While it may not be a contrarian position at this point, I think the defense industry has excellent growth potential in the next few years. Many defense contractors have already seen share prices rocket upward after the initial shock of Sept. 11, but a few have lagged.

One such company, General Dynamics (NYSE: GD), finds its stock in about the same place as 13 months ago, before the U.S. started beating the war drums. But could $16 billion at large offer General Dynamics some potential for gains not appreciated by the market? Perhaps.

Defense is another industry that doesn't allow for a single Rule Maker. Similar to pharmaceuticals, defense contractors operate as a de facto oligarchy: The insiders have staked their positions, and the capital needed to break into the inner sanctum is so high that it's unlikely an assault on the oligarchs will be made any time soon. What's left, then, is healthy competition among defense companies, including General Dynamics, Lockheed Martin (NYSE: LMT), Boeing (NYSE: BA), United Technologies (NYSE: UTX), and Northrop Grumman (NYSE: NOC).

General Dynamics has a pristine balance sheet, a shareholder-friendly management team, and a long and glorious history. A quick read of the company's regulatory filings includes this description: "The company's primary customers are the U.S. military, other government organizations, the armed forces of allied nations, and a diverse base of corporate and industrial buyers." In other words, this is an iron-bending, nail-spitting, blow-stuff-up kind of organization -- no homey touches required.

As such, one would think that during this time of presage of a possible World War III, General Dynamics would be flying high. The problem is that the company generates more than 40% of its revenue from commercial aircraft via its Gulfstream division, and that market isn't showing much promise. In addition, investors are a bit dubious of General Dynamics' shipbuilding sector, particularly after it lost out on buying Newport News Shipbuilding to rival Northrop Grumman. Finally, General Dynamics has failed to garner a number of recent Pentagon contracts.

Meanwhile, the company has turned in several consecutive great quarters, most recently its June quarter, in which it increased sales from the year previous from $3 billion to $3.5 billion, with earnings coming in at $1.29 per share, up from $1.12. For a lumbering industry like defense, that's a significant level of growth.

A good, long read of its 10-K makes me wonder where the negativism about the company's shipbuilding and commercial aerospace sectors comes from. I don't think losing a few bids on defense contracts is even worth discussing. Unless the company exhibits a trend of offering inferior solutions, defense contracts are simply a goes-around, comes-around sort of scenario. Even though the Pentagon would never admit it, the government doesn't want to appear to play favorites among contractors.

In shipbuilding, the fiscal 2004 Defense Department budget includes funding for three Aegis destroyers at $1 billion apiece, all of which will be made by General Dynamics. The company hopes to receive contracts for five additional ships, which would go into the current backlog of more than $20 billion. In addition, General Dynamics received a $440 million contract this week to convert four Ohio Class submarines to a new, covert-strike and special-operations configuration.

But what about those Gulfstreams? Clearly in the current economic environment, sales of multi-million dollar executive jets have declined. Well, yes and no, but mostly no. Gulfstream does face some risks and pretty steep competition from comparable companies, including Cessna, Bombardier, Raytheon (NYSE: RTN), and Dassault. Even more threatening is Eclipse Aviation's potential. The company says it can deliver a six-seater jet for around $850,000, a fraction of the cost of the high-end Gulfstream.

But the market for Gulfstream may not be as weak as the economy would presuppose, for one reason -- fractional jet ownership, begun and perfected by Berkshire Hathaway (NYSE: BRK.A) subsidiary NetJets. NetJets is Gulfstream's largest customer, and it ordered 50 Gulfstream aircraft in early September, with an option for 50 more -- a contract worth $1.5 billion to General Dynamics. Even prior to this, NetJets was a large driver of Gulfstream business. According to the 10-K, it represented 43% of all funded backlog for the division.

Companies don't necessarily want a dominant customer, so the fact that NetJets plays such a big role in the division's future success may not be the best scenario for Gulfstream. However, the economic model for NetJets suggests that Gulfstream may be a bit more resistant to economic swings than otherwise believed. If corporations forgo buying their own planes, and instead opt for NetJets, Gulfstream still benefits.

I'd like to spend some time over the next few weeks examining some of General Dynamics' bells and whistles. As it is, this looks like a company with solid short-term performance and under-appreciated long-term potential.

Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards..

Bill Mann's hoping General Dynamics gives out free samples. He holds shares in Berkshire Hathaway. The Motley Fool is investors writing for investors.

The Rule Maker Portfolio has had a cumulative investment of $42,500. As of Oct. 1, 2002, its current value of all cash and equities is $27,103.65. This equals an internal rate of return of -14.5% since the launch of the portfolio in February 1998.