Investing in Defense Stocks

Defense companies get the bulk of their revenue from one customer: the U.S. government. Fortunately, that customer has deep pockets and a 246-year history of paying its bills. The federal government’s stability gives defense companies and investors some predictability when it comes to managing cash and projecting growth.

Companies in the defense sector offer a wide range of products and services to their main customer, and some are better investments than others. Here's what you need to know about investing in the defense sector and how to pick where to put your money.

Top defense stocks

Let's look closer at these standout companies:

• Lockheed Martin is the world's largest defense pure play. It’s the lead contractor on the F-35 Joint Strike Fighter, the world’s most expensive airplane. Lockheed’s legendary "Skunk Works" research facility in California is world-renowned, and the company has leveraged its research muscle to become a leader in advanced fighter planes, high-tech missiles, and cutting-edge electronics.
• Boeing is best known for its commercial airplanes, but its defense business is large enough to rank among the industry’s titans. Boeing makes several different aircraft and helicopters for the Pentagon and is also involved in space pursuits. The company's defense business has also branched out into autonomous submarines and other products.
• Northrop Grumman is responsible for stealth bombers and has a large space portfolio. The company is closely tied to the nuclear triad, which is a combination of nuclear missiles, bombers, and submarines that are able to strike back if the nation is attacked.
• General Dynamics is one of two primary military shipbuilders and has a portfolio of tanks and land vehicles that make it one of the go-to vendors for the U.S. Army. General Dynamics also has one of the largest defense-focused IT and services businesses, giving it some revenue stability at times when the Pentagon is cutting back on equipment purchases.
• Raytheon Technologies doesn't make warships or fighters, but it has a role in a wide range of important military platforms led by other contractors. It is the product of the 2020 merger between Raytheon, a defense electronics and missile specialist, and United Technologies, which makes aircraft engines and a variety of other aerospace parts.
• Leidos Holdings is the largest government information technology (IT) company. It has also actively expanded into hardware, providing the electronics and brains for autonomous ships and building a strong portfolio of classified research capabilities geared for the intelligence and space community.

If you are bullish on defense but would rather not choose among individual companies, you can buy shares in one or more exchange-traded funds (ETFs) that cover the sector. Three primary ETFs are focused on defense:

• Invesco Aerospace & Defense (NYSE:PPA)
• SPDR S&P Aerospace & Defense (NYSE:XAR)
• iShares U.S. Aerospace & Defense (BATS:ITA)

Defense goes electric

For most of its history, the defense industry’s primary expertise was in metal-bending. These were the few companies on Earth capable of building massive battleships, bombers, and tanks.

But in defense, like the rest of the world, the value is increasingly going not to the companies that forge the steel but instead to the ones that provide the brains that go inside it. Defense electronics and electronic warfare is a growing piece of almost every company’s portfolio. It’s where a lot of the internal investment is going right now.

Defense IT also remains a priority, with vendors scrambling to provide secure networks and data-rich communications systems to the Pentagon.

New administration, new priorities

Defense stocks performed weakly in 2020 as investors grew increasingly convinced that the White House would change hands. But, so far, those concerns appear to be overblown. The Biden administration’s first Pentagon budget is unchanged from the prior year, and, with a renewed focus on modernization and research, funding for defense contractors could trend higher in coming years.

Investors often associate defense with current events. But, given the long lead times for programs and the strong consensus behind investment in the military, you can ignore the political noise and focus on finding the best-run defense businesses.

Will conflict move defense stocks?

While there could be some incremental added sales of munitions and spare parts should the U.S. and its allies get drawn into a new Middle East or Afghanistan conflict, investors should avoid buying in based on that thesis.

Large defense contractors generate much better margins on research and development into advanced new weapons systems than they do from selling one-off missiles or ammunition. If the U.S. government were to deemphasize research to fund active operations, conflict in the Middle East and Afghanistan could actually be a negative to defense stocks. However, given the importance of research, that seems unlikely to happen.

How to find the best defense stocks

The defense sector tends to be a stable group of companies with a few failures but also a few standouts. Here are some tips to consider when evaluating individual defense companies.

Listen to the customer

The Pentagon has an insatiable appetite for new equipment, but, with aircraft carriers costing more than $10 billion apiece and F-35 fighters priced at $80 million or more per plane, there are limits to how much the government can buy. To figure out the likely winners and losers, pay attention to the budgeting process.

Early in the year, the Pentagon sends a funding request to Congress, which then, over the course of the spring and into the summer, holds hearings to discuss priorities and make final allocation choices.

An investor need not hang on every word, but the budget request, which is available on the Pentagon’s website, and commentary elsewhere can provide clues about which billion-dollar programs are an administration priority.

Follow the numbers

Companies will often highlight massive contract awards in press releases without explaining that those big award numbers are often spread out over many years and may be dependent on Congress approving the funds.

Pay attention to these metrics when evaluating defense stocks:

• Free cash flow: This is important for any business, but free cash flow can vary for defense contractors based on whether their projects are new or well-established. Companies often spend more in the early stages of a production contract, temporarily depressing cash flow.
• Corporate backlogs: Investors should pay close attention to corporate backlogs, which are future contracts that have been awarded but not yet executed. How much of that backlog has been funded and how much of it must go through the congressional budgeting process can both vary greatly.
• Book-to-bill ratio: This metric compares the value of orders received in a given quarter with the amount billed and indicates a company's growth potential. A growing company should have a book-to-bill ratio of at least 1.0, implying that orders for future products are being booked at a rate that equals or exceeds what is being shipped today.

Defense companies know that investors are focused on these metrics and typically make the relevant information available on quarterly earnings reports or conference calls.

Should you invest in defense stocks?

Defense companies manufacture lethal products and can be involved in supporting clandestine operations or intelligence gathering that some find unsettling. If you don’t want to support those activities, then investing in defense stocks is not a great choice for you.

Defense stocks, like many industrials, tend to be more plodding than high-flying technology or biotech stocks. Defense stocks are best suited for income-oriented investors seeking steady growth and rising dividends rather than immense valuation increases.