Defense and defense-related stocks may be an ideal play in a down market and economy. The group of companies that make money off the government has already dramatically outperformed the market this year, with the S&P U.S. Aerospace and Defense Select Industry Index up 13.3% year-to-date (YTD) versus the broader S&P 500’s 6.9% return over the same period.

As fourth quarter reporting season kicks into high year, a projected two-year surge in defense spending will likely offset any mixed quarterly earnings news in the near-term. An increase in the defense budget to as much as $750 billion for 2020, is likely to fuel a continued rally for 12 defense stocks. This basket of stocks includes household names such as: Northrop Grumman (NOC), Lockheed Martin (LMT), Raytheon (RTN) and General Dynamics (GD), as well as lesser-known stocks Aerojet Rocketdyne Holdings (AJRD), Huntington Ingalls Industries (HII), BWX Technologies (BWXT), AeroVironment (AVAV), CACI International (CACI), Accenture (ACN), Booz Allen (BAH), and Leidos Holding (LDOS), per Barron’s. 

Defense Stocks Are Soaring

(YTD Stock Performance)

  • iShares U.S. Aerospace & Defense ETF; 11%
  • SPDR S&P Aerospace & Defense ETF; 13.3%
  • S&P 500; 6.9%

Spending Boom, Cheap Valuations

As the Trump administration signals support for upgrading and expanding the military, from missile defenses to the Navy, major contractors are set to see revenues balloon through the end of the decade. 

Defense stocks are also cheap for today's market, trading at an average 12 to 16 times forward earnings and less than 11 times enterprise value/Ebitda, noted Ben Phillips, Chief Investment Officer of EventShares. The investor says he has recently added to shares of aerospace and defense contractors in the firm’s U.S. Policy Alpha ETF (PCLY). 

Phillips is banking on the conviction that spending will rise significantly over two years, with a budget for fiscal 2020 still pending approval from Congress. While the Trump administration is requesting nearly $750 billion, marking a 4.6% jump from the $717 billion appropriated for 2019, Congress may approve less than that as Democrats fight to reduce military spending. Lack of agreement is likely to continue, especially if Trump continues to push for funding for a border wall in the defense bill. Nonetheless, analysts’ consensus is for a major spending agreement to prevail, leading defense contractors to receive higher levels of funding. 

Missile Defense, Navy Expansion 

As the current administration continues to push for increased missile defense spending, calling for more funding for space-based systems and to respond to threats from countries like North Korea and China, Barron’s expects Lockheed Martin, Raytheon, Northrop and Aerojet Rocketdyne to benefit the most.

Efforts to modernize and expand the Navy in a multi-decade plan coincide with general bipartisan support in politicians’ home districts for shipbuilding and high-tech weaponry development. Stocks set to gain the most on a likely increase in Navy spending include Huntington Ingalls, General Dynamics and BWX Industries.

Phillips also likes companies involved in drone technology, such as AeroVironment, and companies involved in outsourcing of government workers, such as government network cybersecurity provider CACI International, consulting firms Accenture and Booze Allen Hamilton, and Leidos Holdings, a diversified government contractor. 

Gov’t Shutdown, Deficit Fears

As for the impact of the government shutdown on big contractors, Cowen analyst Cai von Rumhor is among those confident that it will not affect military spending, per Barron’s. In a note on Tuesday, Cowen wrote that, “most defense large capitalization companies will beat Wall Street fourth-quarter estimates.”

JPMorgan analyst Seth Seifman is also not concerned about growing budgets fears and government deficits, writing that, “we believe the [fiscal year 2020 defense] budget won’t be dramatically different than [2019], so not much has changed for company operations or our estimate.”

Looking Ahead

It’s important to note that all defense stocks may not benefit equally, and that headline risk remains as Trump and Congress battle it out overfunding levels. Both General Dynamics and Lockheed gave cautious guidance for 2019 for various reasons. This may be a warning that, in the shutdown age, even government spending won't lift all defense stocks. Investors will have to crunch the numbers do ferret out the winners.

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