The defense industry has momentum. U.S. investors have been uneasy in 2018 as the international trade war escalated. But while investors consider how to play defense with their portfolios, Morningstar analyst Chris Higgins says it…
The defense industry has momentum.
U.S. investors have been uneasy in 2018 as the international trade war escalated. But while investors consider how to play defense with their portfolios, Morningstar analyst Chris Higgins says it may be a good time to consider buying defense industry stocks, especially after the November midterm elections. The Trump administration has made defense and infrastructure spending top priorities, and Higgins says U.S. defense spending will likely continue to accelerate at least until the 2020 election season. Here are seven ways long-term investors can bet on defense stocks.
Boeing stock is up 17.8 percent in the past six months as the company’s strong fundamental performance has alleviated concerns about the trade war’s potential impact on Boeing’s China business. Higgins says Boeing’s biggest challenge will be meeting rising demand for commercial aircraft. He says Boeing’s backlog of nearly 6,000 aircraft orders will result in an uptick in production. High-margin 737 production is expected to increase by 35 percent from 42 per month in 2016 to 57 per month by 2019. Morningstar has an “overvalued” rating and $323 fair value estimate for BA stock.
Higgins gives Northrop Grumman CEO Wes Bush credit for boosting the company’s operating margins from the mid-single-digits back in 2004 to 12.6 percent in 2017. He says Northrop is poised to be one of the prime beneficiaries from the Trump administration’s increase in defense spending. Higgins says it’s difficult for defensive investors to find cheap defense industry stocks these days, but Northrop is one of the few names in the group that is currently trading at a valuation discount relative to peers. Morningstar has an “fairly valued” rating and $320 fair value estimate for NOC stock.
L3 Technologies gets about 70 percent of its revenue directly from the U.S. government, meaning an increase in government defense spending is always good news for LLL stock investors. Higgins says L3 was forced to clean up its portfolio and restructure its business during the defense downturns and Iraq and Afghanistan troop drawdown of the past decade. Today’s L3 is a leaner business with higher-margin operations, and Higgins says the current environment should enable the company to continue to create long-term value for its investors. Morningstar has a “fairly valued” rating and $204 fair value estimate for LLL stock.
Lockheed Martin is the largest defense contractor in the world, and 80 percent of its revenue comes from the U.S. government. Like many other U.S. defense companies, Lockheed has spent much of the past decade divesting underperforming businesses, reducing its headcount and improving its operating efficiency. Now that the defense industry is booming once again, Higgins says Lockheed is running like a well-oiled machine. Higgins likes the company’s management, its pursuit of long-term growth and its commitment to capital returns. Morningstar has a “overvalued” rating and $327 fair value estimate for LMT stock.
Raytheon has improved its operating margins from 7 percent in 2004 to 12.4 percent in 2017. Even though annual revenue has declined by about $2 billion since 2011, better efficiency has allowed the company to improve its return on invested capital in that stretch. Higgins says these improvements have cleared the path for Raytheon to invest in its business, fund its pensions and commit cash flow to capital returns. Like Northrop Grumman, Higgins says Raytheon is one of the few compelling value plays in the defense sector at its current share price. Morningstar has a “fairly valued” rating and $212 fair value estimate for RTN stock.
When General Dynamics completed its buyout of CSRA in the second quarter, is roughly doubled the size of its IT business, which now accounts for about 25 percent of its overall revenue. Higgins says General Dynamics’ ground vehicle business could get a huge long-term boost from a U.S. Army vehicle modernization initiative which will play out in coming years. He says the CSRA acquisition coupled with General Dynamics’ compelling value make it his top long-term stock pick in the defense sector. Morningstar has an “fairly valued” rating and $220 fair value estimate for GD stock.
iShares Dow Jones U.S. Aerospace & Defense ETF (ITA)
For investors who agree that defense spending will be a top priority in Washington but aren’t convinced of the best stock to buy, the iShares Dow Jones U.S. Aerospace & Defense exchange-traded fund may be the best way to take a diversified position in the U.S. defense industry. The ITA ETF holds all of the six previously mentioned stocks plus shares of 33 other major U.S. defense and aerospace companies. The ETF’s 250,000 average daily trading volume suggests plenty of liquidity, and its relatively low 0.45 percent expense ratio means investors won’t be paying too much in fees for the relative safety of diversification.