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Here's How to Profit from
Uncle Sam's Spendthrift Ways |
Published:
April 21, 2008
Most
investors have heard the argument for defense stocks on
countless occasions. The basic pitch goes something like this: if there's one consumer that never stops spending, even in the
weakest economies, it's Uncle Sam. And defense remains a key
destination for much government spending; therefore, companies
that sell defense products and services to the government are
sure-fire winners.
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There is truth to this argument. After all, as you can see in
our chart, U.S. government spending has been rising steadily
for years. And in most cases, spending growth has outpaced key inflation gauges such as the consumer
price index (CPI). The numbers |
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highlighted on this chart are real, inflation-adjusted figures.
And as you can see, the size of the budget has grown through
good economies and bad, and through both Republican and
Democratic administrations.
But even as total spending increases, individual government contracts can and do get cancelled and delayed. And when that happens, firms
with exposure or reliance on those programs can get hit. For
example, in the early 1990s, the A-12 Avenger II Stealth aircraft was a major new
aircraft project for the U.S. Navy. Dick
Cheney, then the Secretary of Defense, decided to cancel the
Navy's orders for the $165 million planes in 1991. The
developers of the plane, including McDonnell Douglas, got hit on
the news.
Security over Defense
Despite these periodic hiccups, the basic argument for
investing in stocks levered to continued government spending
holds water. And there are areas of the Federal budget less
exposed to budget cuts than high-profile, expensive weapons
systems.
Since the devastating terrorist attacks of September 11, 2001,
spending on national security and safety has ballooned. The list
of projects includes upgrades to security systems at airports,
more advanced scanning equipment for vehicles crossing U.S.
borders, and even sophisticated equipment for identifying and
recognizing facial features of known terrorist suspects in
crowds. Security spending has also involved buying equipment
for so-called first responders -- firefighters, police officers
and emergency medical personnel.
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Much of this security spending is no longer part of the budget
for the Department of Defense (DOD), but is instead budgeted for
the Department of Homeland Security (DHS), a relatively new
department created after September 11th. Our chart shows
Federal outlays for |
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the DHS going back to 1995 and projected out to 2009. The
figures prior to the creation of DHS are estimated based on
security-related spending by the DOD.
Large-scale defense programs can become political footballs at
times; politicians highlight expensive weapons systems spending
as a sign of government waste. For example, the U.S. missile
defense shield has come under fire recently due to cost overruns
and strong resistance by the Russian government. Such high
profile and expensive projects are subject to cancellation or
delay.
But it's politically tough to oppose spending on a new X-ray
system or high-tech equipment designed to keep Americans safer.
Seven years after the 9/11 attacks, terrorism remains a major
fear among most Americans, and recent attacks in major foreign
cities, including London, have re-awakened those concerns. As a
result, spending on safety and security should continue to rise in the coming years.
Moreover, U.S. defense spending is likely to top $460 billion in
2008, roughly 16% of the more than $2.7 trillion U.S. federal
budget. Meanwhile, funding for the DHS will reach just under $70
billion by 2009. While DHS spending is growing quickly, it
remains far lower than the overall defense budget. This should
make DHS spending less of a target during the next round of
government budget cuts.
New Defense
But it remains a big mistake to ignore the pure-play defense
contractors entirely. Even when overall defense spending falls
or growth in the DOD budget moderates, certain niche markets
should continue to grow.
Every four years, the government publishes the Quadrennial
Defense Review, offering a basic plan as to the focus of
future spending. In the most recent review, released in 2006,
the DOD indicated that the focus of future defense spending will
be on high-tech systems designed to help fight unconventional
wars rather than large-scale conventional weapons systems.
For example, the review proposed a +15% increase in the size of
U.S. Special Forces. To help support these enlarged forces, the
Review included plans for more spending on advanced secure
communication systems that can allow communications with
soldiers imbedded deep in hostile territory.
In addition, the DOD has reaffirmed its support for the
so-called Future Combat Systems (FCS), a modernization program
for the U.S. military. A cornerstone of this plan is unmanned
surveillance vehicles. For example, the DOD cancelled plans for
a new helicopter dubbed "the Comanche" and re-allocated those
monies to developing new unmanned aerial vehicles capable of
tracking the movements of enemy forces or insurgents remotely.
The military also has plans for unmanned ground and sea
vehicles.
Thus, even if some high-profile conventional weapons projects
are cut, the DOD's modernization drive is likely to see
continued funding, boosting the bottom lines of quality security
and defense contractors.
Important Note: In the
remainder of this article,
Market Advisor editor Paul Tracy provides two in
depth profiles of two of his favorite security and defense
contractors, both of which are expected to profit immensely from
the expanding U.S. budget and achieve at least +20% earnings
growth for the next 5 years. However, in order to view the
remainder of this article, you'll need to subscribe to our
premium
newsletter --
Market Advisor. After you subscribe, you'll
receive immediate access to this full article, as well as our
monthly
Market Advisor newsletter and a host of
additional premium content. Please visit one of the following
links to continue.
-- Paul Tracy
Editor
StreetAuthority
Market Advisor
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