The defense industry comprises companies that take the bulk of their revenue from the government, be it the Pentagon, civil agencies, or the intelligence community.

Traditionally, when one thinks of defense, one thinks of large companies that manufacture military equipment. That's definitely where most of the revenue and profits lie. But there is also a group of government services firms that manage IT networks, provide consulting and analytics, and take on logistics and other more mundane tasks for the government customer.

Defense shares have been on the offensive in recent years, with the SPADE Defense Index, a collection of defense stocks, doubling from 2014 to 2019 compared to a 50% gain for the S&P 500. After a period of political infighting early in the decade that froze Pentagon budgets and limited spending, the Department of Defense has been making up for lost time by ordering billions of dollars' worth of new fighter planes, warships, and other equipment. Projects put on hold during the budget battles now have the green light, creating new opportunities.

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SPADE Defense vs. S&P 500 data by YCharts.

Valuations are up, making now a poor time to take a blanket approach to investing and buying the entire sector. But there are still opportunities to put new money to work.

How to find the best defense investments

Defense companies have a specialized skill set, having evolved to operate in a largely insular world serving the government but not the private sector. They all tend to benefit as an industry when the U.S. government spends more and suffer together when spending goes down, regardless of which way Wall Street as a whole is moving or the direction of the overall economy.

Military patrol car with sunset in the background.

Image source: Getty Images.

They also enjoy significant barriers to entry, since it's unlikely that a start-up is going to win a $13 billion contract to build the next aircraft carrier. The government is a particular kind of customer with specialized purchasing policies that are unlike those of the private sector. An understanding of the government's procurement policies gives defense companies a competitive advantage against outside, more commercial-focused companies.

Because the stocks tend to broadly trade together, investors need to look carefully at what is contained in each portfolio and match corporate strengths with areas of Pentagon emphasis. There are also sometimes situations when a particular company trades at a lower multiple to earnings than its peers. If an investor can identify the reason for that discount and determine whether it is a structural issue or a short-term problem, they can usually spot opportunities to outperform.

Risks and drawbacks of defense investing

Defense stocks are not for all comers. The companies in this sector make a lot of extremely lethal products. Just as with tobacco or marijuana stocks, there are some investors who are not going to feel comfortable putting money into the sector.

Individual companies can also be subject to high-profile headline risk, whether it is being called before Congress to answer to accusations of overcharging, being the target of a tweet storm by the commander in chief, or getting caught up in an international incident involving a former employee. So far, any stock drops resulting from these issues have been temporary in nature, but a long-term investor should be forewarned that these sorts of incidents are possible. Only buy in if you are willing to ride out the storm.

Top defense stocks to buy right now

Several defense stocks appear well positioned to outperform the sector as a whole in the quarters to come, either because of the strength of their portfolios or by resolving temporary issues. Here's a look at a handful of top companies, including some more predictable businesses for conservative investors and a higher-risk, higher-reward idea for those with a higher tolerance for volatility.


Business Highlights

Lockheed Martin (NYSE:LMT)

Fighter jets, missiles and missile defense, helicopters, hypersonics

General Dynamics (NYSE:GD)

Ships, submarines, ground vehicles, IT, business jets

Leidos Holdings (NYSE:LDOS)

IT network management, electronics and consulting, autonomous vessels

Kratos Defense & Security Solutions (NASDAQ:KTOS)

Drones, defense electronics

Source: Yahoo! Finance data as of June 21, company information.

Lockheed Martin: The biggest and best portfolio

Lockheed Martin isn't just the world's largest pure-play defense contractor. It has also been a competitive dynamo that is leaving rivals in its dust across many lines of business.

Lockheed has won both major fighter design competitions this century, securing contracts to build both the F-22 and more recently the F-35, which is on track to be a trillion-dollar program for the company and its subcontractors over its life span.

It is also dominating recent competitions involving hypersonics, missiles capable of traveling more than five times the speed of sound, taking in more than $1.5 billion in new contracts in 2018 and leading Pentagon officials to conclude "no other contractor has this level of design maturity" that Lockheed offered.

Lockheed owns Sikorsky helicopters, giving it a pole position in a number of competitions planned in the years to come to replace and modernize most of the military helicopter fleet. It is also a leader in missiles and missile defense; it's responsible for manufacturing the THAAD anti-ballistic system deployed along the Pacific rim to counter North Korea and for building the PAC-3 missile used on the popular Patriot missile defense platform.

Two Lockheed Martin-made fighters, the F-22 and the F-35, fly together in formation.

