Garden of World Peace. Photo credit: Immanuel Giel via Wikimedia Commons

Peace or conflict? While this may seem like a random question, when you invest in a defense company like Lockheed Martin (NYSE:LMT) or Northrop Grumman (NYSE:NOC), you're betting that the world isn't headed for peace. Here's why this is important for investors.

The "pure" defense Play
In contrast to defense companies like Boeing, which receives a majority of its revenue from commercial airplanes sales, "pure" defense companies are companies that receive almost all of their revenue from selling defense systems -- this includes everything from warships like the Gerald R. Ford-Class Nuclear Aircraft Carrier and fighters like the F-35, to cyber security software.

The aircraft carrier Pre-Commissioning Unit (PCU) Gerald R. Ford (CVN 78) is moved to Pier 3 at Newport News Shipbuilding. Photo credit: U.S. Navy photo via Huntington Ingalls Industries by Chris Oxley.

In fact, in its 2014 annual report Lockheed states, "In 2014, 79% of our $45.6 billion in net sales were from the U.S. Government, ... 20% were from international customers (including foreign military sales (FMS) contracted through the U.S. Government) and 1% were from U.S. commercial and other customers."  

Likewise, according to Northrop's 2014 annual report, for the year ending December 31st 2014, 84% of total sales came from the U.S. Government, and 13% came from international sales (which includes foreign military sales). Simply put, pure defense companies like Lockheed and Northrop make money when governments see a need for, or maintenance of, defense systems. Conversely, without this real or perceived need, these companies would see their profits decline, as they don't have a large commercial business segment to fall back on.

Examining your defense investment
When you invest in a company, you're buying into that company's future and betting there's a market for whatever product that company makes. This is especially important to keep in mind when investing in defense companies like the above.

F-35 Lightning II. Photo credit: Lockheed Martin via Northrop Grumman.

Right now, defense spending is declining thanks to deficit reduction pressure and the Budget Control Act of 2011, or BCA, and this will likely have a more pronounced impact on both Lockheed and Northrop going forward. In fact, Lockheed states, "We expect 2015 net sales will decline in the low single digit range from 2014 levels as we continue to see downward pressure from the effects of U.S. Government budget reductions, primarily in our services businesses." And Northrop states, "Our primary customer is the U.S. Government, from which we derived approximately 85 percent of our total sales during each of the past several years. The U.S. Government is implementing significant reductions in government spending and other significant program changes." 

In other words, it's probable that in the not-too-distant future, defense profits for both of these companies will suffer, and that could negatively impact their stock price. This is where your defense outlook comes into play. If you believe the world is headed for peace, and the need for defense systems is on the decline, now might be a good time to start looking at cashing in on your defense stocks. On the other hand, if you believe the world is just getting crazier by the second, the current reduction in defense spending shouldn't overly concern you.

What to watch
The ugly truth about investing in pure defense companies is that these companies can only make a profit if the world continues to face conflicts. More pointedly, the more conflicts the world faces, the more defense companies prosper. Right now, U.S. defense spending is on the decline thanks to the BCA, and, barring a catalyst for emergency funding, it's likely that defense companies will see an increase in loss of revenue the longer the BCA is in effect. Plus, there are other concerns beyond financial that could impact defense companies. However, if you think the world is far from peaceful, selling your defense stocks based solely on the current budget restrictions and probable future decline in revenue is not the best bet.