Defense stocks revive - but for how long?

Defense and aerospace stocks had been becalmed in an ocean of investor indifference for about a year. But last week, a brief gust of buying swept the group when veteran takeover artist T.Boone Pickens put Boeing on his shopping list. ``Clearly, the ultimate value man, T.Boone Pickens, recognizes this group is dirt cheap,'' says Michael Lauer, an analyst with Oppenheimer & Co.

Defense issues are trading at 7 to 12 times earnings, while the overall market trades at about 17 or 18 times earnings.

Indeed, the Dow Jones industrial average widened the price-earnings gap last week as it climbed to record highs. It closed Friday at 2572.07, up 86.74 points. Strong earnings and takeover talk fueled the rally.

So far this year, the Dow industrials are up a whopping 35 percent. But Standard & Poor's aerospace index has climbed only 15 percent.

By most standards, these issues are a bargain. And Mr. Pickens is undoubtedly savvy. But Wall Street is generally not convinced this group will offer the best investment returns.

``It's not an industry money managers are flocking to,'' observes Robert Kugel, a defense analyst at Morgan Stanley & Co. ``They're very cheap stocks but there's no `hook' here.''

``Bleak'' is how Peter Aseritis at Smith Barney, Harris Upham & Co. describes the industry outlook.

Defense contractors are beset by negatives - which, to many other people, are probably positives:

Waning defense spending. The expected outlay of $295 billion in 1988 will mark the third consecutive year of a real dollar decline in United States spending. Defense spending is dropping among major industrial nations, except for France.

Arms control progress. Last week, another stumbling block to banning intermediate-range missiles was hurdled. Improving prospects for an arms agreement, perhaps capped by a Gorbachev-Reagan summit this fall, led investors to expect further defense spending cuts.

Some analysts contend that a cut in cheap but powerful nuclear weapons would require a compensating increase in more-expensive conventional weapons in Europe. But as Mr. Kugel says, ``After completing a major peace treaty, it would be hard to convince people you ought to spend more on conventional weapons.''

A tougher customer. The federal government continues to crack down on defense contractors for improper billing. It is using multiple suppliers to increase competition among contractors. And it is pushing contractors to foot more of the research and development bill, thus increasing investment risk, since some companies won't get the production contract. ``Since 1984, margins have been declining at a fairly rapid rate,'' notes Kugel.

Presidential politics. Uncertainty over the defense budget grows with the election of a new president next year. ``President Dukakis, for instance, would be very different from President Bush,'' points out Mr. Aseritis.

Contrarians may find this an ideal hunting ground. But one doesn't have to be contrarian, just more discriminating, says Mr. Lauer at Oppenheimer.

``While there may be no growth in the general aerospace markets over the next five years, the defense electronics industry should grow 3 to 5 percent annually, with selected sectors recording a higher gain,'' he notes.

His favorite sector? Antisubmarine warfare.

Specialists in this area include small companies such as Diagnostic/Retrieval, Sippican, EDO, and Sparton. The uncovering of the surreptitious sale of software and machinery to the Soviet Union by Japanese and Norwegian companies has boosted the prices of those stocks about 20 percent in recent weeks.

Even so, Lauer says, ``they're still very cheap, selling substantially below previous highs.''

Last week, a classified Defense Department study estimated it would cost $8 billion to $10 billion over the next 10 years to reestablish the US edge. That money won't all go to antisubmarine warfare, and what does will take time to be appropriated, but ``clearly these firms will continue to gain a larger piece of the procurement pie,'' says Lauer.

Despite the dour industry forecasts, several analysts believe Martin Marietta, Northrop, and Raytheon are profitably bucking the trend. Martin Marietta is the biggest holding of the Fidelity Select Defense and Aerospace Fund.

``They've got a good backlog of orders,'' says fund manager Brad Lewis, ``a solid base of business. They're building defense electronics business and selling at 10 times earnings.''

Aseritis points to growth coming for Martin Marietta's Titan heavy booster rockets, which the Air Force is using in lieu of the space shuttle. The Air Force has already placed a $4 billion order. Further orders, says Aseritis, could increase sales to $8 billion.

Lauer at Oppenheimer thinks Raytheon, selling at about $81 now, is a $100 stock. ``The company's got a 21 percent return on equity with two major operations [energy and aircraft] losing money,'' he says. ``Imagine what they could do without those units or if they started making money?'' Lauer notes that the downside is somewhat limited by an aggressive stock buyback program.

Northrop stands to benefit greatly from the Advanced Technology Bomber (Stealth) program. Dean Witter Reynolds added the stock to its buy list last week on this basis. Likewise, Lockheed is one of two contenders for the $45 billion Stealth fighter program, due to be awarded in 1991.

Both companies are considered takeover candidates, and their prices have run up on rumors in recent months. ``There's not much upside left in Lockheed unless Ford comes along and opens its wallet,'' notes Mr. Lewis at Fidelity.

Kugel acknowledges the relative strength of Martin, Northrop, and Raytheon. But he has no buy recommendations. ``To recommend these stocks is like telling you I have the most attractive houses on a lousy block.''