A Few Ground Rules for Picking Defense Stocks
Some investors who are jumping into defense stocks seem to be following the example of the Moscow hard-liners who ousted Mikhail S. Gorbachev: Make a move quickly, worry about the details later.
Stocks of major defense contractors continued to soar Tuesday as Wall Street gauged the potential effects of the Soviet crisis. But the rally seems haphazard except for its focus on size. “People are going for what’s big and juicy,” notes Gary Reich, analyst at Shearson Lehman Bros.
McDonnell Douglas, the nation’s No. 1 defense contractor, led the surge Monday and Tuesday, rallying $2.50 on Monday and $4.25 on Tuesday to close at $55.50. Lockheed and General Dynamics also were big winners Tuesday.
In contrast, lesser known names such as E-Systems and Loral Corp.--major developers of defense electronics systems--have yet to show impressive gains on the news.
What happens next? Some analysts say the surprise may be that the rally in defense shares will soon broaden--even if the Soviet coup fails. On Wall Street, these stocks have finally regained the respect they lost in the mid-1980s, and that’s no small event.
Even so, investors will have to pick potential defense winners within the context of a few important ground rules:
* Defense spending still will go down. Adjusted for inflation, U.S. defense spending has been shrinking each year since 1985. Unless the Soviets overrun Europe, no one believes that Congress and the White House will turn on a dime and suddenly raise spending dramatically, with a $360-billion-plus federal budget deficit staring taxpayers in the face next year.
“There is an agreement with Congress not to even try to raise defense spending before 1993-94,” Reich says. So there is no windfall awaiting defense contractors.
* Even with lower spending, many defense firms are prospering. The reality (or hope) of the New World Order kept these companies in the doghouse for most of the late 1980s. They had their own personal perestroikas . Now, after downsizing and streamlining for leaner Pentagon budgets, many defense firms are expected to begin showing earnings growth again this year or next. That will be a major change.
Indeed, before the Persian Gulf crisis began a year ago this month (as President Bush asked Tuesday, “What is it about August?”), most defense stocks had been falling steadily since 1988.
By the time Iraq rang the alarm, the stocks had declined “almost to the point of ridiculousness,” says analyst Paul Nisbet at Prudential Securities. Lockheed had fallen from $61.50 in 1987 to $25 by mid-1990. Loral, which posted record earnings in both 1989 and 1990, still saw its stock trading at $24 last summer, down from $49 in 1987. In fact, even at $44.625 now, Loral remains 10% below its 1987 peak price.
* Investor psychology is important, and it’s changing for the better for these stocks. Coming so quickly after the Persian Gulf crisis, the Soviet coup is going to reinforce the need for a strong U.S. defense force. That may not translate into more dollars for the Pentagon, but it is likely to dissipate any remaining feeling on Wall Street that defense companies are dinosaurs in the 1990s, analysts say.
“The sentiment for these stocks is going in the right direction now,” says Shearson’s Reich. That sentiment has been helped by McDonnell’s apparent escape from cash-flow problems, as it rolls out the MD-11 commercial aircraft. The Pentagon’s recent award of the major Advanced Tactical Fighter contract to the Lockheed/Boeing/General Dynamics team also rejuvenated interest in the defense group.
Just as important, more investors are likely to see very little risk in these stocks at current levels, given their low prices relative to earnings per share, and (in some cases) decent dividend yields.
Which stocks have the greatest potential in the near term? McDonnell may not be through rising, if only because the stock had been so heavily beaten up by “short” sellers, Reich says. About 11% of McDonnell’s outstanding shares had been sold short as of mid-July by traders expecting the price to collapse. As those shorts rush to cover their positions by buying the shares on the open market now, McDonnell stock begins to look like a rocket.
Longer term, many analysts suggest that investors look most closely at the defense electronics firms such as E-Systems and Loral, and at software and professional-services companies such as Torrance-based Logicon.
With the Soviet crisis, Congress’ concerns about Pentagon readiness are likely to focus on strategic nuclear weapons systems and on surveillance systems, says Byron Callan, analyst at Prudential. As he notes, “There’s not a lot the Marines can do in a situation like this.”
Logicon, which has been a hot stock all year, is a big supplier of mission-planning software for Northrop’s B-2 Stealth bomber program, as well as software for war-gaming exercises. The company’s earnings are expected to be around $3.15 a share this year, and $3.45 next year, by Value Line’s estimates. Even at a stock price of $32.375, that leaves Logicon at a pretty low price-to-earnings multiple compared to E-Systems and Loral.
New Respect for Defense
Despite their surge this week, most defense stocks still sell for relatively low prices compared to their earnings--and those earnings are on the rise again.
52-week Tues. close ’91 Div. Stock high/low and change P-E* yield Boeing 52 1/2-38 1/2 45 7/8, + 1/2 10 2.2% E-Systems 44-25 1/4 40 3/4, + 1/2 12 1.8% General Dynamics 46 3/4-19 46 3/4, +2 1/2 8 2.1% GM Hughes 21-16 1/4 18 7/8, + 1/2 13 3.8% Lockheed 47 3/4-24 3/4 45 3/4, +1 5/8 10 4.4% Logicon 32 5/8-14 3/8 32 3/8, +1 7/8 10 1.2% Loral 45 1/2-27 44 5/8, + 7/8 11 2.2% Martin Marietta 60 3/8-34 1/4 58 5/8, +1 1/2 8 2.6% McDonnell Douglas 59 3/4-26 1/2 55 1/2, +4 1/4 7 2.5% Northrop 31 1/4-14 1/2 30 1/2, + 3/8 9 3.9% Raytheon 87 5/8-59 3/4 87 1/4, + 1/4 10 2.8% S&P; 500 391-295 379, +3 15 3.2%
* stock price-to-earnings ratio based on estimated 1991 earnings per share; all stocks trade on NYSE.
Source: Value Line Investment Survey
