around 10. That's low both historically and on an absolute basis:

Company

P/E Ratio (2001)

P/E Ratio (2006)

P/E Ratio (Recent)

General Dynamics (NYSE: GD  )

16.6

17.6

10.8

Lockheed Martin (NYSE: LMT  )

28.9

17.0

9.8

Northrop Grumman (NYSE: NOC  )

12.3

17.1

9.8

Raytheon (NYSE: RTN  )

38.3

19.9

10.1

L-3 Communications (NYSE: LLL  )

33.5

19.1

9.1

Source: Capital IQ, a division of Standard & Poor's. The P/E ratios for 2001 and 2006 are averages for the years. The recent P/E ratio is as of yesterday's close.

To make sure these companies haven't lost their earnings efficiency, take a look at their recent returns on capital versus five and 10 years ago. They've all held up pretty well, if not improved:

Company

Return on Capital (2001)

Return on Capital (2006)

Return on Capital (Recent)

General Dynamics

17.2%

13.6%

14.8%

Lockheed Martin

6.2%

17.6%

32.9%

Northrop Grumman

6.8%

7.2%

10.5%

Raytheon

2.3%

8%

13.3%

L-3 Communications

7.8%

8.1%

9.8%

Source: Capital IQ, a division of Standard & Poor's.

The buy thesis
Because the market seems too pessimistic on the industry, I'm buying a basket of these five low-multiple, high-return companies for my real-money portfolio. I'll be allocating $400 to each pick, for a total of $2,000. For context, my portfolio started with $5,000 in November, with $1,000 added each month.

My return expectations on these picks are muted. I'm not looking for shares to skyrocket -- just hoping to take advantage of a bit of overdone market pessimism.

There's an additional opportunity to beat the basket returns by diving in deeply and analyzing each company on its own particular merits. I may do so in the future, but for today, I'm happy with a higher-level basket approach.

To follow along with my entire portfolio, check out my real money portfolio page. Fool on!

Anand Chokkavelu doesn't own shares of any company mentioned. The Fool owns shares of L-3 Communications. 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.


Read/Post Comments (6) | Recommend This Article (17)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 06, 2011, at 1:55 PM, bzhayes wrote:

    With a $400 buy-in you are going to be paying around 2% in trading fees to buy and another fee to sell. Since you are trying to invest in a sector instead of an individual company its seems like you would be better off buying an ETF like ITA or PPA. Unless you are going to hold the stocks for a very long time you would probably save on fees and get increased diversification in the sector.

    Also, why does the disclosure statement say you don't own any of these companies, but your article state you are buying all of them?

  • Report this Comment On January 06, 2011, at 2:49 PM, boogaloog wrote:

    As a long-time employee of Raytheon, I have to agree with this post. RTN's stock price got ahead of itself a decade ago (along with every other stock), but it seems like it has been at bargain levels for several years now, especially after cleaning up some of the money pit businesses (construction, aircraft) and paying off a huge portion of its debt.

    Fears over defense spending are misplaced in my opinion, especially by those who look at which political party is in the White House. Times were tight here during Papa Bush's tenure, cash was flowing freely during the Clinton era, we had reductions-in-force during W's years, and we're starting to hire again under Obama. It has infinitely more to do with current threats and product line age than with whose name is on the check.

    Yes, some programs were cut recently, but others have sprung up. You only hear about the ones that were cut because it makes for great fear-mongering headlines. But I have no worries about my job for years to come.

    As far as other companies in the list, I'm not as knowledgeable. But I do have to laugh when people talk about the F-22 "cut" in production, which was merely a confirmation that they wouldn't EXTEND production beyond the currently planned numbers, and MORE jobs would be created by the INCREASE in F-35 production. I have nothing to do with either of those programs, but I'm sure they have tentacles throughout the industry. And of course this could all change at any time -- as with any defense program. But I know this: we Americans (especially politicians) LOVE spending money on bigger and better weapons.

    Disclosure: I own shares of RTN and GD (which has done very well for me, thank you)

  • Report this Comment On January 06, 2011, at 9:41 PM, TMFBomb wrote:

    @bzhayes,

    I am buying these companies for a real-money portfolio. It is the Motley Fool's money, not mine. We purchase the shares the day after the article's published.

    For the purposes of the real-money portfolio, my trading cost is pretty low. Everyone should factor in their trading costs based on their own situations and consider position sizes accordingly.

    I didn't buy an ETF because I specifically wanted these five lower-multiple companies.

    @boogaloog,

    Thanks for the additional insight!

    Fool on,

    Anand

    -Anand

  • Report this Comment On January 09, 2011, at 5:09 PM, midaslefk wrote:

    Did you also consider LEAPS on these positions?

  • Report this Comment On January 10, 2011, at 8:40 PM, TMFBomb wrote:

    @midaslefk,

    For now, I'm running this portfolio as a long-only portfolio (i.e. no options or shorting...simply buying stocks I think are undervalued).

    -Anand

  • Report this Comment On January 31, 2011, at 7:25 PM, hornbull wrote:

    FWIW, I bought some shares of RTN today when it dipped below $50. From a FCF and ROIC perspective, it's trading at a deep discount. As for budget cuts from the DOD, I was encouraged to hear on the earnings call that international sales are expected to make up about 25% of total sales. A diversified portfolio of contracts not entirely dependent on domestic defense budgets is good news to me. And lastly, a 3% dividend yield isn't anything to scoff at either. If recent history holds, we could see the dividend hiked up about 10% next quarter.

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