The No. 1 Reason You Should Not Buy Military Stocks in 2017

Should you invest in military stocks in 2017?

If you're looking in the rearview mirror, the answer sure looks like it should be "yes!" Over the past year, the top five biggest military stocks listed on U.S. stock exchanges gained an average of 36% -- and that's not even counting their dividends! Here is a list of America's five biggest defense stocks by revenues, and how those stocks performed:

Data source: finviz.com.

Defense was one of the hottest sectors in the stock market in 2016. But 2017 might not turn out so hot for investors. The reason: Military stocks are not cheap anymore. Not even close.

Image source: Getty Images.

In defense of defense stocks

There are any number of reasons to like military stocks -- their ability to generate steady sales and profit in almost any market, their above-average dividend yields, and, of course, their recent outperformance on the stock market. But to my eye, there's one big reason to distrust the ability of military stocks to continue to outperform in 2017.

One of the most important things to look at when evaluating defense stocks is the prices they pay when they purchase new subsidiaries, and the prices they get paid when they spin off divisions they no longer want. Naturally, these valuations fluctuate somewhat, depending on whether a business is earning respectable (say, 10%) profit margins or not, and whether it's carrying a heavy debt load; whether it's growing at a decent (10%) rate, or faster, or slower. But on average and over time, it seems to be that defense stocks are cheap when they sell for less than a price-to-sales ratio of 1, and expensive when they sell for more than that.

This rule of thumb applies to entire defense companies, by the way, and not just to individual divisions of military companies. Financial-data powerhouse S&P Global Market Intelligence maintains a massive database of stock prices and data on revenue generated by the companies those stocks represent. Compare one to the other, and what you'll find is that, since the turn of the century, the five biggest U.S. defense stocks have all sold for a debt-adjusted price that gives them almost exactly a P/S ratio of 1 in regard to their annual sales.

Here's how the numbers break down:

• From 2000 to 2016, General Dynamics traded for an average debt-adjusted price-to-sales ratio of 1.09.
• Raytheon averaged 1.08 times sales.
• Lockheed Martin -- 0.96.
• Northrop Grumman -- 0.90.
• Boeing -- 0.85.

The average for the group as a whole has been 0.98 times sales. But that's how defense companies have traded historically. Now let's look at what these defense stocks cost today:

• General Dynamics: 1.81 times sales -- 66% above its long-term average and 81% north of a ratio of 1.
• Raytheon is even more expensive, at 1.87 times sales -- 73% above its average and 87% above 1.
• Lockheed Martin costs 1.63 times sales -- 70% above average and 63% more than 1.
• Northrop, at a P/S of 1.72, costs 91% more than usual
• Only Boeing looks close to fair value. Its 1.11 P/S ratio is 30% higher than normal but only 11% "overvalued" -- if you agree that a ratio of 1 is the default fair value.

What it means to investors

Admittedly, there are other ways to look at all of these stocks. Like other companies, defense stocks can also be valued on price-to-earnings, on price-to-book value, and even on price-to-free cash flow. But to my mind, the simplest, easiest way to tell if a military stock is probably overvalued or undervalued is to look at its price-to-sales ratio.

And right now, for every defense stock I look at without exception, the P/S ratio is flashing red.