Defense Stocks Have Been Red-Hot. Is It Too Late to Buy In?

Last year was a tough one for defense stocks, but the sector has rallied so far in 2021. 

On this clip from Motley Fool Live, recorded on June 10, Fool.com contributor Lou Whiteman and Industry Focus host Nick Sciple discuss what is driving that turnaround, what the future might hold for the defense industry, and what type of investor might find the stocks attractive even after the recent surge.

Nick Sciple: Well, one business where the government is the sole customer has been doing quite well this year, that's defense stocks. If you look, the defense sector are doing quite well this year. The headline I saw this week that Huntington Ingalls Industries (HII -0.75%), which is one of the largest ship builders in US, also the employer of my stepdad, so has a little spot in my heart. Hiring 3,000 workers for their ship yards. One of the things we've talked about in the past, as maybe potential flies in the ointment of the defense story is that there have been a significant investment made or allocation made toward enlarging the navy under the previous administration now with President Biden moving in, some worries that maybe that gets pulled back. Well, when you have one of the nation's largest shipbuilders saying, "Hey, we're hiring 3,000 more workers." that's really showing confidence in a continued robust defense budget. What do you make of the environment for defense stocks and what we can maybe read through from this action by Huntington Ingalls?

Lou Whiteman: Sure. So for context, this is definitely good news, it's 3,000 jobs and it's on of the Gulf Coast. It's in the Ingalls' side of it which, Nick, you understand from being from down there, but is the ugly step child of Huntington Ingalls because it's not the nukes that they have in Virginia Beach. This is good news, but I mean, look, Ingalls right now has 11,000 employees. A couple of years ago, almost 13,000. This is sort of an ebb and flow. What we have seen is that some of these last-generation ships that were already baked in before the previous administration talked about growth, those contracts are maturing and to the point where we are getting steady workflow, so I think that explains Ingalls. That's where they make the destroyer, that's where they make the Coast Guard cutter. I think it's more of a sign of steady work.

But your point is a good one. Too much is made of an administration's year to year budget when people consider this sector. What we're seeing with this bounce back off of a terrible 2020, where most of the stocks were down 10-30 percent based largely on the fear of new administration. Now, we've seen the budget, we're saying, "Hey, ok, they can live with this." so we're seeing the bounce back. The budget is out now, we can actually look at it. It is flat to down. Investment spending, which is the contractor portion of the bigger pie, is down but only down by about one percent. It's $248 billion, with a B. That's about $2 billion better than we expected. R&D, which tends to be higher margin than a new ship, is up. What we found in the last few months as the budget started to take shape is the worst fears weren't going to be realized, and the stocks recovered. I think it makes sense, I think people who were listening to the two of us last year might have seen this coming. But I think the sell-off was overdone and so now this is more of a bounce back back than a Biden defense rally or something like that.

Sciple: Not to get too political here, but I think when you think about some of their priorities of the Biden administration and that we want to stimulate the economy, we want to create jobs, it's always challenging to get these stimulus spending the bills passed. Well, one thing that can be supported on both sides of the aisle at least on spending more, is defense. It's one place where you can get both sides to agree. "Hey, we can spend some money on defense." If you look at some of the priorities of the administration. You could tell a story about how there's probably some support for defense spending. When you look at the sector today, Lou, obviously, a lot of these companies up significantly so far this year, they still seem attractive or do you think the valuation is normalized? What are your thoughts?

Whiteman: I thought some of them looked attractive before the sell-off, and so now that it's back, I got my feeling on relative attractiveness really hasn't changed. I thought there were some screaming buys last year during the sell-off. It's funny to look at because Lockheed Martin (LMT -0.05%) is kinda the laggard this year, they are only up 10%, were they best performer last year when they are only down 8% when some were down 20% to 30%. I do think for long-term holders, especially those interested in income because you get dividend yields of 2-3 percent, I don't see anything in the winds that make me think this sector is going to hit the skids. Remember, on the politics and all of this, most of what they are building today was allocated years ago. The weird, cool thing about investing in this sector is that with this one customer, this customer that is so transparent in their outlook and plans for what they want to spend over the next five years, each year. You have that. You have backlogs in the 10s to 100s of billions for these big companies. Even if defense spending falls off the cliff, that's a 2030 problem at this point. There is a sleep at night, it's not going to give you cloud-stock appreciation sometimes but dividend focus, sleep at night, steady growth. Nothing has changed in the last year as they've gone down and up that changes my opinion on that.

Sciple: Yeah, and this is the type of sector that frankly you don't want hyper-growth because that means some bad things are happening in the way. You want it to be just steady, the walk softly and carry a big stick type spending. [laughs]

Whiteman: Very good point. Yes. [laughs]