Investors train sights on defense

The US defense industry - hammered by consolidations, mergers, and shrinking budgets during much of the 1990s - is poised for growth during the first decade of the new millennium, analysts say.

Defense budgets, especially procurement outlays, are expected to rise - good news for defense-firm front offices.

Following a review of the US military by the Bush administration, new smart-technology-based weapons systems - including a limited "star wars" antimissile system - are expected to take precedence over older battlefield-oriented weapons programs. That means added dollars for scores of high-tech firms.

But the boost for defense is not just a byproduct of the new presidency. The pace had accelerated in the final years of the Clinton White House and that support is not expected to change with the US Senate under Democratic control.

Wall Street has taken notice. Aerospace/defense profits soared more than 50 percent last year. For the first quarter of this year, profits were up 69 percent compared to the first quarter of 2000, according to Standard & Poor's Corp. Major firms, including Boeing, General Dynamics, Lockheed Martin, and United Technologies, turned in hefty gains.

No one is talking about a return of the enormous - critics would say, profligate - defense budgets that characterized the 1980s. But analysts agree that the downsizing of the industry in the 1990s is over, and outlays for defense will show a steady, gradual rise this decade.

Between 1987 (the high point for defense spending in the Reagan years) and 1997, spending for procurement (weapons systems and goods) fell 36 percent, according to analysis by DRI-WEFA, an economics consulting firm in Lexington, Mass.

"We see spending for military procurement rising between 4 and 6 percent [each year] through the decade," says Sara Johnson, an economist with DRI-WEFA. Such growth exceeds the firm's annual growth forecast for the US economy of about 3.3 percent.

Some experts, in fact, are even more optimistic. Paul Nisbet, who heads up JSA Research, a Newport, R.I., firm that monitors the defense industry, says he believes procurement spending will rise 50 percent over the next four years, from $60 billion in 2002 to about $90 billion in 2006.

Total defense budgets - which include salaries, pensions, maintenance costs, operations, and all other military-related expenses, including procurement - are expected to rise at a slower pace this decade.

With some rare exceptions, much of the additional dollars for procurement will go toward funding newer, lighter, and more-agile weapons systems, and away from the big-ticket programs of the past several decades, Mr. Nisbet says. While the Bush administration has not yet finished its review of the existing defense structure, Nisbet expects a downsizing of the Army, and an upgrading of programs that deal with terrorism and ethnic/guerrilla conflicts.

While some analysts had anticipated a boost for the controversial B-2 bomber program under Bush, any major expansion is now in question with the changeover in the US Senate, says Peter Arment, a defense analyst with JSA Research. Mr. Arment also expects development of an antimissile program "to be slowed." But overall procurement budgets will "continue to grow" at a steady clip, he says.

Northrop-Grumman Corporation, which would be a primary beneficiary of a renewed B-2 bomber program, is still expected to profit as a leader in development of pilotless surveillance aircraft.

Although Wall Street has traditionally had a love/hate relationship with defense contractors - in large part stemming from their volatility, reflecting whether they are politically in or out of favor - many individual investors balk at supporting firms that make weapons of war. A number of socially responsible mutual funds, for example, screen out defense-related stocks. Among them: the Domini Social Equity Fund and the Pax World Fund. But defense firms insist they are defenders of democracy - that by making military products, they help the US remain strong and reduce the likelihood of war.

Whatever the case, many mutual-fund investors have a few defense stocks in their holdings. As of May 21, for example, some 1,549 of the 2,889 equity funds tracked by Morningstar held selected aerospace or defense stocks. But only a handful of these funds held more than 10 percent of their assets in defense/aerospace stocks.

Interestingly, the more aerospace/defense stocks the fund held, generally the higher the annual return.

For boosters of the defense sector, one fund, the Fidelity Select Defense and Aerospace Fund, is considered a "pure play" within the sector. It's up 8 percent this year.

In the case of individual stock holdings, the best play, according to Nisbet, is among mid- and small-cap defense firms that tend to have low price-to-earnings ratios. He considers most large firms, such as Boeing and Raytheon, to be fully or close to fully priced.

(c) Copyright 2001. The Christian Science Monitor