3 Cheap Defense Stocks

LONDON -- Talk business cycles and share prices, and most of us think of miners, agri-businesses, and oil. But engineering shares also have a cyclical dimension -- and right now, three engineers with strong defense businesses have gone on sale.

Why? The backdrop is obvious: budget-induced government cutbacks on both sides of the Atlantic. With a need to throttle back government spending, defense chiefs have been told to find savings.

Top of the list: fancy hardware, produced by just these engineers. So aircraft carriers and their aircraft have been delayed; Nimrod upgrades canceled and aircraft scrapped; munitions and anti-roadside bomb kit purchases deferred; and avionics maintenance and refurbishment programs delayed or canceled.

Slumping P/Es
But recent company results have also affected sentiment, with bad news depressing prices further. One share, in particular, has slumped 15% just today, after releasing a management update that spooked the market.

Put another way, despite the broader market trading close to a 12-month high, these former premium-rated engineers have underperformed and now trade well below the market's overall price-to-earnings ratio of 11.

BAE Systems
BAE Systems needs little introduction. In recent years, thanks to some canny acquisitions, it has expanded far beyond its aerospace roots to become something of a defence‑related one-stop shop, with military aircraft, surface ships and submarines, tanks and other combat vehicles, ordnance, electronic warfare and missile systems all on offer.

The bulk of the company's sales go to the governments and defense ministries of its five "home markets" -- Australia, India, Saudi Arabia, the U.K. and the U.S., with the latter three comprising the bulk of the order book. Is defense spending likely to remain permanently depressed? I doubt it very much, which is why I'm happy to hold.

Chemring
Chemring's shares were already depressed, thanks to cutback-related contract delays, the abrupt departure of the finance director and pressure on profits. The company manufactures munitions and protective systems such as anti-missile "decoy" countermeasures, and has also developed a line in detecting and defeating roadside bombs -- the latter the subject of contract delays by the U.S. Defense Department.

But an interim management statement, released this morning, prompted a 15% fall in the share price, after warning of errors in a new accounting system in an American subsidiary, further contract delays, and a fall in the order book.

Cobham
Cobham manufacturers sophisticated aerospace avionics systems, for both military and civil applications, as well as air-to-air refueling systems. It's a company that for me has always been too expensive, trading on a high P/E and offering a low yield.

No longer: Defense cutbacks began to bring the business in scope last year, and disappointing half-year results released earlier this month prompted a further fall in the share price. As with Chemring and BAE Systems, the name of the game at Cobham is diversification, and in particular diversification away from military work and NATO governments.

Which to buy?
Frankly, I think all three are a "buy," and would happily add Cobham and Chemring to my holding in BAE Systems. In each case, the news flow is negative, and it's not difficult to see why the shares are on sale.

But if I had to pick just one, it would probably be Cobham: Better diversified, with both military and civilian customers, it's a gem that won't be this cheap forever.

Opportunity
It's not just defense-related engineers that are being battered at the moment. Another British business, also with a global footprint, is trading on a beaten-down P/E. So much so that it's caught the eye of Warren Buffett, who only rarely makes forays outside of the United States.

What's more, Buffett now owns more than 5% of this share -- and has been taking advantage of market weakness to top up more. This free special report from The Motley Fool -- "The One UK Share Warren Buffett Loves" -- highlights the compelling investing thesis that Buffett has seen. Why not download a copy? It's free, and can be in your in-box in seconds.

Want to learn more about shares, but not sure where to start? Download our latest guide -- "What Every New Investor Needs To Know" -- it's free. The Motley Fool is helping Britain invest. Better.

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