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 245-year history of paying its bills. The government’s stability gives defense companies and investors some predictability when it comes to managing cash and projecting growth.

The companies 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

There are about two dozen U.S.-based public defense and government services contractors, but we're going to break down these standouts.

• Lockheed Martin (NYSE:LMT) is the world's largest defense pure play, with a focus on aviation, missiles, and missile defense. 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 (NYSE:BA) is best known for its commercial airplanes, but its defense business, though generating less than half of total revenue, is large enough to rank it among the defense 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 (NYSE:NOC) is responsible for stealth bombers and has a large space portfolio. The company is closely tied to the nuclear triad, the cornerstone of U.S. defense policy since the end of World War II involving a combination of nuclear missiles, bombers, and submarines able to strike back if the nation is attacked.
• General Dynamics (NYSE:GD) is one of two primary military shipbuilders and has a portfolio of tanks and land vehicles that makes it one of the go-to vendors for the 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 (NYSE:RTX) 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 (NYSE:LDOS) is the largest of the government services companies. 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 between individual companies, there are also lower-risk investments like exchange-traded funds (ETFs) that cover the sector. ETFs are collections of stocks or other securities focused around a particular industry or theme. They tend to be less risky than individual stocks because your investment is not tied to one particular company or management team.

There are three primary ETFs focused on defense, Invesco Aerospace & Defense (NYSE:PPA), SPDR S&P Aerospace & Defense (NYSE:XAR) and iShares U.S. Aerospace & Defense (BATS:ITA).

Investing in defense companies

Many associate defense companies with tanks and guns, but the sector is usually defined more broadly to include companies that cater primarily to the Pentagon or other government agencies. The list includes weapons makers, but also services companies that run IT networks, manage inventories, and perform other tasks for government agencies.

Their strengths include understanding how to navigate the Byzantine government procurement process and having armies of employees with the security clearances necessary to do defense work.

Defense companies have predictable revenue, with the government annually providing a five-year outlook of planned purchases. The sector also tends to pay healthy dividends, cash paid to shareholders for each share they own, in part because some of their research and development is funded as part of the government’s defense spending, freeing cash for return to shareholders.

The Pentagon has awarded a lot of important contracts in recent years, and the industry is set up well to see cash generation increase in the second half of the decade. That should translate into higher dividends and could spur a wave of acquisitions.

How to find the best defense stocks

The defense sector tends to be a stable group with few failures, but also few standouts. Here are a few tips to consider when evaluating individual 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 selling for at least $80 million 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.

The Defense Department early in the year lays out its funding requests to Congress, which then over the course of the spring and into summer will hold hearings to discuss military 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, (https://www.defense.gov/), and commentary elsewhere can provide clues as to what billion-dollar programs are a priority and what can be put off. You can also sometimes get a heads-up on a program that might be in line for cancellation.

Presidential elections can bring fresh questions for defense stocks, but despite the industry’s tight ties to the government, long-term investors can mostly ignore the political bluster. Pentagon budgets tend to ebb and flow based more on current events and broader pushes to cut spending and balance the budget, and they are typically only marginally affected by who is occupying the White House.

Follow the numbers

Companies will often highlight massive contract awards in press releases, but the devil is in the details. Those big award numbers are often spread out over many years and may be dependent on Congress’ approving the funds.

• Free cash flow, the cash a company generates after expenses, is important for any business, but investors should note that the number can vary for defense contractors based on whether its projects are new or well-established. Companies often spend more in the early stages of a production contract, temporarily depressing cash flow. Don't panic if quarterly free cash flow comes in below expectations, but do take the time to listen to conference calls or read their transcripts to find out why management said it happened and whether cash should rebound in the quarters to come.
• Investors should pay close attention to corporate backlogs, future sales that have been awarded but not yet built and paid for. Also look at how much of that backlog has been funded and how much of it must go through the congressional budgeting process.
• Look also for the company's book-to-bill ratio, a measure comparing orders received in a given quarter with the amount billed, to get an idea of a company's growth potential. A growing company should have a book-to-bill of at least 1.0, implying orders coming in for future products are at least equal to what is being shipped today.

Fortunately for new investors, the companies know Wall Street is focused on these numbers, and they typically make that 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 might find unsettling. If you don’t want to be involved in those things, you don’t want to invest in defense stocks.

More broadly, defense stocks, like many industrials, tend to be more plodding than a high-flying technology or biotech stock. Defense stocks are better-suited for income-oriented investors who are looking for steady growth and dividend increases, rather than those looking for stocks with the potential to double in a short amount of time.

Defense companies, like the products they manufacture, are built to allow you to sleep easy at night. If that is what you are looking for, defense investing might be right for you.