Faltering Economy Gives Defense Equities A Reprieve

Last week saw a continuation of the recent drumbeat of bad news about defense spending, with many experts predicting that outlays for weapons will fall steadily in the years ahead. So of course the equities of the biggest military contractors sold off, right? Wrong! According to Byron Callan of Capital Alpha Partners, General Dynamics was up 7%, Lockheed Martin and Northrop Grumman were up 6%, and Raytheon was up 4%. Some of the smaller military hardware makers saw increases of over 10%, and defense services companies saw their shares rise by 5% or more.

You’d think George Bush was back in the White House. What’s going on? Well, part of what’s going on is that investors have rediscovered the thesis that defense stocks are a good hedge against recession — a “counter-cyclical” investment in the parlance of Wall Street — so all the talk of a double-dip recession has made defense equities look more attractive. Another thing that’s going on is investors have begun to doubt the hastily-adopted deficit reduction law driving all the rumors about weapons cuts will play out as planned. And then there’s the actual performance of companies in the defense sector, which remains strong despite all the warnings about falling demand from the government customer.

Although investors are right to question the notion that future bad news has already been priced into shares, the defense industry has been planning literally years for a downturn and therefore is ahead of the curve in compensating for any softening of demand. Lockheed Martin retired hundreds of senior executives before sales even began to take a hit. Raytheon put its foreign military sales on a vector to exceed 30% of revenues by mid-decade. Northrop Grumman spun off its under-performing shipbuilding business and a services business that was too conflicted to thrive under new acquisition rules. General Dynamics is diversifying its revenue mix while positioning to benefit from a rebound in business jets.

Beyond the belt-tightening and diversification measures many contractors are pursuing, defense equities appear to be benefiting from the fact that military contractors can look pretty appealing in a recession. Imagine you are an institutional investor who has to decide amidst all the present uncertainty where to invest your clients’ money. The commodity bubble may be about to burst, financial stocks are out of favor, the housing market is weak, retailers are suffering from the new-found frugality of consumers, and manufacturing activity is trending downward. Where do you invest? Defense equities may be a smart bet for the next few years, because the really big cuts in military outlays aren’t scheduled to materialize until 2013, and by then the whole political landscape may have changed.

Besides, even if weapons spending plummeted tomorrow, big system integrators like Northrop Grumman and General Dynamics have tens of billions of dollars in backlog that they can husband to sustain revenues and returns for years to come. The CEO of the nation’s biggest naval shipbuilder told me last month that business conditions in his shipyards today are determined by decisions the government made six or seven years ago, which means his results aren’t likely to be affected by this year’s choices for a long time to come. So why wouldn’t investors be piling into defense equities at this point? Unless they want to bet that gold is going to $2,500 per ounce, defense may be one of the best options Wall Street has.