Getting Armed for a Defense Stock Portfolio

Like football fans in the upper deck, mutual fund managers have been chanting "defense" over and over lately. But those cheers could quickly turn to jeers if the industry doesn't win some big upcoming budget battles in Washington.

Defense stocks have been on a spectacular, albeit stealthy, run since last summer. Flying well below the market's radar, the Philadelphia defense index, which tracks the 17 largest defense and aerospace companies, is up 30% over the past year -- more than double the return of the S&P 500 Index(SPX). In the fund world, the (FDSAX)Fidelity Select Defense & Aerospace fund, one of the few funds devoted to the sector, is up 13% year to date, a full 10 percentage points better than the S&P.

Most recently, defense sector stalwarts Lockheed Martin(LMT), Northrop Grumman (NOC) and L-3 Communications(LLL) blew away Wall Street's second-quarter earnings estimates and raised full-year guidance, citing continued strength in defense spending and growth in homeland security projects.

Mutual fund managers benefiting from the sector's run-up expect the rally to continue through the end of the year. Nevertheless, they are trying to temper investor enthusiasm for a group that has returned to trading on congressional votes instead of responding to terrorist strikes.

Permanently Committed

"There will always be a need for defense," says Dan Ahrens, portfolio manager at the (VICEX)Vice fund. "We are permanently committed to it." Ahren's fund, which invests solely in alcohol, gambling, tobacco and defense stocks, is up 6.8% this year.

That commitment to the national defense costs taxpayers about $400 billion a year, with the bulk of that going toward maintenance and operations. Roughly $150 billion of that sum is targeted for defense contractors, an amount that will remain virtually unchanged from 2005 to 2006.

One might think the flat year-over-year budget for big-ticket weapons would limit the upside for defense stocks after their monumental run. However, a number of analysts say there are a few potential positives that should keep the group marching on, although perhaps at a slower pace.