Yes, my friend, there is a corner of this exuberant stock market where it is still possible to buy shares in outstanding companies at reasonable valuations.
This promised land is called the U.S. defence industry. The sector has a long history of delivering big rewards for shareholders. For some reason, though, investors seem curiously unexcited by its potential.
Their lack of enthusiasm is not a new phenomenon: In recent decades, defence stocks have typically traded well below market averages, according to Lawrence Hamtil, a financial analyst at Fortune Financial Advisors LLC in Kansas City.
In a recent blog post, he urged investors to look beyond the market’s persistent disregard for defence contractors and ponder the sector’s many appealing qualities.
The greatest of those attractions is the high quality of the underlying businesses. Big defence contractors enjoy unusually stable earnings and carry lower debt levels than many of their industrial peers.
Better yet, these companies are immune to many competitive threats. That is because one huge client – the U.S. government – dominates their order books.
Most industries can only dream about such a perfect client: When it comes to military procurement, Washington will always buy American. It won’t take its defence business offshore. It prefers to deal with people it already knows. It isn’t inclined to pinch pennies, either.
“Military machinery has become increasingly complex and expensive, and new projects require years to design, test and produce,” Mr. Hamtil wrote. “Given the critical nature of these weapons programs, special materials for these projects must be obtained without much concern for costs.”
This gives defence contractors an unusual amount of pricing power – a power that is reflected in the lush rewards they have generated for their investors. Over the past decade, the S&P Aerospace & Defense Select Industry Index has gushed an average 18 per cent a year in total return for shareholders.
Despite that sterling performance, many of the best-known stocks in the sector continue to trade well below the broad market.
For instance, shares in Northrop Grumman Corp. sell for 13 times the company’s earnings over the past 12 months. Lockheed Martin Corp. stock goes for 15 times trailing earnings, and General Dynamics Corp. shares for 17 times.
By comparison, the broad U.S. market trades for more than 31 times trailing earnings.
Why are defence stocks so much cheaper than most? It may be because of their dependence on government spending. Any sign that Washington might trim the defence budget would be bad news for companies that depend on a steady stream of government spending.
Today’s bargain prices could reflect fear that U.S. President Joe Biden will gut military spending to fund his domestic priorities.
That is a plausible reason for worry. However, Mr. Biden’s first budget requested US$715-billion for the Department of Defence – a tiny increase from the previous year and far from miserly. Drastic cuts seem increasingly unlikely given mounting tension with China.
More likely would be a scenario in which defence spending keeps pace with inflation. But even if spending were to get nipped in years to come, the unusual cheapness of defence stocks offers a buffer against a dramatic decline in the sector.
Joseph DeNardi, an analyst at Stifel, summed up the case for buying defence stocks when he upgraded Northrop Grumman to “buy” from “hold” in June. He gave three reasons for his decision: Northrop’s cheap valuation, its high-quality businesses and “a still elevated global threat environment.”
Much of that reasoning can be applied across the entire industry. Investors searching for a low-risk way to stay invested in an expensive stock market may find the area to be particularly compelling because defence contractors rarely lose money for their shareholders.
With the exception of a brief period in the mid-1970s immediately after the end of the Vietnam War, defence stocks have produced consistent positive returns since 1963, Mr. Hamtil said. If history is any guide, there are few better ways to play defence against an expensive stock market than by investing in defence.
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