Are Defense Stocks Really This Cheap?

Warren Buffett famously declared, "A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful." With that in mind, I think that reviewing the prospects of one of the most feared sectors in the market, defense, could potentially reveal worthwhile investment ideas.

The numbers don't lie
Based on the broad numbers, defense stocks certainly look much cheaper than the overall market. To get a sense of aggregate measures for the sector, I used the PowerShares Aerospace & Defense (NYSE: PPA), which currently trades at a price-to-earnings ratio of 13.5. The S&P 500 trades at a higher 17.5 P/E, making defense stocks approximately 23% cheaper than the overall market. With all the talk of looming federal spending cuts, this kind of discount makes sense on the surface.

The facts don't lie, either
Examining defense-related reports and budget proposals can help to clarify the nature and direction of future spending. Fortunately, several great sources can help us do so. 

For fiscal 2011, the Department of Defense, or DoD, requested a budget totaling $708 billion, which subdivides between a baseline budget figure and additional procurements for what it calls "Overseas Contingency Operations" -- namely, Afghanistan and Iraq. This year, the DoD sought funding of $549 billion for its base budget figure, and $159 billion for conflicts abroad. The Base Budget figure should prove relatively inelastic, since it represents the cost of maintaining our national security. The DoD currently projects this Base Budget figure to grow at a nominal rate of 3% and a real rate of 1% through FY 2015. The government's expectation that spending on its Base Budget will grow seems significant indeed.

However, as the U.S. continues to decrease its involvement in both Iraq and Afghanistan, the Overseas Contingency Operations (OCO) figure should begin to shrink. President Obama set a target to transition the American war effort in Afghanistan away from active engagement, and to transfer security responsibilities to Afghan security forces, beginning in 2014. It will clearly require several more years of active deployment to achieve this ambitious goal. However, the DoD projects the OCO figure to fall to $50 billion next year, and remain at that level through 2015.

With news of the strong insurgent presence still coming from out of Afghanistan, does that type of reduction seem reasonable? I don't think so, and apparently, neither does Defense Secretary Robert Gates. The New York Times reported that Gates admitted, "The United States will nonetheless be in Afghanistan for many more years to come."

The entire Department of Defense also seems to echo this viewpoint. Congress requires that the DoD release a Quadrennial Defense Review (QDR) every four years, as a "review of Department of Defense strategy and priorities." It serves as a great resource to gain insight into the DoD's viewpoints regarding the future national security landscape. The 2010 Quadrennial Defense Review echoed Mr. Gates, saying, "In the mid- to long term, we expect there to be enduring operational requirements in Afghanistan and elsewhere to defeat Al Qaeda and its allies." It certainly appears that those most intimately familiar with our foreign conflicts see no end to our involvement in them any time soon. In fact, expert opinion and government documents suggest that military spending will remain higher than expected looking forward -- quite the opposite from the doom and gloom so many now predict.

Your Foolish takeaway
Now that we've determined why the industry seems so cheap, let's see which stocks might stand the best chance of outperforming the market. On the surface, these stocks seem especially cheap, considering what we've uncovered above:

Source: Capital IQ, a division of Standard & Poor's.
LTM = last 12 months; TEV = total enterprise value.

Digging past these two metrics should provide savvy investors with potentially underpriced stocks positioned to thrive in the coming years. Each week for the next six weeks, I'll analyze one of the above companies to see whether it seems especially poised to succeed in the years to come.

You could also follow the advice of our Rising Stars contributor Anand Chokkavelu, who opted to simply purchase a basket of these stocks to gain exposure to the aggregate sector. Either way, it seems apparent that the market expects a more pessimistic outcome for the defense industry than the facts can support. This kind of top-down analysis can help focus your research efforts toward potential areas of opportunity.

Want to keep up with my analysis of the six stocks above, and get the latest commentary? Feel free to add them to your Fool watchlist by clicking here.