5 defense stocks for embattled budget times

Fears of government spending cutbacks have kept many aerospace and defense stocks trading at bargain prices.

By John Reese Jun 22, 2011 12:39PM

Image: Guided Missile Destroyer (© The Stocktrek )With talk of deficits, debt ceilings and potential budget cuts dominating the U.S. political landscape in recent weeks, a good deal of fear and uncertainty have been swirling around stocks of companies that could be impacted if the government starts slashing its budget.

 

One such area is aerospace and defense firms. The defense budget has come under great scrutiny lately as Congress tries to claw away at the $1.4 trillion U.S. budget deficit. That -- along with investors' increased appetite for riskier stocks amid the Federal Reserve's money-printing binge -- has helped keep the shares of many A&D companies trading on the cheap.


Last week, however, the House Appropriations Committee passed a defense budget that cut President Obama's spending request less than some had feared, good news for defense-related companies.


What's more, some aerospace & defense firms get less revenue from the U.S. government than you might think, either because of diversified product lines or because they earn big chunks of revenues from other governments overseas. Some others that do rely heavily on the U.S. government are just flat-out cheap enough to merit interest. So the cloud hovering over this sector may well be creating nice buying opportunities.

 

Of course, not all A&D stocks are created equal. So to find the best of the bunch, I recently used my Guru Strategies -- each of which is based on the approach of a different investing great -- to scan through the sector and see which of these stocks look most attractive right now. One is General Dynamics (GD), which I wrote about earlier this month, and which still gets approval from my Peter Lynch- and Joel Greenblatt-inspired models. But here are some that are also near the top of the list.

 

Raytheon Company (RTN): Massachusetts-based Raytheon provides state-of-the-art electronics, mission systems integration, and other products and services used in a variety of communications, command, and intelligence systems, and also provides mission support services. The $17-billion-market-cap firm has taken in more than $25 billion in sales in the past year.  

 

Raytheon gets strong interest from the model I base on the writings of mutual fund great Peter Lynch. It considers the firm a big, steady "stalwart", because of its high sales and moderate 14.5% long-term earnings per share growth rate. (I use an average of the three-, four-, and five-year EPS growth rates to determine a long-term rate.) Lynch famously used the P/E/Growth ratio to find stocks with good growth that were selling on the cheap, adjusting for dividend yield in the case of big stalwarts like Raytheon. When we divide Raytheon's 10.3 price/earnings ratio by the sum of its 3.5% yield and 14.5% growth rate, we get a yield-adjusted P/E/G of 0.57, which easily comes in under this model's 1.0 upper limit.

 

Another reason the Lynch-based model likes Raytheon: the firm's reasonable 36.4% debt/equity ratio.

 

Rockwell Collins Inc. (COL): Based in Iowa, Rockwell makes electronics used in the communications and aviation industries. Its systems transmit almost 70% of all U.S. and allied military communications, but it also has customers in the commercial arena.

 

Rockwell ($9.4 billion market cap) gets strong interest from my Warren Buffett-inspired strategy. This approach looks for firms with lengthy histories of increasing annual EPS, low debt, and high returns on equity (a high ROE is a sign of the "durable competitive advantage" Buffett is know to seek in his buys). Rockwell's EPS have decline in the past two fiscal years, but prior to that it had upped EPS in every year of the past decade, so the Buffett model sees the recent dips as more of a buying opportunity than a sign of long-term trouble. The company also has less debt ($509 million) than annual earnings ($585 million). And, its average ROE over the past decade is 33.6%, more than doubling this model's 15% target.

 

L-3 Communications Holdings, Inc. (LLL): New York City-based L-3's offerings range from Intelligence, Surveillance and Reconnaissance to secure communications to training and simulation to aircraft modernization and maintenance. The $8.7-billion-market-cap firm has taken in more than $15.6 billion in sales in the past year. Today, The Wall Street Journal reported that an activist investment group that is L-3's largest shareholder is pushing for the firm to sell or spin off lower-margin parts of its business. Shares jumped more than 5% by early afternoon.

 

L-3 is another "stalwart" according to my Lynch-based model, thanks to its high sales and 14.9% long-term EPS growth rate. And even after today's gains, the strategy still thinks L-3 offers a lot of value -- it has a yield-adjusted P/E/G around 0.6,

 

FLIR Systems, Inc. (FLIR): FLIR makes infrared cameras, night vision products, and thermal imaging systems. Its products are used by government agencies, as well as commercial and industrial firms. The 33-year-old company has a $5.3 billion market cap, and has taken in about $1.5 billion in sales in the past 12 months.

 

Oregon-based FLIR gets strong interest from my Buffett-inspired model, which likes that the firm has upped EPS in every year of the past decade and has no long-term debt. FLIR has also averaged a 21.4% return on equity over the past ten years, another reason this model is high on it.

 

National Presto Industries (NPK): National Presto, which makes 40-millimeter ammunition, precision mechanical and electro-mechanical assemblies, and medium-caliber cartridge cases, gets about half its revenues from defense-related endeavors. But it also has one of the more intriguingly diversified product lines you'll ever find. Its two other business segments: Housewares/Small Appliances, which includes the manufacturing of pressure cookers and kitchen appliances; and Absorbent Products, which makes adult diapers used to deal with incontinence.

 

Wisconsin-based Presto ($675 million market cap) gets high marks from my Lynch-based model, which considers it a "fast-grower" because of its 26.8% long-term EPS growth rate (based on the average of the four- and five-year EPS growth rates). The stock's 11.0 P/E ratio and that growth rate make for a stellar 0.41 P/E/G. In addition, Presto has no long-term debt, a great sign.

 

I'm long RTN and FLIR.

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