This article is part of our Rising Star Portfolios series.
When a sector is beaten down, I get interested.
When a sector is beaten down and nothing has fundamentally changed, I get really interested.
I believe that's the case in the defense industry.
Why so bullish?
In the banking industry, there are beaten-down stocks because of uncertainty around balance sheets, foreclosures, and stability.
In the health-care industry, there are beaten-down stocks because of worries that regulation will change the fundamental profit drivers of the industry.
In the defense industry, there are beaten-down stocks because of worries over defense cuts.
I've been trolling around in each of these sectors (click here for my calls in the banking space), but I'm focusing on the defense industry today, because defense offers us a chance to buy into an industry that's more stable than the market's pricing. Companies are trading at historically low multiples, and even though the pie may get smaller because of cuts by the U.S. Department of Defense, I'm betting the currently envisioned extent of those cuts is an overreaction.
There are five large defense companies trading for earnings multiples of around 10. That's low both historically and on an absolute basis:
|
Company |
P/E Ratio (2001) |
P/E Ratio (2006) |
P/E Ratio (Recent) |
|---|---|---|---|
|
General Dynamics |
16.6 |
17.6 |
10.8 |
|
Lockheed Martin |
28.9 |
17.0 |
9.8 |
|
Northrop Grumman |
12.3 |
17.1 |
9.8 |
|
Raytheon |
38.3 |
19.9 |
10.1 |
|
L-3 Communications |
33.5 |
19.1 |
9.1 |
Source: Capital IQ, a division of Standard & Poor's. The P/E ratios for 2001 and 2006 are averages for the years. The recent P/E ratio is as of yesterday's close.
To make sure these companies haven't lost their earnings efficiency, take a look at their recent returns on capital versus five and 10 years ago. They've all held up pretty well, if not improved:
|
Company |
Return on Capital (2001) |
Return on Capital (2006) |
Return on Capital (Recent) |
|---|---|---|---|
| General Dynamics |
17.2% |
13.6% |
14.8% |
| Lockheed Martin |
6.2% |
17.6% |
32.9% |
| Northrop Grumman |
6.8% |
7.2% |
10.5% |
| Raytheon |
2.3% |
8% |
13.3% |
| L-3 Communications |
7.8% |
8.1% |
9.8% |
Source: Capital IQ, a division of Standard & Poor's.
The buy thesis
Because the market seems too pessimistic on the industry, I'm buying a basket of these five low-multiple, high-return companies for my real-money portfolio. I'll be allocating $400 to each pick, for a total of $2,000. For context, my portfolio started with $5,000 in November, with $1,000 added each month.
My return expectations on these picks are muted. I'm not looking for shares to skyrocket -- just hoping to take advantage of a bit of overdone market pessimism.
There's an additional opportunity to beat the basket returns by diving in deeply and analyzing each company on its own particular merits. I may do so in the future, but for today, I'm happy with a higher-level basket approach.
To follow along with my entire portfolio, check out my real money portfolio page. Fool on!
