Strengthen Your Defenses

This article is part of our Rising Star Portfolios series.

The defense sector has become a battleground for U.S. budget hawks. And sure, with defense spending the third-largest component the national budget, it's a natural place to turn for cuts. So it's logical for defense contractors, who rely on federal agencies for their livelihood, to be scared that their source of ultra-stable revenue will dry up, right?

That's clearly what the mainstream investing world thinks. Year to date, the defense sector has declined 8.1%, versus a 7.6% gain for the S&P 500. But as un-vestors, we aren't the mainstream investing world. We do our recon work and discover why an investment is unpopular. If we're able to understand the issue well enough to disagree, or if the fears compensate us fairly for the risk involved, we'll jump in. That's exactly what happened when we bought Medtronic.

To help us determine whether or not the poor relative performance of defense stocks is warranted, I've asked fellow Fool and defense-sector expert Andrew Sullivan, CFA (TMFRedwood) to shed some light.

Bryan Hinmon: We read headlines that the defense budget is going to be slashed. What is the truth behind those headlines?

Andrew Sullivan: There are pressures on the budget, but it's simply not true that it will be slashed. The base budget (excluding war funding) is expected to grow from $549 billion in 2011 to $616 billion in 2015. Even the proposal from the Deficit Reduction Commission to cut $100 billion out of the budget is misleading, because most of the proposed cuts come out of personnel, health-care, and general overhead such as base closures. 

Hinmon: What companies are best prepared to weather budget scrutiny and cuts? What companies aren't?

Sullivan: Even though the sector as a whole is attractive, you'll do better in companies with strong, versatile capabilities that add tremendous value, or smaller companies with greater growth potential. I think of L-3 Communications (NYSE: LLL) in the first category, for its electronics and communications that are adaptable to many platforms and missions, and VSE (Nasdaq: VSEC) for the second – a smaller, more nimble company with room to grow. 

Hinmon: What characteristics of the defense industry make it attractive for investment?

Sullivan: This is a great industry because of its slow rate of change, high barriers to entry, and countercyclical nature. Defense isn't correlated to the economy, so it provides ballast to your portfolio in the event of economic and market swings. What's great about the sector now is that this valuable benefit is coming on the cheap, because the sector is so out of favor. 

Atten-hut!
With Andrew's insights as a jumping-off point, I think there are two additional factors we should look for:

1. Exposure to growing areas of spending (like cybersecurity) and avoidance of pet projects likely to be cut
2. Strong balance sheets

Companies fitting this mold, reduced to rock-bottom prices by an unloving market, should provide excellent returns:

Source: Capital IQ, a division of Standard & Poor's.

Over the next few days, I'll be digging into a few of these names for possible inclusion in the Un Portfolio. I'd love to hear your thoughts on the industry in general, and these companies specifically. Come join the fun on the Un Port's discussion board. Can't get enough Andrew? Chat him up on all things gold, defense or just plain cheap.

This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money free stock picks. See all of our Rising Star analysts (and their portfolios).