Defense stocks went nuclear in 2017 on the promise of a Trump-orchestrated Pentagon spending surge. A top Department of Defense official just admitted it's time for investors to curb their enthusiasm.
Deputy Secretary of Defense Patrick Shanahan told reporters that the fiscal 2019 Pentagon budget request would include a "step up" in funding, but said the highly anticipated buildup would fall to later years. The Pentagon needs time to reassess priorities following its recently released National Security Strategy policy document, he said, while promising the 2020 budget request would be the "masterpiece."
Betting on Trump
Candidate Trump campaigned on the need to "make America great again" in part by boosting military spending, promising a beefed-up Navy, additional airpower, and improved missile capability as a show of strength to deter foreign aggression. Investors bought in, sending shares of Lockheed Martin (LMT -0.34%), Northrop Grumman (NOC -1.15%), Huntington Ingalls Industries (HII -1.48%) and Raytheon (RTN) up around 30% in 2017. Even General Dynamics (GD -1.97%), despite issues with its Gulfstream business-jet operation, is up 17%.
Across the sector, companies currently trade at double the price-to-earnings and price-to-sales multiples that they did only a few years ago.
True to his word, Trump, along with Republican Congressional leaders, has made Pentagon funding a priority. The stopgap funding resolution passed Dec. 21 to keep the government running included an extra $4.7 billion in emergency spending for missile defense and Navy repairs, and both the budget request submitted by the White House and Congressional spending plans have included some sort of an uptick in defense spending.
If Trump were to find a way to fund everything he has promised, the run-up in defense shares would be more than justified. The Congressional Budget Office in a December report estimated the full buildup advocated by the administration would boost spending by $683 billion over the next decade.
Worth waiting for the masterpiece?
But as Shanahan, a former Boeing exec who has been at the Department of Defense since July, makes clear, turning those campaign promises into actual policy takes time. The Pentagon has an ever-evolving list of needs, and paying for even a portion of what defense officials say is needed will require repealing the Budget Control Act of 2011 and finding new ways to fund increased spending.
And while weapons modernization is one of the priorities when ramping up defense spending, it is important for investors to remember that only some of the additional funds are going to flow to the contractors. Trump also wants to grow the size of the military and boost pay for service members, priorities that are going to soak up a considerable portion of any budget increase.
The bottom line is that investors jumping enthusiastically into defense stocks were getting way ahead of results. Defense companies, with multiyear production schedules and a reliance on government funding, tend to be poor candidates for momentum investing.
The good news is, defense shares can hold these levels. Pentagon spending appears set to increase, even if it isn't at the pace that some investors would hope for. And the gains have come off an artificially low base due to budget sequestration and spending freezes from earlier in the decade that turned investor sentiment against the defense sector.
Shanahan's "masterpiece" might well arrive in 2020, as he hopes. Investors would be wise to remember that even if it does, most of it is already priced into the stocks.