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How to Invest in Military Stocks

By Rich Smith – Aug 16, 2017 at 9:16AM

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Defense stocks have gotten very expensive, but there's still one that's a bargain.

2016-2017 has been a great time to invest in military stocks. Over the past year, the five biggest defense stocks have averaged returns of more than 37% -- and have become a whole lot more expensive.

Military Stock

Trailing-12-Month Stock Performance

Dividend Yield

Total Return

Boeing (BA 4.65%)

76.2%

2.4%

78.6%

General Dynamics (GD 0.81%)

32.8%

1.7%

34.5%

Northrop Grumman (NOC 2.01%)

25.3%

1.5%

26.8%

Lockheed Martin (LMT 0.07%)

16.3%

2.4%

18.7%

Raytheon (RTN)

26%

1.8%

27.8%

DATA SOURCE: FINVIZ.COM.

Despite the run-up, with things heating up again in North Korea (in the Middle East, they never cooled off), investment banker Morgan Stanley thinks military stocks could continue to post strong financial returns for some time to come (as they explained in a recent series of defense stock ratings). Then again, like Yogi Berra used to say, "It's tough to make predictions, especially about the future."

Yes, Donald Trump has promised to increase defense spending bigly next year. Yes, he's authorized billions of dollars worth of arms sales to foreign militaries. And, yes, all of that should mean more money for defense companies, which should mean (and already has meant) good news for defense stocks. Problem is, as the defense budget swells, so, too, do the prices of aerospace and defense stocks, which are no longer as cheap as they once were.

If you have been thinking about how to invest in military stocks, it's more important than ever to keep an eye on valuation.

Textron Scorpion Jet with numbered pylons

Judged on the numbers, only one defense stock is a bargain today. Image source: Textron.

How to value a defense stock

Military stocks are just like any other stock, in that you can value them on earnings, dividends, and free cash flow. But I've said this before  and I'll say it again: Over long periods of time, military stocks tend to revert to an average valuation based on their annual sales. Over the 17 years since this century began, military stocks as a group have sold for about one times annual sales on average -- but they're selling far more than that average today.

Currently, the five defense stocks named above sell for an average of 1.8 times annual sales -- 80% above their long-term average valuation. Valued at 1.5 times sales, Boeing is the cheapest of the five, while Raytheon is the most expensive -- 2.1 times sales. Lockheed Martin is right in the middle at 1.8 times sales. But every single one of the large biggest defense contractors costs nearly twice its average valuation over the past two decades today.

Two reasons military stocks are not great bargains...

Why is that? Despite the headlines, it's not because these companies have above-average growth prospects. Actually, the average defense stock is expected to grow its earnings at no more than 10% annually over the next five years -- roughly in line with the growth rates expected elsewhere on the S&P 500.

Nor is it because military stocks pay great dividends -- at least, not anymore. Rather, dividends within this group average a bit less than the 2% common among other S&P 500 stocks.

Moreover, both the average growth rate and the average dividend yield of the defense companies rely on a big boost from Boeing, which pays the highest dividend yield in the group (2.4%) and boasts the fastest projected growth rate -- 18%. If not for Boeing being in the group, military stocks as a whole would look even less attractive relative to the rest of the market.

... and one big reason why they cost so much

No, the real reason investors are paying up for defense stocks today (I think) is because military stocks are presently earning some of the highest profit margins they've ever earned in recorded history. This fact has not gone unnoticed by President Trump, who's called upon Lockheed Martin, Boeing, and others to roll back their prices. If and when defense stocks' profit margins return to historical norms, I'd expect to see their price-to-sales ratios revert to the norm as well, which brings me to my most practical bit of advice:

The one military stock that still sells for less than its annual sales (i.e., less than one times sales) is Textron (TXT 2.77%).

Textron stock is a bargain in the rough

Priced at 0.9 times sales today, Textron doesn't sell at a huge discount to the average valuation for military stocks. But Textron stock does offer a modest margin of safety -- and it's a whole lot cheaper than its peers. This is probably partly a function of Textron's operating profit margin, which at 7.6%, is below the group. It's a function partly of its debt load, which at $3.1 billion net of cash, is rather high for a military stock with only a $13 billion market capitalization.

Those caveats aside, beggars can't be choosers. With military stocks as a group clearly overvalued, Textron is the closest thing to a bargain defense investors will find on the market today.

Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Textron. The Motley Fool has a disclosure policy.

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Stocks Mentioned

The Boeing Company Stock Quote
The Boeing Company
BA
$133.44 (4.65%) $5.93
Lockheed Martin Corporation Stock Quote
Lockheed Martin Corporation
LMT
$400.00 (0.07%) $0.26
General Dynamics Corporation Stock Quote
General Dynamics Corporation
GD
$220.45 (0.81%) $1.78
Textron Inc. Stock Quote
Textron Inc.
TXT
$60.52 (2.77%) $1.63
Raytheon Company Stock Quote
Raytheon Company
RTN
Northrop Grumman Corporation Stock Quote
Northrop Grumman Corporation
NOC
$483.69 (2.01%) $9.55

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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