Research in Action: Why Defense Stocks May Still Help Growth and Value Investors

May 15, 2014 8:58 AM
By Rama Bondada

Do defense stocks still work when the world's biggest consumer of military products, services, and technology is cutting back? The answer may surprise you.


Don't let declining defense spending fool you. Defense stocks still have the potential to advance.

Among my top picks are a Fortune 100 company that is leading a $220 billion program with nine other countries to develop fighters that can perform ground attacks, reconnaissance, and air-defense missions with stealth capability; a diversified technology and innovation leader that is seeing increased demand for stronger missile-defense systems from U.S. allies; and a top Pentagon supplier that he likes more for its very popular and very profitable line of business jets. (See "Quality Stocks in Three Flavors.")

I was negative on defense until I realized that what few investors understood is that these companies typically have very strong cash flows and no debt. So even if the top line was declining, they were able to grow earnings per share by 10% using some of their free cash flow to buy back billions of dollars worth of stock.

Another driver of defense stocks is a pension accounting principle that allows companies to book higher profits as the amortization of its pension obligation increases. Helping that process along is the fact that the federal government pays half of the defined benefit pensions for defense contractor employees, and some of that funding is baked into huge, multiyear contracts.

Also helping such companies are so-called “cumulative catch-up adjustments” on multiyear contracts, which reflect management’s ability to streamline operations and cut costs, leading to some of the best margins in decades, despite declining sales.

When the U.S. federal government was increasing its budget [during the wars in Iraq and Afghanistan], officials didn’t have the time to see if they were really getting the best price. So now you're starting to see defense companies right-size those programs.   

Will rising geopolitical tensions and cyber-warfare boost defense stocks even more? Attack that question here.

Lord Abbett Research Analyst Rama Bondada covers the the aerospace and defense sectors.

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