The defense sector fell out of favor in 2020 as investors worried about long-term growth trends and focused their dollars instead on high-flying tech names.

Election years often weigh on defense, as a change of administrations can mean a shift in priorities and create uncertainty about future spending. But the world isn't getting any safer, meaning there is no long-term shortage of demand for the products these companies sell.

For those looking for income via dividends and long-term growth potential, there's still a place for defense stocks in the portfolio. But there are also some potential headwinds that make it a good time to focus on individual winners, and not just invest broadly in the sector.

Here are three key themes defense investors need to consider heading into 2021.

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Defense index vs. the S&P 500 data by YCharts

1. Where will the federal budget go from here?

Investors headed into the 2020 election fearing a "blue wave" that would put one party in control of both the White House and Congress. That didn't materialize, pending a couple of U.S. Senate races, but the concerns about future Pentagon budgets were well-founded.

Truth is, the Pentagon budget tends to be cyclical, and no matter who won the November election, defense contractors after years of solid growth were bracing for a flattening. The trillions in unexpected COVID-19 spending has only added to the country's overall budget pressures, all but ensuring defense spending was in for a slowdown regardless of election results.

But even if the general trend is clear, there is still a lot to be learned in the months to come as President-Elect Joe Biden and his administration present their first budget request to Congress. Among the key things investors should be watching for:

  • Will the new administration continue the trend of refocusing the Pentagon toward Great Power competition, and away from fighting insurgencies, and focus investment on areas where the U.S. needs to keep pace with Russia and China? (I believe it will.)
  • Will the new administration beef up investments in autonomous planes and warships at the expense of legacy platforms? (There is at least some reason to worry the Air Force is having second thoughts about investments in new tech.)

2. Will M&A deals get done?

Speaking of the new administration, defense investors also need to monitor how the Pentagon reacts to industry M&A. The government has applied a light touch to defense consolidation over the last four years, but the incoming Pentagon leadership team is expected to take a more skeptical view toward mergers.

We'll know more soon. Lockheed Martin's (NYSE:LMT) proposed $4.4 billion acquisition of Aerojet Rocketdyne (NYSE:AJRD) is almost sure to cause grumbling from Aerojet customers, including Raytheon Technologies (NYSE:RTX) and Boeing (NYSE:BA), as Aerojet is one of a very small number of companies that supply rocket engines and missile propulsion systems.

Aerial view of the Pentagon.

Image source: Getty Images.

My best guess is Lockheed Martin will get the deal approved, using Northrop Grumman's (NYSE:NOC) acquisition of Aerojet arch-rival Orbital ATK as a template. But it is almost certain strings will be attached.

One thing we know for sure is other potential buyers and sellers will be watching closely. Investors will want to keep an eye on how the process plays out to get a clearer view on the Biden administration's views on consolidation, and how likely we are to see other deals announced in the quarters to come.

3. Who are the growth names in a non-growth environment?

Assuming budgets are flatlining, and there is no rubber stamp on mergers, there are still a handful of companies that should be able to stand out as growth stocks.

Defense hardware companies, names like Lockheed, Northrop, Boeing, and General Dynamics (NYSE:GD), have forecast only modest growth in 2021. But each still has tens of billions in orders in their backlogs to help ride out any potential slowdown in new orders.

Among equipment makers, L3Harris Technologies (NYSE:LHX) looks like a growth leader. The company, formed from the merger of L3 Technologies and Harris, has a heavy emphasis on defense electronics and communications, including a large space program.

L3Harris is also rapidly expanding international sales, which could offset any weakness in the U.S. Overall the company expects to return 100% of free cash flow to shareholders, setting up a potential large dividend hike in early 2021.

There are also opportunities among government services companies, names like Leidos Holdings (NYSE:LDOS), Booz Allen Hamilton (NYSE:BAH), and ManTech International (NASDAQ:MANT) that help manage government IT systems. These companies were neglected during the last budget slowdown, causing delays in IT modernization that arguably helped contribute to the cyber hacks various government departments are dealing with today.

The Pentagon rarely makes the same mistake twice, and if anything, tends to overcorrect from cycle to cycle. With cybersecurity constantly in the news, expect these companies to continue to be funded even at the expense of a couple of added fighters or tanks.

Investor takeaway

There are opportunities for defense investors in 2021, but with all the uncertainty facing the sector, it pays to be choosy. Focus on these three key questions to help identify the opportunities in a year that appears full of risk.

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.