Motley Fool
0
All posts from Motley Fool
Motley Fool in Motley Fool,

How to Invest in Defense Stocks

There's no doubt about it: Defense stocks are not cheap. Over the past year, shares of America's five biggest defense companies have shot up more than 37% in price. One military stock in particular -- Raytheon (NYSE: RTN) -- now costs more than twice the one-times-trailing-annual sales valuation traditional among defense contractors, while the average big military stock costs more than 180% of annual sales.

Military stock

TTM Stock Performance

Dividend Yield

Total Return (TTM)

Boeing (NYSE: BA)

76.2%

2.4%

78.6%

General Dynamics (NYSE: GD)

32.8%

1.7%

34.5%

Northrop Grumman (NYSE: NOC)

25.3%

1.5%

26.8%

Lockheed Martin (NYSE: LMT)

16.3%

2.4%

18.7%

Raytheon 

26%

1.8%

27.8%

Data source: FINVIZ.COM.

This is a huge deviation from the norm -- and a big reason to think twice before you buy into any defense stock right now. But what's the alternative?

I mean, President Trump says he's going to make big investments in defense, right? This suggests that the defense market is about to boom, and it only makes sense to want to invest in that trend before it happens -- and I'm not saying that's a bad idea. But if you ask me, paying a premium for one of the five big defense contractors right now, at the high water mark for defense industry profit margins, is just asking for trouble.

Instead, investors need to "think different."

Kratos Defense builds drones for the military that are different from everybody else's. Image source: Kratos Defense.

Avoid the obvious

At valuations of 1.8, 1.9, and 2.1 (!) times annual sales, defense stocks like Lockheed Martin, Northrop Grumman, and Raytheon are trading far above their normal ranges.

Now, will all three of these firms benefit from a boom in defense spending? Probably. And yes, they're all doing a terrific job of turning defense budgets into defense revenues and defense profits, at high margins, today. But if and when their profit margins return to more normal levels, the prices on these stocks are bound to take a hit.

Defense stocks with a civilian cushion

Instead, consider an alternative idea: Invest in a company with a big defense business, but one diversified into a big non-defense business that limits its exposure to defense budgets. Boeing and General Dynamics are two great examples here.

Both Boeing and General Dynamics look very expensive when valued on sales, and when compared to the usual average valuation of 1-times-sales applicable to defense stocks. But Boeing is well diversified away from defense in its Commercial Airplanes business. According to data from S&P Global Market Intelligence, Boeing gets twice as much revenue from selling non-military jet aircraft as it does from all its defense and space businesses combined. And it's these commercial businesses that will be the big drivers behind Boeing's anticipated 15.5% long-term earnings growth going forward.

General Dynamics -- although it's more exposed to defense than Boeing -- still derives 40% of its profits from its civilian Gulfstream business jet division. At 1.9 times sales, General Dynamics stock is still too expensive for me to be able to recommend it, but the Gulfstream business should cushion General Dynamics stock in the event the defense business takes a hit to profit margins in the future.

Wild cards

More adventurous investors may prefer to "aim small, miss small" -- and invest in a small defense contractor in the hopes it will get bought out by one of the big defense companies. For example, last year I made the argument that Kratos Defense & Security Solutions (NASDAQ: KTOS) would make a fine addition to Boeing's portfolio of companies.

Boeing never got around to taking my advice and buying Kratos. (But maybe it should have -- Kratos's stock has nearly doubled in the interim.) On the other hand, last month we did see Britain's Ultra Electronics bid to gobble up small defense contractor Sparton Corporation (NYSE: SPA).

Sparton's longtime partner in the production of sonobuoys for the Navy, Ultra announced on July 7 that it would pay $23.50 per share in cash to acquire Sparton. The terms of that deal will work out to a $235 million purchase price, slated to close by year-end.

Ultra is getting a real bargain in Sparton, whose $400 million in annual revenues implies a purchase price of less than 0.6-times-sales for Ultra. Perhaps if you can find a similar small defense contractor selling for a similar price-to-sales ratio, there's a chance it could be bought as well?

Specifics please

Which such "small defense contractors" should you be looking at? After the wave of consolidation that hit the defense industry after the Soviet Union's fall, there aren't a whole lot left to choose from -- at least not in the realm of small publicly traded defense companies. (I've pointed out in the past that most of the innovation in defense systems today is happening in the private realm.) But there are some.

I've already mentioned Kratos Defense, which is an innovative creator in the field of jet-powered combat drones. At 1.6 times sales, Kratos stock is pretty expensive, but it's still at least a relative bargain compared to the valuations of its larger peers.

Another defense company that bears watching as a potential buyout target is Kaman Corporation (NYSE: KAMN), which builds anti-submarine warfare helicopters for the military. Kaman Corp only costs about 0.8 times sales, and while its profit margins aren't huge, Kaman is solidly profitable. Outside the U.S., Australia's Austal Limited (NASDAQOTH: AUTLY) is worth a look as a play on further development of the Navy's Littoral Combat Ship, as the latter morphs into a frigate. At less than 0.5 times sales, Austal stock looks downright cheap. And then back here in the U.S., there's Oshkosh Corporation (NYSE: OSK), which basically owns the global MRAP business, building armored trucks for both U.S. and foreign militaries. It's a good business to be in so long as America insists on "fighting land wars in Asia" -- and Oshkosh stock isn't terribly expensive at 0.85 times sales.

Long story short, it's not easy finding cheap defense stocks today. But if you're willing to turn over a few stones, I do think it's still possible to find a bargain or three.

10 stocks we like better than Boeing
When investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*

David and Tom just revealed what they believe are the 10 best stocks for investors to buy right now... and Boeing wasn't one of them! That's right -- they think these 10 stocks are even better buys.

Click here to learn about these picks!

*Stock Advisor returns as of August 1, 2017

Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.