Why Defense Stocks Are Going Up

The defense sector has become a tale of two cities — or at least, two zip codes. If you live on Main Street where the defense plants and depots are located, things are looking rather bleak. Contracts are being delayed, capital investments are being slashed, and workers are being furloughed. If you live on Wall Street where defense stocks are traded, though, happy days are here again. All of the big defense stocks are trading at or near their 52-week highs, with General Dynamics, Lockheed Martin, Northrop Grumman and Raytheon each seeing double-digit percentage price increases year-to-date. Shipbuilder Huntington Ingalls is up nearly 30% in the last five months, and Gencorp — parent company of rocket-maker Aerojet — is up a staggering 50%.

This isn’t the way defense downturns are supposed to look. When demand from the government customer softens, share prices usually slide to reflect a weakening earnings outlook. So far, though, the biggest companies have found ways of keeping shareholders happy despite projections of flagging sales. Northrop Grumman is steadily buying back shares so that E.P.S. will keep rising. Lockheed Martin is paying a 4.3% dividend (which was above 5% before shares ran up). General Dynamics is aggressively slashing costs and promising increased focus on shareholder value.

Byron Callan, a respected sector analyst at Capital Alpha Partners, says that defense companies have doubled the allocation of cash from operations that is going to dividends and share repurchases. He thinks that could be a bad thing over the long run, even if it is rewarding investors today. Companies in vibrant sectors like tech typically plow cashflow back into the business, and sell their shares on the promise of future growth. Defense companies seem to be signaling that they don’t see compelling opportunities to invest in their core markets, and therefore they are returning funds to shareholders.

If that’s the way executives see things, it probably isn’t due just to declining demand. It probably also is a verdict on the increasingly onerous terms and conditions that the Pentagon is imposing on contractors, which entail rising risks and falling returns. When companies have to spend more of their money up front to play in competitions where the winner might be forced to recompete before a reasonable return is realized, it makes them less inclined to keep pouring money into their defense business. Some will undoubtedly follow the example of General Dynamics in acquiring non-defense lines as a way of becoming less dependent on military customers.

Part of the run-up in defense stocks may have nothing to do with defense. With the Federal Reserve continually injecting liquidity into markets while depressing interest rates for savers, a bubble may have formed in equity markets. Many sectors are beginning to look overbought, notwithstanding the fact that corporate balance sheets are exceptionally healthy. In such an environment, it is natural for investors to take another look at the defense sector, which is “counter-cyclical” in the sense of not being as tied to the rhythms of the business cycle as other sectors. In other words, current conditions in equity markets may make investors want to buy themselves some portfolio diversity by holding the equities of companies that get their revenues mainly from the government.