The writer argues that the recent Russian incursion into Ukraine, along with conflicts in other hotspots, will help push defense stocks higher.
Are defense companies currently safe investments?
Let’s take a closer look to assess their vulnerabilities.
Based on their recent performance, it’s not hard to see why this industry has caught the media’s attention.
A glance at the following chart comparing the PowerShares Aerospace & Defense ETF (PPA) with the S&P 500 shows just how far ahead of the market defense stocks have rocketed in the past year.
This is normally a steady, low-volatility group, but it’s almost as if defense stocks have become a levered play on the broader market.
But it’s not just their high-flying performance that is worrying – their valuations have become lofty, as well.
War is Fully Priced
In the table below, we have included valuation metrics for seven of the largest defense stocks:
Regardless of the valuation metric used, defense stocks are currently expensive. They’re no longer the deep value propositions they once were when they were out of the spotlight.
Take Lockheed Martin (LMT), for example.
LMT has been a stellar dividend performer, and Dividends & Income Daily has certainly been bullish on the stock in the past. But initiating a position at this valuation is a different story altogether.
LMT seems fairly priced at a P/E of 15.1. A closer look, however, shows LMT with a high CAPE (Cyclically Adjusted Price Earnings) ratio of 24.2 and a price-to-book value of 10.6, which is a significant premium to its peers. By most measures, LMT is too rich at these levels, and its above-average yield of 3.3% doesn’t compensate us for the additional risk.
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Boeing (BA), which also has a sizable commercial business, is even more expensive. It trades at 19.5 times earnings and has a CAPE ratio of 33.7 – both well above reasonable valuation levels relative to the growth the company has experienced.
In the long term, these defense companies face serious headwinds that will materially impact their growth potential.
There are indications that the federal government will be unable to continue its current levels of defense spending.
Budget Battle Weary
The following chart from the Congressional Budget Office (CBO) below illustrates the problem with current government spending trends.
By 2024, it’s estimated that the three largest budget items – Social Security, healthcare and debt service – will consume 100% of federal tax revenue.
Of course, this level of spending is completely unsustainable. Even though politicians will do everything they can to spend recklessly, fiscal restraint is inevitable in the end.
Using CBO numbers, defense spending is destined to fall. This decrease is understandable, considering that the United States already spends a tremendous amount on its military.
All of this means that defense firms will face a dwindling revenue source.
As we’ve shown, these companies are being priced as if aggregate defense industry revenue will continue to increase indefinitely.
The defense industry used to be a defensive sector, like healthcare and consumer staples, due to its non-cyclical revenue stream. Now, defense stocks seem to be priced for perfection and are sure to surprise investors looking for protection – with or without war.
Richard Robinson, Ph.D.