Lockheed Martin-made F-22 Raptor and F-35 Joint Strike Fighter flying together. Image source: Lockheed Martin.

Managing it all is the Aegis Combat System, also made by Lockheed Martin. The company is also involved in space systems and should get a share of the awards as the new Space Force is established.

Add it all up, and Lockheed Martin has a prominent role in most of the areas that the Pentagon has identified as priorities. And that provides investors with some level of predictability into the future: Lockheed has built a backlog of more than $130 billion in future business.

Despite its best-in-class portfolio, Lockheed Martin's valuation is not a standout. Its price as a multiple to earnings has trended in line with those of other contractors for years. Lockheed Martin is also a dividend champion, boasting the top yield among contractors since 2012.

General Dynamics is shedding its anchor

General Dynamics admittedly doesn't have quite the defense portfolio Lockheed Martin can boast, but it's far better than what you would think if you judged by its share price. Over a five-year period ending in June 2019, shares of General Dynamics climbed about 50%, less than one-third the 160% appreciation holders of Lockheed Martin stock enjoyed.

There was a good reason for that underperformance. General Dynamics is the owner of Gulfstream, maker of business jets, and the bizjet market has never recovered from the Great Recession. Gulfstream acted as an anchor weighing down earnings for years as investors waited for a recovery that never materialized.

It appears Gulfstream is finally on the upswing. Changes in tax law in 2018 related to depreciation, coupled with an aging corporate fleet, have business jet sales poised for recovery. The timing works out well, as Gulfstream has new products to sell into the recovery.

Improvements at Gulfstream will take time to hit the bottom line; margins on airplane programs tend to increase over time as volume grows and early development costs are paid for. But Gulfstream, along with General Dynamics, should see margins increase dramatically through the early part of the next decade.

An M1 Abrams tank fires during a wargame practice.

General Dynamics' M1 Abrams tank in action. Image source: General Dynamics.

General Dynamics does have some issues on the defense side, but those too are temporary. Profit margins have been on the decline because of the large number of early-stage projects General Dynamics has on the books. Older contracts tend to be the most profitable; newer programs like the Navy's Columbia-class ballistic submarine, expected to be the most expensive new boat program on record, tend to compress margins because of the research and development and the tooling that go into new work.

Having too many new orders is a good problem to have over the long term, but it has contributed to negative investor sentiment for now.

Given how closely defense contractors are linked and their reliance on the same customer, it is rare to find a good company on sale. General Dynamics is in such a situation, and the valuation gap figures to close as the Gulfstream and defense issues are resolved and profitability improves.

It's hard to time a turnaround -- General Dynamics has stayed down for longer than most, myself included, had expected. But it looks like the company's margin relief is finally on the horizon.

Leidos Holdings: Built to win

Leidos Holdings (the name is said to have been taken from a snippet of the word "kaleidoscope") primarily operates on the services side of the industry, doing consulting, electronics, and IT work for a broad range of defense and civilian agencies. While best known as a Pentagon and intelligence contractor, the company also has extensive business with civil agencies focused on modernizing aging IT systems and a health division working to secure medical data.

The company is the largest pure-play government services firm thanks to a 2016 purchase of Lockheed Martin's IT business. Its core business tends to come down to being the lowest-cost bidder and being able to implement quickly after winning a contract, and scale helps with both.

Services firms were held back during the Washington budget battles of the early 2000s, as the Pentagon and many civilian agencies cut back on IT modernization to save money, but the floodgates have opened in recent years. Leidos has a large influx of new business coming online, including a massive contract to manage and support NASA's computers and networks, that should be fully up and running heading into 2020 and should rocket revenue and earnings higher.

Given the growing importance of cybersecurity, it seems unlikely services firms like Leidos will be put on the back burner again no matter what happens in Washington.

As Leidos and the services markets mature, expect the company to have new ways to win. The trend toward lower taxes and the need to shift an ever-growing percentage of government revenues to entitlement programs are forcing government agencies to do more with less funding, a trend that should encourage additional outsourcing and more opportunities for services companies. Leidos, as the largest of those companies, should be a major beneficiary.

Similarly, a decade full of partial and total government shutdowns is making it harder for Washington agencies to find and retain qualified employees, potentially pushing more work onto third-party vendors over time.

Leidos is unlikely to ever turn into a platform company competing with Lockheed Martin or General Dynamics to build new equipment, but that market is also pivoting in Leidos' direction. As ships and planes become more high tech, the value proposition is increasingly moving away from bending metal and toward providing the electronics to make the weapons systems work. Look for Leidos, with its strong electronics and IT foundation, to try to grab some of that business.

