By now you've heard the news: Last weekend, U.S. Special Forces units raided the Venezuelan capital of Caracas and arrested President Nicolas Maduro and his wife, taking both away for trial on narcotics and terrorism charges in New York. Oil stocks surged on the news Monday -- and so did defense stocks, with shares of Textron (TXT 1.97%) gaining 2.2%, Lockheed Martin (LMT +0.52%) 2.9%, and General Dynamics closing the day up 3.5%.
Venezuela is just the latest news drawing investor attention to the defense industry.
Image source: Getty Images.
War continues to rage in Ukraine, China is threatening Taiwan, and the Middle East remains a hotbed of conflict from Iran to Syria to the Red Sea. In a geopolitical environment like this one, defense stocks are red hot as investors try to follow the money and buy what they figure world governments will be buying.
But here's the thing -- that might not be a great idea.
For more than a year, I've warned investors that defense stocks cost too much. No matter how hot the market is for military products, there's such a thing as paying too high a price.
NYSE: LMT
Key Data Points
What history says about defense stocks
Over the 10-year period from 2004 to 2013, the 10-year period from 2014 to 2023, and the 20-year period from 2004 to 2023, I've calculated the average enterprise value-to-sales ratios (EV/S) for each of 10 major U.S. defense companies, utilizing data from S&P Global Market Intelligence. (As a reminder, EV/S ratios are similar to price-to-sales ratios, except that EV/S adjusts market capitalizations to factor in net cash on the balance sheet and net debt.)
As you'll see below, this data shows that defense companies at the start of the century cost about 1x their annual sales, but prices have climbed steadily over the past decade. Averaging the numbers, defense stocks have, over the past 20 years, cost about 140% of annual sales -- and this is the number I'm tentatively assuming to be the new "fair value" for defense stocks.
| Average | 1.06 | 1.89 | 1.40 |
| Company | Average EV/S from 2004-2013 | Average EV/S from 2014-2023 | Average EV/S from 2003-2023 |
|---|---|---|---|
| Boeing | 0.89 | 1.83 | 1.36 |
| General Dynamics | 1.04 | 1.68 | 1.36 |
| Huntington Ingalls | 0.51* | 1.14 | 0.64* |
| Kratos Defense & Security Solutions | 0.97 | 2.21 | 1.59 |
| Leidos Holdings | 1.5** | 2.21 | 1.34** |
| L3Harris Technologies | 1.44 | 2.84 | 2.14 |
| Lockheed Martin | 0.81 | 1.78 | 1.30 |
| Northrop Grumman | 0.74 | 1.94 | 1.34 |
| RTX Corp | 1.42 | 2.07 | 1.74 |
| Textron | 1.31 | 1.17 | 1.24 |
Data source: S&P Global Market Intelligence. * Huntington Ingalls data begins in 2011, the year when Northrop Grumman spun off Huntington Ingalls as a separate company. ** Leidos data begins in 2006, the year of its initial public offering (IPO). Data on its average enterprise value-to-sales ratio for 2014 is missing because the company changed its fiscal year in 2015.
How do these 20-year-average numbers compare to what stocks cost today? Let's take a look:
|
Average |
2.95 |
2.68 |
| Company |
EV/S today |
Price-to-sales ratio today |
|---|---|---|
|
Boeing |
2.58 |
2.12 |
|
General Dynamics |
1.94 |
1.82 |
|
Huntington Ingalls |
1.36 |
1.14 |
|
Kratos Defense & Security Solutions |
10.08 |
9.98 |
|
Leidos Holdings |
1.60 |
1.39 |
|
L3Harris Technologies |
3.14 |
2.65 |
|
Lockheed Martin |
1.82 |
1.59 |
|
Northrop Grumman |
2.41 |
2.07 |
|
RTX Corp |
3.32 |
2.95 |
|
Textron |
1.23 |
1.12 |
Data source: Yahoo! Finance.
What this means for defense stock investors
What has changed since we last checked in on the defense valuations a few months ago? With the exception of Boeing (which got a little cheaper) and Leidos and Northrop (which held pretty steady), all of these stocks have become even more expensive -- as have defense stocks, as a group.
If you own defense stocks, this sounds like good news. The "trade" is working! And yet, at prices like these -- P/S ratios are nearly triple what they were at the start of the 21st century -- investors should ask themselves just how much risk they can tolerate?
If the fighting in Ukraine ends, will sales prospects for defense stocks still look attractive? Might President Donald Trump's actions in Venezuela cause countries like Iran and China to rethink their aggressive foreign policies, lowering tensions in the Middle East and South China Sea? If that happens, neighboring countries' perceived need to beef up their defenses might also cool down -- and weapons sales with them.
Conversely, even if geopolitical conditions don't improve, I don't see much room for multiples to expand in the defense sector from their current, historical highs. If I'm right about that, defense stocks could significantly underperform the S&P 500 in 2026.
