Earlier this week, international megabanker Citigroup announced it had downgraded shares of three big defense contractors. For the first time in six years, Citigroup says it cannot recommend buying shares of General Dynamics (NYSE:GD), Northrop Grumman (NYSE:NOC), or Huntington Ingalls (NYSE:HII), either. The reason?

They're just too expensive.

"But wait," you say. Didn't President Trump just say he wants to increase defense spending by 10%? Didn't Trump say in his recent address to Congress that this will be "one of the largest increases in national defense spending in American history"? And doesn't that mean good things for defense companies?

Well yes, he did. And yes, it will be. And that's a problem.

Tank barrel.

Before going off half-cocked about "expensive stock valuations," General Dynamics should point this cannon at itself. Image source: Getty Images.

The trouble with optimism

One of the troubles with investing in the stock market is that the market is famously forward-looking. Investors often buy stocks based on how they think a company will do in the future (forward price-to-earnings ratio), rather than on what it has successfully accomplished in the past (trailing P/E). And when it comes to defense stocks, a lot of folks have bet big that defense companies will do very well in the future. They've bid up stock prices in anticipation of this good news, with two results:

  1. There's little room left for defense stocks to go up.
  2. There's increased risk that if defense spending, and defense profits, doesn't increase as fast as anticipated, defense stocks could crash.

That's why Citigroup downgraded General Dynamics, Northrop Grumman, and Huntington Ingalls last week. It's also why you should be very cautious about buying defense stocks today. And it's not just me saying that -- nor just Citigroup, either.

A word from the wise

Presenting at the Barclays Industrial Select Conference in Miami last month, the chief financial officer of General Dynamics itself lamented the high valuation on defense companies these days. As Jason Aiken explained, the company has been looking to make a big acquisition for three or four years now. Unfortunately, said Aiken, "we haven't necessarily found anything that we found to be compelling either from a price expectation perspective or from a fit and rationale perspective."

Oh, General Dynamics has made a few nip-and-tuck acquisitions here and there. In 2014, it bought ARMA Global, a contractor supporting U.S. special forces, and in 2016, General D netted robotic submarine manufacturer Bluefin Robotics and aircraft management provider Avjet. Neither acquisition was large enough that General Dynamics felt it material enough to mention the purchase price, however.

Instead of acquisitions, General Dynamics has focused for the most part on buying back its own shares -- $8.6 billion worth repurchased over the past three years. That's proven a good investment, with General Dynamics stock up 71% in three years. Accordingly, the company intends to continue repurchasing shares, and doesn't contemplate making any acquisitions this year.

The trouble with repurchases

But here's the problem: General Dynamics management can clearly see that other defense companies are too expensive to buy. However, it suffers from a severe case of myopia regarding General Dynamics' own shares -- which are among the most richly valued in the defense industry.

Priced north of 1.8 times sales, General Dynamics stock sells for a more expensive price-to-sales ratio than do either of the other two stocks Citigroup downgraded this week -- Northrop Grumman (1.7 times sales) and Huntington Ingalls (1.4 times sales). GD stock even looks gosh darn expensive relative to shares of the nation's biggest defense contractor, Lockheed Martin, which costs only 1.6 times sales. In fact, as I explained last week, General Dynamics stock currently trades at a whopping 66% premium to what it has averaged over the first 16 years of this century.

The upshot for investors

Simply put, General Dynamics is right to avoid buying other defense companies, and rightly recognizes that everyone else is too expensive to invest in. What General Dynamics doesn't seem to get is that because its own shares are overpriced, too, it should not be buying General Dynamics stock, either.

And neither should you.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.