Only Some Defense Firms Will Benefit From War on Terrorism

While some investors are still licking their wounds from last week's market free fall, others see the plunge as an opportunity to buy oversold stocks.

Indeed, given the recent damage to the market, several options exist. But because the terrorist attacks have turned the business world upside down, many mutual fund managers are waiting to see just how the disaster affects businesses. But a majority of money managers agree on at least one sector: aerospace, defense and intelligence companies will benefit from the U.S. war on terrorism.

What fund managers don't know, however, is just how the U.S. will fight terrorists armed with box cutters. Will large, traditional military contractors receive the lion's share of the military budget, or small outfits specializing in intelligence and surveillance?

Some political authorities predict that Congress will approve a one-third increase in the $300 billion military budget for the fiscal year that starts Oct. 1, 2002.

Evidence of the uncertainty among money managers can be seen in the performance of mutual funds with heavy defense holdings as well as individual stocks. Even the best-performing defense funds have lost ground since the Sept. 11 attack. For example, (ISCAX Quote)Federated International Small Company fund and (EMMAX Quote)Federated Emerging Markets have fallen 10.9% and 13.4% respectively. And (FSDAX Quote)Fidelity Select Defense & Aerospace and (FSAIX Quote)Fidelity Select Air Transportation are down 0.51% and 22.5%, respectively.

Performance of Funds With Heavy Defense Exposure Since Sept. 11: Even the 10 best-performing funds are not yet responding to the crisis
Fund	9/17/01-9/26/01 Performance	Three-Year Performance*	Current Percentage of Holdings in Aerospace/Defense
Corbin Small-Cap Value	2.0%	-2.3%	21.4%
Bonnel Growth	-0.1	5.5	10.9
Gabelli ABC	-0.1	11.3	12.2
Nuveen European Value	-0.2	4.3	10.1
Gabelli Mathers	-1.2	3.4	23.8
BlackRock International Small Cap	-2.1	22.4	12.2
Federated International Small Cap	-2.3	2.37	15.7
Fidelity Select Defense	-2.5	9.0	61.9
SG Cowen Income + Growth	-2.5	12.3	11.2
GE International Equity	-2.6	-3.4	15.7
* Through 9/26/01; Source: Lipper

Most defense stocks also are flat to down. For instance, while General Dynamics (GD Quote) has increased 8% between Sept. 17 and Sept. 27, Lockheed Martin (LMT Quote) fell 1.5% and Boeing 3.9%.

An adviser to the Pentagon says the government will invest in the military budget on all fronts. "All six of the major military contractors are going to be beneficiaries in the coming surge in defense spending: Raytheon(RTN Quote), TRW(TRW Quote), Northrop Grumman(NOC Quote), Boeing (BA Quote), Lockheed Martin and General Dynamics," says Loren Thompson, the chief operating officer of Lexington Institute, a military-strategy think tank.

The war will be fought by air, by sea and by cunning, adds Thompson. "You will also see funding for electronic intelligence gathering, smart bombs and smart munitions."

Picking Their Targets

But Wall Street isn't so certain. Some fund managers are placing their bets on the big military contractors, while others believe the war on terrorism will increase the value of specialized munitions and surveillance companies.

"It's hard to pinpoint which companies are going to benefit from the defense budget increase," says Jim Zhao, a defense analyst at Federated Investors, which has defense companies in 18 of its funds.

Zhao recommends avoiding military contracting companies that have large commercial airline divisions, such as Boeing (BA Quote) , which derives 60% of its revenue from the commercial airline industry. "I'm looking for those that are pure-play military," he says.

Going High-Tech

On the other hand, managers at mid- and small-cap funds believe that innovative, high-tech companies and subcontractors will outperform large contractors during this crisis. John Rutledge, portfolio manager of the (ETCAX Quote)Evergreen Technology fund, for example, invested in L-3 Communications(LLL Quote), which makes "avionics" -- high-speed radio-wave communications systems specially designed for military vehicles.

"This is the ideal type of military stock to own, given the current challenge we face," Rutledge says. "This is going to be a war based on intelligence."

David Corbin, manager of the (CORBX Quote)Corbin Small-Cap Value fund, is approaching aerospace/defense investing slightly differently. Corbin has allotted 21.4% of his mutual fund to military stocks -- one of the largest exposures. He searches for companies that have commercialized at least part of their businesses.

SureBeam(SURE Quote), for instance, has developed a meat and produce scanner that checks for chemicals or bacteria. "Originally, that technology was developed as part of Star Wars [President Ronald Reagan's defense initiative]," Corbin says.

John Rogers, an analyst who follows Boeing for Oregon-based investment banking firm D.A. Davidson & Co., says that one safe investment is replacement-service parts. Rogers says it will take a while before the money in the military budget reaches companies, thus delaying any building of new products. In the interim, armed forces will just upgrade old equipment.

Meanwhile, some portfolio managers are considering security companies. Evergreen Technology's manager Rutledge also holds ChoicePoint(CPS Quote), which screens employees' identification and credentials. Corbin, the manager of Corbin Small-Cap Value, is considering private security companies such as Wackenhut(WAK Quote).

Adding to the conundrum, only a handful of funds focus exclusively on aerospace and defense. Two such funds include Fidelity Select Defense & Aerospace and Fidelity Select Air Transportation. In comparison, Federated International Small Company fund has nearly 16% of its assets in aerospace/defense contractors, while Federated Emerging Markets has 7.5%.

Even though money mangers are quick to develop funds that follow trends, not many new defense funds will be opened in this poor market environment, says Donald Cassidy, senior analyst at Lipper. Investors seeking to take advantage of an increase in defense spending might be better served by buying a select group of stocks, he says.