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Even though President Bush's proposed $379 billion defense budget was higher than what many experts expected, it wasn't a huge surprise to Wall Street. The smart money had already bid up major defense stocks in recent weeks, with

Lockheed Martin


up 14% year to date and



up 15.1%.

Jim Zhao,
Defense Analyst,
Federated Investors

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But it's not too late to invest in the sector, according to Jim Zhao, a defense analyst with Federated Investors. Zhao believes these stocks will continue to benefit from increased defense spending over the next three to five years. Specifically, he believes that stocks of military contractors that execute well on their business plans stand to increase as much as 15% in the near term. And once the economy begins to recover and investors rotate out of defense stocks and into consumer cyclicals, that should be an especially good time to buy defense issues.

Read on to find out which areas of the defense industry Zhao believes stand to benefit most from America's New War and why.

TSC: In the days immediately following the attacks of Sept. 11, most defense analysts, you being no exception, said that they did not know which areas of the defense industry would benefit from increased vigilance against terrorists until it became clearer what kind of war we would wage against Afghanistan, for starters. Do you have any greater insight now on this question?


A pretty widespread group of companies stands to benefit. But specifically, I think it's more focused on the Air Force, mobility, JSF's

joint strike fighter or F-35's, which are the same thing. The prime contractors are Lockheed Martin,

Northrop Grumman


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, and Raytheon.

The cutback is probably in the Navy vessels, which would impact

General Dynamics


and, to some degree, Northrop. Those are the two big shipbuilders in the U.S.

TSC: Why a cutback in the Navy?


I don't know, but the number that came out seems to be on the low side for the Navy. I guess the emphasis is on mobility and long-range fighter planes. So the money gets shifted there.

TSC: As a defense analyst, you work with various portfolio managers at Federated. Which ones have a fairly large exposure to the defense sector? And are you finding an increased interest in investing in defense among the portfolio managers?


Actually, all of the funds have pretty good exposures there, and we have a wide variety of different holdings of the defense stocks;

we own probably every stock in the defense sector, except



, because of its commercial aerospace exposure.

And, yes, the portfolio managers are paying more attention, particularly with respect to Bush's intended '03 military budget. Going forward, it seems like it's a multiyear defense spending increase, setting the stage for multiyear earnings growth.


Federated Capital Appreciation Fund,


Federated Stock and


Federated American Leaders are three of our larger funds that have defense contractors in their top holdings.

TSC: What is your overall take on the president's proposed increase in military spending?


I think it's a great thing for the defense stocks. But before the announcement, there were a lot of expectations built into the stocks. So, I would say that right now the stocks are a little rich. But they still are our core holdings going forward just because the earnings perspective for the next three to five years is



TSC: If the expectations have already been built into the stock prices, is it worth it for an investor to get into this sector now or is it too late?


I would go into new positions on the pullback ... that is likely to happen once the economy begins to recover and investors put their money into consumer cyclicals. Based on the '03

budget number, I would say these stocks are fairly valued. They probably have 10%, 15% upside from here. It's probably not worth building a large position. But if the stocks pull back, and it could happen if people started to rotate into cyclical names, expecting the economy will recover, defense names will get pulled back. And that would be a good time to establish a new position there.

That's the main risk going forward -- cyclicals stealing the momentum. But in terms of earnings, these companies do not have earnings risks in the next few years. But I will still be paying close scrutiny to management and execution. While the macro environment for defense stocks is very positive, if the management of these companies cannot execute nimbly, that would be a factor analysts and the Street would take into serious consideration.

The Street has already factored in these earnings, so it's up to the companies' execution to make it happen. At these valuations, you really have to pick the right companies; but if it were on a pullback, I wouldn't worry too much about it.

TSC: The defense industry is a rather unusual one, with only a few names dominating, most of which you have named. Are there any smaller companies you are recommending to the portfolio managers as well?


Alliant Techsystems


, a warhead and missile propulsion systems maker that will benefit directly from replenishments after the war. And

L-3 Communications


, which is a faster-growing company. They are the leader in the communications side of the business for defense and electronics, and they also are a player in airport screening. They are growing their well-diversified business through roll-ups, and are well-positioned to benefit from the expected increase in spending in all of those areas.

TSC: Is there anything specific worth noting about the president's proposed 14% increase in the budget?


Yes, it's higher than what most people were expecting, and the trend looks like it's a multiyear increase, with both the government and the public now in support of a deficit budget to support these efforts.

With the '02 budget at $330 billion, and the proposed '03 budget at $379 billion, I would call that a significant increase; and from '90 to the mid '90s, you actually saw the defense spending going down. This is a major turning point.

But, what we really care about is the procurement and R&D spending, what we call "hardware spending," because while the lion's share of the military budget goes towards personnel,


where the money actually goes to those defense contractors.

The procurement for this year is $68 billion, vs. $61 billion in '02. And R&D is $54 billion in '03, vs. $48 billion in '02.

TSC: What's your thinking on the possibility of future terrorist attacks and the subsequent effects on defense spending and homeland security?


Our belief is that you are going to see defense spending going up, that the war is not going to be over after Afghanistan. It's going to be lasting much longer than people expect. Probably not going to take a dramatic form, as in Afghanistan, but we are going to see ongoing public support for defense spending.

TSC: In closing, what's your personal outlook for defense spending?


On a macro view, and fundamentally, the money is going to be increasing. Before, we were worried about the budget surplus impact on defense spending. But after 9/11, the public support for defense spending is much higher now. We are willing to go into a deficit, just to support defense spending. So the macro environment is very positive.

In terms of defense stocks, momentum is still very strong, but because of the high valuations, the upside for defense stocks in the near term is probably limited because we got what we expected for '03 spending.

So now we just have to wait and see how companies execute and get the numbers. We will be paying special attention to management.