With the recent epidemic of gun violence in America, and tightened gun regulation from Washington looking increasingly likely, you might think that right now is a terrible time to buy gun stocks.
Perverse as it may sound, research shows that the aftermath of just about any gun tragedy -- or the months of debate leading up to legislation to prevent the next tragedy -- is often a great time to buy gun stocks. The reason: Gun owners, or folks contemplating buying a gun, view the risk of legislation that might prevent gun sales as something to be avoided.
They respond logically to this risk, by rushing to the gun store to buy a gun. This causes gun sales to rise, profits from gun manufacturers to rise, and gun stocks -- you guessed it -- to rise as well. The fact that the feared gun legislation never seems to actually materialize doesn't seem to affect the pattern much at all.
Acting on the knowledge
As author and Bloomberg reporter Paul Barrett explains in his 2013 classic Glock: The Rise of America's Gun, this is how things have always played out before. There's little reason to expect things will happen any differently in the wake of 2016's wave of gun violence. And that means that right now, today, could be an excellent time to invest in a gun stock. Here are two for you to consider:
Smith & Wesson
With or without the mooting of new gun laws to assist it, Smith & Wesson (NASDAQ:AOBC) stock has been doing just fine of late. According to data from S&P Global Market Intelligence, sales are up 16% annually over the past five years, while earnings before interest and taxes (EBIT) have compounded at a 53% annual rate -- which is simply incredible.
Last year, Smith & Wesson booked $94 million in net profit from its business, and produced positive free cash flow of $138 million. That gives the stock a P/E ratio of 16.9, and a price to free cash flow ratio of just 11.5. While Smith & Wesson stock pays no dividend, analysts predict that its earnings will grow at an average rate of 15% annually over the next five years. Weighed against the P/E, that suggests the stock might be slightly overvalued today -- but considering the amount of cash S&W is generating, it still looks like a bargain to me.
The situation at Sturm, Ruger (NYSE:RGR) looks somewhat different. Like Smith & Wesson, Sturm, Ruger stock is raking in profits in a big way. Last quarter's financial report showed the company growing its earnings 50% on "only" a 26% rise in sales. Over the past five years, S&P Global data show Ruger growing sales faster than Smith & Wesson (compounded growth rate: 18%) even if earnings have grown somewhat less swiftly (EBIT growth rate: 20%).
More recently, if we include Q1's blockbuster results in the calculations, Ruger has earned just under $70 million in profits over the past year, and generated $78.5 million in positive free cash flow. That's only three-quarters the profit that S&W booked, and barely half the free cash flow. Yet at a market capitalization of $1.28 billion Sturm, Ruger stock is being valued by investors at 80% of Smith & Wesson's worth.
And the best gun stock is...
Luckily for investors, this makes the decision of which stock to buy -- Smith & Wesson or Sturm, Ruger -- clear as day. Sturm, Ruger isn't generating enough GAAP profit, nor nearly enough free cash flow, to justify its premium P/E and P/FCF ratios relative to Smith & Wesson.
Moreover, analysts who follow both stocks expect that next year will see a small slump Smith & Wesson's profits of just 1%, but a 26% plunge in profitability at Sturm, Ruger. Meanwhile, as far as long-term estimates go, not enough analysts are certain enough about Ruger's prospects to voice an opinion on its long-term growth rate. We've therefore got a lot more certainty about where S&W will be a few years from now, than we have about Ruger.
It all adds up to a much stronger case in favor of investing in Smith & Wesson stock, than for buying Sturm, Ruger stock. Smith & Wesson, therefore, is the better buy.
Fool contributor Rich Smith does not own shares of, nor is he short, any company named above. You can find him on Motley Fool CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 288 out of more than 75,000 rated members.
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