Several aerospace and defense companies recently posted record quarters.

Axsys Technologies

( AXYS),

Applied Signal Technology

( APSG),

Hi-Shear Technology

( HSR),

Raytheon

(RTN) - Get Report

and

Elbit Systems

(ESLT) - Get Report

are top-sector performers, according to our quantitative model. As our list of "buy"-rated stocks dwindles, these five have maintained the highest marks, indicating strong fundamentals.

On the flip side, here are three aerospace and defense stocks that have recently underperformed.

Aerosonic

(AIM) - Get Report

,

Tri-S Security

(TRIS)

and

Environmental Tectonics

( ETC) are rated "sell" by our quantitative model. However, all three companies improved revenue, lowered their net loss and made progress toward profitability in the latest quarter.

Defense stocks usually hold up well during recessions because a substantial portion of industry revenue is derived from U.S. government contracts. Still, stock-market pessimism and political uncertainty are risks. Key legislators are advocating a cut in defense spending to counter increased spending on the financial bailout. Pentagon officials recently warned that defense spending is on the chopping block.

Speculation that the Obama administration will increase contract oversight is adding to worries. That would make it more difficult for defense companies to win government contracts and might put pressure on an industry accustomed to wide margins. The 2009 Defense Authorization Act was passed on Oct. 14. Two of the bill's main goals are to restrict the use of non-competitive contracts and to provide more transparency on government spending.

Analysts predict that some defense companies stand to benefit from more competition. Small firms with innovative technologies may be poised for a jump. Prime contractors and those involved in combat-systems development, an arguably bloated portion of defense spending, could be damaged by new legislation.

There appears to be consensus that defense spending will remain intact for the first year of the new president's term, assuming prolonged economic weakness. The war in Iraq and increased military involvement in Afghanistan could benefit companies. Current uncertainty may represent an unusual buying opportunity or, alternately, a forecast of future decline. Consider macroeconomic, political and idiosyncratic risk before investing in aerospace and defense companies.

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