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.
Tom West, defense analyst for Columbia Management, points out that despite the government's growing budget deficit, defense spending comprises just 3% to 4% of GDP. And while that may seem high, it's still far off the 7% figure hit under President Reagan. "It's not a lavish budget," says West. "We are still making up for some of the underspending of the 1990s. The average age of our equipment is still rising." Moreover, supplemental budgets are often passed by Congress and not taken into account on Wall Street. Tim Bei, defense analyst for T. Rowe Price funds, says many investors worry about a budget freeze later this year, but forget to consider the $80 billion supplemental budget that was passed in May. "Most of that was for M&O, but $15
billion to $20 billion was for procurement," says Bei. "And it won't be spent until 2006." Of course, at the root of the supplemental budget is the war on terrorism, a cause for which the government will always find the necessary dollars. "Defense contracts may have to be cut down the road due to budgetary restraints," says Andrew Walker, defense and aerospace analyst for Janus funds. "But we are at war, so that favors the defense companies." Analysts say another factor on the side of defense companies is valuation. The group currently trades at 11 to 13 times cash flow, which is well below the market average. Analysts use cash flow instead of earnings because these companies have big noncash pension charges.
"People worry about the defense budget leveling off, even contracting, due to budget deficits," says Columbia Funds' West. Fund manager anxiety, and volatility in the sector, will surely increase later this year once the Quadrennial Defense Review gets under way in Washington. At the last QDR in 2001, Defense Secretary Donald Rumsfeld described his strategy to do more with less by increasing spending on new military technology as opposed to heavy cold-war era machinery. Most analysts expect Rumsfeld to continue his path toward a leaner, higher-tech military. With the QDR approaching and defense stocks hitting new highs, Roger Threlfall, defense analyst for Dreyfus funds, says "the trend is not your friend here." Threlfall advises investors to select stocks that can get better payback on the operational side as well as those that are well positioned for whatever approach comes out of Washington. His top pick is Lockheed Martin. Another key element going forward is capital deployment, or in other words, how defense companies use the cash they have built up over this strong run. Aside from buying back shares and increasing dividends, fund managers say larger defense companies may use their cash to shop for smaller weapons manufacturers to fill the gaps in their product offerings. Some say speculation over heightened M&A in the defense space already has pushed up shares of technology solutions providers CACI International ( CAI) and Anteon International ( ANT). Both are trading at earnings multiples far higher that of their peers. With consolidation, modernization and budget constraints in the air, Ahrens says he is maneuvering his portfolio toward smaller, highly specialized (and somewhat lesser known) names like Innovative Solutions & Support ( ISSC) and Orbital Sciences ( ORB). "Homeland defense, which means high tech weaponry, spyware, bomb detection and armor, is the place to be," says Ahrens. "You need to be selective now." The trend may be toward tech, but Tom Kolefas, portfolio manager at TIAA-CREF, says "big 'heavy metal' projects will never be written out of the budget, especially considering all the new uncertainties in the world, notably in Asia." Kolefas' top choices are traditional defense powerhouses General Dynamics ( GD) and Raytheon ( RTN). To view Gregg Greenberg's video take on building a defense stock portfolio,