For the past few years, some analysts warned against investing in defense contractors. Their thinking is that the U.S. government will “get religion” and reduce spending… even on the defense industry, which is in enough foreign wars that it should be called the “offense industry.” So it’s time to sell defense stocks and jump into sectors offering better growth prospects, right?
Wrong. Unless you like taking risks, having the equities of big military suppliers in your portfolio is almost always a smart move. Although politicians love to bash the defense industry, its stocks offer unique characteristics that most investors can’t obtain any other way. And it shows in the performance of defense stocks.
The market has spoken
The chart below displays the performance of “offense” contractors Northrop Grumman Corporation (NYSE:NOC), Lockheed Martin Corporation (NYSE:LMT), Elbit Systems Ltd. (USA (NASDAQ:ESLT) over the past 12 months. These companies produce things like jet fighters, missiles, radar systems, and unmanned aerial drones. They rely almost entirely on government spending. Last year, Northrop got 90% of its business from the U.S. government. For Lockheed, that number was 82%. Together, these two companies alone raked in more than $60 billion in government money last year.
The red line above shows the performance of Northrop Grumman Corporation (NYSE:NOC), the blue line shows the performance of Lockheed Martin Corporation (NYSE:LMT), and the green line stands for Elbit Systems Ltd. (USA (NASDAQ:ESLT). For Comparison purposes, I added the S&P 500 in purple to serve as a benchmark. As you can clearly see, over the past year – it’s been highly profitable to play defense. All three defense stocks have climbed by 30% to 40% a year, easily besting the S&P. Last week, these three stocks broke out to their highest levels in more than four years. Despite claims to the contrary, no cutbacks are affecting these stocks.
The unique traits of the defense industry
Let’s take a look at three reasons why defense stocks are now booming and are more than likely to continue their uptrend.
Counter – cyclical
Right now, China and Europe are slowing down and the possibility of another Middle East war looms as Israel prepares to attack Iran’s nuclear complex. If Israel strikes, that will probably lead to Iranian missile launches, action in the Strait of Hormuz, spiking oil prices and other developments that depress the shares of most commercial companies. But not defense shares. When war looms, demand for the goods and services of military suppliers rises. That’s why defense stocks are regarded as counter- cyclical.
Always in demand
Within the domestic defense market, industry has evolved in a way that makes it highly resilient to softening demand. When the Cold War ended, the top tier of the sector consolidated into a handful of military conglomerates that do business with all the military services in both hardware and services. Waning demand in any particular market segment presents little threat to these sprawling enterprises. The industry is so concentrated that there often are only one or two qualified suppliers of key military items, and politicians usually are determined to keep it that way.