3 Top Defense Sector Stocks

Welcome back to Defense Investing 101, Fools.

Over the past few weeks we've been discussing a variety of ways to invest in the defense sector. We've looked at which American defense contractors have the best products for solving the problem of Somali piracy. We've discussed Defense Secretary Gates' latest Pentagon budget proposal. We've laid odds on who should win (and lose) based on how they help fight the ground wars in Iraq and Afghanistan, the naval war in the Gulf of Aden, and the cyberwar here at home. And we've discussed which companies stand best positioned to profit from these trends in years to come.

There's just one question we have not addressed (and for good reason). That question is...

Valuation
A wise Fool once told us that valuation matters in investing -- and it does. The problem with valuation, though, is that it changes from day to day.

I'm not just talking about stock prices. The last few months have given us all a refresher course in just how truly manic-depressive Mr. Market can be. But what I'm talking about is the numbers that companies produce themselves -- their performance.

Every three months, stocks undergo the ritual of earnings season, updating us on their latest tallies of profit and loss. Only with these numbers in hand can we compare the stock prices and decide whether we're being asked to pay a fair price for the company. But with all the major defense contractors having finished reporting their first-quarter results, we've finally got some hard numbers to work with. Now we can figure out which of these companies are not just poised to profit from the business they're in -- but priced to provide you some profit as well.

Let the hunt for value begin.

*Backlogs as reported by Standard & Poor's division CapitalIQ as of Q1 2009, or, when data is missing, as reported in the firms' own 8-k earnings filings (except in the case of United Tech which did not contain such data); in UT's case, backlog data is current as of Q4 2008.

Backlog
Before running down the results, a couple comments on the subject of backlog are in order. Every company reports its backlog differently. L-3, for example, reports only the highest quality, funded backlog. Boeing gives a detailed backlog breakdown of funded and unfunded backlog -- but it also recently provided us a case study in how quickly backlog can evaporate when a single big customer gets a case of the willies.

Still, the data we see above does seem allay fears that President Obama will be the ruin of defense investors. To the contrary, what we see here is an industry in the peak of health. L-3's anomalous number aside, the worst company above looks to be United Tech, yet even UTC has more than a year's worth of work on its books. Most of these companies have at least two years' worth of work laid out for them, and Boeing in particular (see caveat above) has enough work to keep it busy for the next five-and-a-half years.

Nice.

Somebody's got to lose...
Regardless, I put Boeing at the bottom of the list for three reasons. First, it's burning cash. Second, its P/E looks too high relative to growth. Third and perhaps most importantly... that same backlog which gives us such a clear view of Boeing's future is also visible to analysts. And this increases the chance that they're right when they tell us that Boeing has the worst (i.e. slowest) growth prospects of any company in this industry.

United Tech, Northrop, and L-3 join Boeing at the bottom of the list because for various reasons, ranging from mild overvaluation (United Tech) to weak GAAP numbers (Northrop) to apparent weakness in backlog (L-3). Additionally, United Tech and LLL carry debt loads that are relatively higher than the rest of the group, although the industry as a whole looks well capitalized.

... while three somebodies win
Raytheon, Lockheed, and General Dynamics carry strong balance sheets, while their valuations appear attractive relative to their growth prospects. Looking out over the coming decades, I expect we'll see Raytheon continue to enjoy strong growth in its core business -- and don't be surprised if its purchase of the rights to the KillerBee UAV pays off in spades. Lockheed obviously has the F-35 fighter jet under its wing. And General Dynamics -- well, you can't go wrong owning the undisputed king of armored warfare at these prices.

Foolish takeaway
Mind you, I have great admiration even for the "losers" in today's column. I respect United Tech's management in particular. L-3 tempts me with its price and its five-star CAPS rating, Northrop with its growing dominance in unmanned aerial vehicles, and Boeing -- heck, I actually own Boeing, having picked up a few shares back when its prospects looked better.

But if you want to know which three firms look best today, then here they are: Raytheon, Lockheed, and General D. Give 'em a hand, folks, and consider giving them a place in your portfolio.

Victory through superior defense sector investing:

• M-ATV Bids: The Pentagon Picks Its Winners
• Boeing Steals Lockheed's Thunder (Er, Lightning)
• Pentagon Unveils Crystal Ball
• "Hey! Who's Flying This Thing?" 2009 Edition

And if you want the very best in Foolish defense investing ideas, check out Motley Fool Rule Breakers, where we're looking into options for everything from flying model airplanes, to bomb-proof trucks, to bulletproof soldiers. We never intended to become the "defense contractor" newsletter -- that' s just where the opportunities seem to be. 30-day trials are free.