Don't know the difference between a JLTV and a JDAM? Can't tell the difference between a Wasp assault ship and an argyle-sweater-wearing a cappella quartet? Well, fear not, novice defense investors. The Fool has your back on all things that go BOOM! The future may look rocky for investors in the defense field, but there's hope for your portfolio if you know the right places to look.

After a difficult period during the 1990s in which the military saw its budget remain mostly flat, military contractors have seen their fortunes turn during the past decade. In a paradox that defense investors are familiar with, a more dangerous world provides more avenues for their investment dollar to grow. Responses to terrorism and wars in Afghanistan and Iraq helped lead to an 8.45% growth rate in national defense spending between 1998 and estimates for 2009 spending:

Year

Defense Outlay (Billions)

Percent of Federal Government Outlays

1998

$268.2

16.2%

2001

$304.8

16.4%

2004

$455.8

19.9%

2007

$552.6

20.2%

2009 (Estimate)

$654.7

21.7%

Source: Budget of the United States Government, Fiscal Year 2009. Estimate for 2009 based on revised 2010 budget figures.

Even if you discount the cost of wars, Bloomberg tabulates that defense spending has increased by 43% after adjusting for inflation since 2000. Not surprisingly, military contractors saw their stock prices follow the government's spending lead. Even after sharp pullbacks in the past year, most large contractors have seen their stock prices significantly outperform the broader market:

Company Name

10-Year Average Annual Return

S&P 500 (For Comparison)

(1.3%)

General Dynamics (NYSE:GD)

6.9%

Northrop Grumman (NYSE:NOC)

4.5%

Lockheed Martin (NYSE:LMT)

9.7%

Boeing (NYSE:BA)

1.2%

Source: Yahoo! Finance. Reflective of July 31 closing price. Stock prices are adjusted for dividends. S&P return based on SPDR ETF.

It was a grand old time ... while it lasted
However, few industries are as reliant on government support and geopolitical events as the defense industry is. So as the U.S. makes plans to exit Iraq and a new administration gets to work in Washington, there's considerable uncertainty in the industry.

  • For one, budgets will most likely shrink. The 2013 estimated defense budget currently stands at $561 billion, with a planned $50 billion for "overseas contingency operations." While that's still a considerable outlay (for context, that's about eight times as large as current No. 2 national-defense spender China), it's still about 7% less than 2009 levels.
  • Industry participants also enjoyed what analyst Richard Aboulafia of the Teal Group termed "the most prosperous era for aviation markets in post WW II history" between 2003 and 2008. He further noted that "it was the first simultaneous civil and military market upturn in over 25 years." This isn't a phenomenon that just helped Boeing, either. Aboulafia estimates that the business-jet sector grew at an astounding 18.8% compounded annual growth rate for the period. That was enough to light a fire under the returns of General Dynamics and Textron (NYSE:TXT), both of which complement their military business with large business-jet segments. The trend looks to reverse itself as business jets, commercial jets, and defense programs all face struggles in the years ahead.
  • And perhaps most importantly, just where those shrinking military dollars will be spent is becoming more uncertain. Defense Secretary Robert Gates has written that he wants to create a more "balanced" strategy that modernizes the military to deal with the unconventional conflicts of tomorrow.

Unconventional? How?
We've spilled much digital ink here at the Fool, telling you that creating a more "balanced strategy" involves maintaining a technological edge while making the U.S. better prepared to handle the threats that turned Iraq and Afghanistan into uphill struggles. Goodbye to costly short-range fighter jets and hello to unmanned aerial vehicles that are cheaper to purchase and operate. Say bon voyage to Army projects that coordinate soldiers across the battlefield with linked sensors that cost hundreds of billions and hello to cheaper, more practical solutions, such as more mobile vehicles that better protect troops against mines and improvised weapons.

The new realities of warfare have reduced the barriers of scale needed to play in defense contracting. Small-fry companies such as AeroVironment (NASDAQ:AVAV), Elbit Systems (NASDAQ:ESLT), and privately held General Atomics found a niche selling unmanned aerial vehicles that are more practical for fighting the kind of conflicts Gates envisions. Their success is a stark example of how megaprojects are being curtailed, as the defense industry shifts to smaller, more entrepreneurial start-ups that win through technological prowess rather than scale.

How to juice those returns
So Gates is taking a hatchet to the Pentagon's sacred cows, but change is long overdue. The need for building a bigger gun (or nuclear arsenal) to win conflicts is becoming outdated; building an army that's more nimble, adaptable, and precise is in.

Big defense contractors aren't going away anytime soon. There are still plenty of high-tech fighter jets, tanks, and submarines that only a select oligopoly of large companies can produce. However, stagnant domestic defense budgets should be a warning sign to defense investors that the next 10 years will be much more difficult than the preceding 10.

If you want to outperform in the sector, consider adding some of the smaller companies that specialize in small but growing fields, such as unmanned vehicles, as well as companies that specialize in other emerging trends, such as cybersecurity. They lack the pension obligations that larger companies are often saddled with, and they offer services specifically focused on areas that can promise explosive growth while defense budgets inch forward (or even recede) at a snail's pace.

Some dynamic companies are invading this stodgy old field. Your portfolio will thank you if you take notice.

If you want to see more information on defense investing in your portfolio, check out Rich Smith's ongoing series " 6 Stock That Never Surrender ." Rich has juiced his portfolio with smaller specialized companies that he thinks can outperform the market. Also make sure to drop a comment on what defense stocks have caught your eye.

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Eric Bleeker owns no shares of any companies mentioned above. AeroVironment is a Motley Fool Rule Breakers recommendation. General Dynamics is a Motley Fool Inside Value selection. Try any of our Foolish newsletter services free for 30 days. Tonight, the Fool's disclosure policy dines on turtle soup.