Vladimir Putin invades Ukraine and sabre-rattles about nuclear weapons. Xi Jinping says he wants his military to be ready to invade Taiwan by 2027.
Then there’s Iran and North Korea. Both implacably dislike the U.S. and are formidably armed.
You see, then, why I think defense stocks are timely now. In my model portfolio (the stocks I own for most clients), three of the 25 slots are currently reserved for defense stocks.
Here’s a look at those three, and three more I think are promising.
General Dynamics
General Dynamics Corp. (GD, Financial) is one of the most diverse of the defense contractors, producing tanks, nuclear submarines, destroyers, armored personnel carriers and military electronics. In my opinion, it’s also one of the best run.
One thing I look for in a company is the ability to earn a 15% return on stockholders’ equity fairly consistently. General Dynamics has done that 10 years in a row, and in 14 of the past 15 years.
As a sideline, General Dynamics makes Gulfstream business jets. The Covid pandemic gave this segment a boost by making commercial flights less attractive.
Northrop Grumman
With sales of about $37 billion a year, Northrop Grumman Corp. (NOC, Financial)is one of the largest defense contractors in the world. It has a broad product line, including missiles, drones, satellites, stealth bombers and a variety of aircraft parts.
It has achieved a 20% return on equity or better nine years in a row. The figure for the past four quarters was 33%. Given all that, you might expect the stock to be expensive, but it’s not too bad, at 20 times estimated earnings.
Analysts expect that earnings will go down this year. The reasons are complicated, but one element is that Congress is under pressure to cut spending, perhaps including military spending.
I think defense cuts will be debated, but not passed, given the palpable threats from Russia, China, North Korea and Iran.
Lockheed Martin
The proprietor of the famous Skunk Works in Palmdale, California, where many top-secret defense projects are developed, is Lockheed Martin Corp. (LMT, Financial). Lockheed is the largest U.S. defense contract, with annual revenue of about $66 billion.
Lockheed’s profitability over the years has been astounding. I consider a return on equity of 20% or more to be outstanding. Lockheed has been above 50% at least 15 years in a row.
That profitability figure was magnified by the use of debt. Lockheed currently has debt equal to 162% of stockholders’ equity, which is more than I would normally accept. However, given the consistently powerful profit performance, I think the debt load is acceptable.
Ducommun
A small stock I like is Ducommun Inc. (DCO, Financial) of Santa Ana, California, which makes aerospace components for Boeing Co. (BA, Financial) and others. It is about 67% military and 33% civilian. Revenue in the past four quarters was about $730 million – far smaller than the other stocks mentioned today.
At the recent price of $44, Ducommun shares go for just about book value (corporate net worth per share), and 0.75 times revenue. That’s bargain territory in my book.
Only four Wall Street analysts cover this small company. (Three call it a “buy.”) But some big-name investment managers own it (as of March 31 filings). They include Chuck Royce (Trades, Portfolio), Jeremy Grantham (Trades, Portfolio), Jim Simons (Trades, Portfolio) and Mario Gabelli (Trades, Portfolio) -- or at least their firms.
Leonardo
The largest defense contractor in Italy is Leonardo S.p.A. (MIL:LDO, Financial), headquartered in Rome. The Italian government owns about 30% of the company. It makes helicopters, aircraft, aircraft parts and military electronics.
Past profits have been erratic, but I like the stock for two reasons. First, I believe that European countries will be forced (mainly by the threat of Russia) to increase their defense spending. Second, Leonardo’s stock is quite cheap at seven times the past four quarters’ earnings.
BAE Systems
The largest defense company in Great Britain is London-based BAE Systems Plc (BAESY, Financial). At 18 times recent earnings, it’s not as cheap as Leonardo, but its profit record is more consistent. BAE has achieved a 20% return on equity or better in 11 of the past 15 years.
BAE stock has doubled in the past three years, but it made no net progress in the seven years preceding that. Fighter jets are the company’s specialty. Beyond Britain, it has substantial sales to the U.S. and Australia.
John Dorfman is chairman of Dorfman Value Investments in Newton Upper Falls, Massachusetts. His firm or clients may own or trade the stocks discussed here. He can be reached at [email protected].
