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The Globe and Mail

U.S. defence stocks caught in fiscal crossfire

The Lockheed Martin Joint Strike Fighter is shown after it was unveiled in a ceremony in Fort Worth, Texas, in this July 7, 2006, file photo.

Ron T. Ennis/AP

The country's at war, the economy's weak, and U.S. weapons are in demand all over the world. You'd think these would be banner days for defence stocks.

Instead, they've been shredded like cannon fodder. The equal-weighted NYSE Arca Defence Index, which represents the major Pentagon contractors, is down 17 per cent in six weeks.

That's still nearly triple its value at inception – ten days after 9/11 – which shows what a good decade it's been for the arms merchants. But all offensives must come to an end, and after some 35 years of purchasing guns and butter on ever-expanding credit, a thriftier nation is considering downsizing to bayonets and margarine, as it were.

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Defence stocks have been caught in the fiscal crossfire, and are arguably the new budget-chopping Congressional super committee's most important hostages.

That's because the fiscal 2012 defence "base" budget accounts for 41 per cent of all non-discretionary U.S. spending – which counts all outlays for agencies and programs other than mandatory entitlements, such as Social Security and Medicare.

If the super committee (made up of six Democrats and six Republicans, drawn from both legislative chambers) fails to agree on cuts saving $1.5-trillion over a decade that would be acceptable to their colleagues by the end of this year, $1.2-trillion in across-the-board cuts would take effect starting in 2013.

And Pentagon's share, based on that "base" budget (which doesn't even include another $347-billion appropriated for the wars in Afghanistan and Iraq, as well as Homeland Security and Veterans Services) would be $500-billion over 10 years, on top of the $350-billion in cuts already in the books under the deal to raise the debt ceiling.

So that's why investors are running scared.

Now for the good news. Both Congressional Republicans and the Obama administration have labelled the looming half-trillion in automatic defence cuts unacceptable. You can argue with that logic, but there's no doubting the political risk of reneging on those commitments.

So any super committee budget-cutting deal is likely to be kinder to military spending that the "doomsday" alternative of automatic cuts would be, the more so since, as the Associated Press points out, many of the panel's members have significant defence work in their states and districts.

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There are other reasons to believe defence contractors won't starve. Any rational rethink of the defence budget would target first the massive, costly footprint of U.S. forces overseas, including such anachronisms as the 50,000 U.S. troops guarding Germany.

Furthermore, as the U.S. retrenches and begins to bring the troops home, its allies – notably in the Asia-Pacific region – are likely to feel that much less secure, which will lead them to increase their own spending on advanced weapons systems, many of them imported from the U.S.

Finally, advanced weapons systems are notoriously hard to kill in Congress, and when the orders are merely scaled back, the cost-plus model protects contractors' revenue.

Meanwhile, Northrop Grumman is selling for eight times trailing earnings and four times trailing cash flow, while yielding 3.7 per cent. Lockheed Martin is comparably cheap, and yields 4.2 per cent. Dividend chasers who've recently piled into utility stocks with such alacrity appear to be dipping their toes into defence stocks over the last couple of days.

A much riskier name worth considering is AeroVironment , a maker of military drones as well as fast-charging equipment for electric vehicles. As the U.S. winds down its expensive wars and reduces the military footprint, it's likely to rely more heavily than ever on the relatively inexpensive drones for intelligence work and the task of hunting enemies in hostile territory.

Furthermore, if military cuts spur industry consolidation, AeroVironment, with its market cap of $620-million, would make a tasty and inexpensive snack for one of the leviathans.

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The analysts at FBR Capital Markets think the company should be able to grow by 10 per cent to 15 per cent annually. The stock was at $28 and change on Aug. 2 when they upgraded it to "outperform," citing upside potential after the recent declines, despite "the overwhelmingly negative sentiment for defence stocks."

And today, AVAV continues to trade just under $28. So the upside potential remains on the table, while sentiment appears to be turning.

Igor Greenwald is the global editor at

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