Three Reasons to Like Defense in 2008

As the Presidential election process moves forward, next to New Hampshire and then beyond, one of the many issues that will be discussed is defense spending. But regardless of the headline-grabbing babble coming over the coming months, I believe defense stocks will have a strong 2008.

Last week, I took to task the commonly held belief that Republicans are better for defense stocks than Democrats. The data suggests that there simply is no correlation between the political party of the President or Republican representation in Congress and the main driver of defense stocks, growth in budget authority for procurement and RDT&E, which together I refer to as "modernization" spending.

Budget authority is the "legal authority for an agency to enter into obligations of dollars in a certain amount" that will -- typically one to two years or more later -- result in cash outlays, meaning actual disbursements by the Treasury. Outlays means revenue for the defense contractors, but budget authority is a leading indicator and is thus more predictive of defense-stock price performance. Most investors focused on this sector key off of budget authority.

With those terms defined and that myth now thoroughly debunked, let me take a minute to explain why I believe this year will be a good one for the pure-play defense stocks, which are held in both the Dow Jones U.S. Aerospace & Defense Index Fund (ITA - commentary - Cramer's Take) and the PowerShares Aerospace & Defense Fund (PPA - commentary - Cramer's Take).

First, look around the world. In addition to the ongoing Global War on Terror (which is funded in a separate, supplemental budget), there are plenty of volatile parts of the world that are causing some sleepless nights for folks in the Pentagon, including Iran, North Korea, India/Pakistan, and, importantly, China -- just to name a few.

There is certainly a high threat level right now that is likely to persist for many years to come and historically budget growth tends to go hand-in-hand with high global threat levels, regardless of the political party in the White House or dominating Congress.

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At time of publication, Norton had no positions in the stocks mentioned, though positions may change at any time.

Charles L. Norton, CFA is a principal of GNI Capital, an equity long/short money management firm that provides investment management services to institutional clients including mutual fund sponsors, trust companies, investment advisory firms, corporate retirement plans and family offices. Mr. Norton is responsible for portfolio management and investment research for all of the company's managed assets, including the Vice Fund (VICEX) and the Generation Wave Growth Fund (GWGFX). Previously, Mr. Norton had been a vice president in the equity research department of a New York-based hedge fund, where he also managed separate long/short equity accounts. Prior to his experience on the buy side, he was an investment banking analyst at Smith Barney. He has a bachelor of science in management degree in finance from Tulane University's A.B. Freeman School of Business, and is a CFA charterholder. He is a member of the CFA Institute and the CFA Society of Dallas-Fort Worth. While Mr. Norton cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.