The Sea Hunter autonomous ship turns after coming out of port.

The Sea Hunter, an autonomous ship developed by Leidos. Image source: Leidos Holdings.

We've already seen one example: Leidos is working with the Navy on a large autonomous ship that made history by traveling from San Diego to Hawaii and back without crew, supplying the brains and electronics while outsourcing manufacturing. That's still the exception and not the rule when it comes to Leidos, but it is a trend that should help the company in the years to come.

Kratos: Bleeding-edge tech and valuation

Kratos Defense & Security Solutions is cut from a very different cloth compared to most of the staid, buttoned-up defense contractors. The onetime wireless-infrastructure vendor pivoted to defense over the course of a decade and has spent much of the time since the shift moving in and out of various electronics and services businesses.

Kratos' quarterly earnings announcements at times have been adventures. The company ended up in the crosshairs of a short-seller and to this day remains a higher-risk/higher-reward stock than most companies in the defense sector. But it increasingly appears Kratos has found its niche, and the potential rewards for investors as this business matures are substantial.

The company has been a longtime seller of high-speed, jet-powered drones used to simulate missile launches for target practice. At the same time it was selling those relatively "dumb" drones, it was also working on a line of sophisticated aircraft designed for the Air Force's futuristic "loyal wingman" program, which envisions drones flying into battle alongside piloted aircraft to offer more firepower and to overwhelm enemy radar systems, helping to keep crewed aircraft safe.

Kratos is far from the only Pentagon contractor building wingman drones, but it increasingly appears the company is winning the race. While competing systems aren't scheduled for first flight until 2020, Kratos' XQ-58A Valkyrie is flying and undergoing tests with the Air Force Research Laboratory. Pentagon officials are making plans to order 20 or 30 more Valkyries to ramp up testing, edging toward a full-fledged order as early as 2021.

The tests are going well enough that the Air Force seems to be developing potential new uses for the Valkyrie, including adding new sensors and weapons and developing artificial intelligence that will one day allow the drones to learn and adapt in combat situations.

The Valkyrie drone flies over a desert landscape.

Kratos' XQ-58A Valkyrie performs during a test flight. Image source: Air Force Photo by 2nd Lt. Randolph Abaya, 586 Flight Test Squadron.

Investors should be warned that part of the appeal of these drones is that they come cheap, with Kratos expected to sell them for less than $3 million apiece in a production run of at least 100 planes. That's compared to the $80 million-plus cost for a single Lockheed Martin F-35. And while there are a broad number of potential uses for drones, there are also technical and ethical hurdles that will take decades to resolve before drones could ever replace crewed fighters in the sky.

For Kratos, getting a full production order for the Valkyrie would be a huge accomplishment. It could also be just the tip of the iceberg for the company. The plane is the first of up to 10 tactical drone programs Kratos has in the works to address various uses and missions, some classified.

Kratos has great potential, but be warned that this potential is already priced into the stock. As the headlines have improved for the company, investors have taken notice, sending shares of Kratos up more than 400% in the three years ending June 30, 2019.

The stars would have to align perfectly for Kratos shares to have another three years like the period between 2016 and 2019, but this is still a young, developmental-stage company with a large addressable market, a market-leading product, and substantial R&D to help it sustain and build its advantage.

Kratos is not as well suited for income-focused investors as most defense stocks and is best suited for a portfolio with a tolerance for volatility and a willingness to take risks. But the company is much less of a speculative stock than it was as recently as March 2018, when the short report first hit, and it still has an enticing amount of runway ahead of it.

Are defense stocks right for your portfolio?

Defense stocks, thanks to the extended nature of government procurement and the Pentagon's requirement to post its procurement road map five years out, can provide a certain level of predictability for investors. Alas, having buying orders laid out years in advance also can limit the surprise and stock jump that typically come from a major new order.

For this reason, defense stocks are typically most enticing to investors focused on predictable income streams instead of those hoping to double their investment in a short amount of time.

Defense is also somewhat insulated from the business cycle, since these companies are reliant on the public sector and not corporate spending for revenue and growth. But investors need to be aware there are years in which the entire industry greatly underperforms the market indexes, largely due to lawmaker priorities shifting away from defense or political infighting hampering government spending.

Defense stocks aren't for everyone. If you want to make them part of your portfolio, it is best to pick either standout performers that have the products and order books to fuel continued growth or relative underperformers with the potential to close the gap in a relatively short amount of time.