Playing Offense with Defense Contractors

Yesterday was one heck of a day for the consumer nondiscretionary stocks thanks to Kraft's (KFT - commentary - Trade Now) bid for Cadbury (CBY - commentary - Trade Now). I sincerely hope that you profited from my March piece, "Final Four From the Supermarket Aisles," wherein I identified Cadbury as my favorite in the Candy Division and a potential acquisition target. The stock was up 38% yesterday!

While I'm at it, I might as well throw in another shameless plug and mention that I nailed all four sector brackets. Since the article was published through yesterday's close, the four companies I selected as winners have outperformed the four that I pitted them against. So I'm officially declaring the tournament over!

Today, however, I would like to broaden the discussion beyond the Cokes (KO - commentary - Trade Now), Colgates (CL - commentary - Trade Now) and Nestles (NSRGY - commentary - Trade Now) of the world. Let's talk about the defense contractors that share the key characteristic of recession resistance but trade at even better valuations than the staples.

Take a look at Raytheon (RTN - commentary - Trade Now), for example. It has a very well-diversified book of business with no single contract accounting for more than 3% of revenue, and it has a strong balance sheet and trades for a forward p/e of about 9.

Want to get to a forward P/E in the 8s? Take a look at Northrop Grumman (NOC - commentary - Trade Now). This company yields 3.5% and may well benefit from the new administration's approach -- the Pentagon is shifting spending priorities toward some areas where Northrop has strength, such as cyberwarfare technologies and unmanned planes.

And that brings us to my one caveat with the sector -- the unpredictable nature of the Pentagon. You never know when a program will get pulled or whether a major bid is going to be successful. Just look at Lockheed Martin (LMT - commentary - Trade Now) after news broke that the F-22 was being terminated. The stock quickly moved from the $80s to the $70s.

For that reason my approach favors a large basket with small position sizes. But the bottom line is these are high-quality businesses because they have terrific customers -- governments that can just keep printing money.

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For what it's worth, here's how I'm playing my Cadbury shares: I sold half the position yesterday and bought puts on the other half. Seeing the selling pressure in Kraft, I initiated a small position there.

Long CBY, KO, CL, NSRGY, RTN, NOC and KFT.

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At the time of publication, Masino was long CBY, KO, CL, NSRGY, RTN, NOC and KFT, but positions can change at any time.

Rich Masino is president of Private Investor Research and editor of The Substantial Investor. He is a private investor who manages a family long/short investment portfolio that holds numerous positions across a variety of asset classes.

Before starting Private Investor Research, Mr. Masino co-founded a telecommunications company that grew to 500,000 customers. He sold all of his interests in the company in 1998.

He holds an MBA in finance from St. John's University.