Bigger Guns Mean Bigger Profits for Investors

Editor's note: Our Pre-Memorial Day special examines military-related stocks and how to buy, sell or trade them. This feature includes a video by Gregg Greenberg, Defense-Stock Domination; and articles by Marc Courtenay One Priced to Buy; Robert Weinstein Bigger Guns, Bigger Profits; Richard Saintvilus Boeing's Offense Is Defense; Richard Suttmeier Sequester Survivors; and Richard Cox Bullish Earnings Support Defense.

NEW YORK ( TheStreet) -- In a so-called age of austerity and sequestration, the defense industry continues to thrive, aiming profits directly at investors.

Major defense contractors Northrop Grumman ( NOC) and Raytheon ( RTN) have blown up the charts so far this year.

These defense contractors have made new 52-week highs in the last two weeks, and have extended so rapidly that they are overbought on the daily chart. No worries, though. I will demonstrate how you can get your share of the defense industry with lower risk than your neighbor. Before explaining how to optimize a buy, we should consider why you should buy.

Both companies are highly correlated in fundamentals and stock-price action. Often when I write or talk about two companies in the same sector, I get asked which one is the better investment. As a rule, if you're on the fence between two companies, you should choose the one you know or follow the most. The more you know about a company, the greater your edge, so stick with what you know the best.

If they're both the same to you, I'll help out with a tie breaking pick that I like best.

NOC Net Income Quarterly Chart NOC Net Income Quarterly data by YCharts

The first thing that may pop out at you is the revenue for both companies is declining, but the profit is growing. Obviously that can't go on forever, but it doesn't need to. Through effective cost control, margins have actually grown, not fallen as one may expect in a contracting economy and industry.

For prospective and current investors, the most exciting aspect is how much room there is to grow. Even with over 10% gains in the last two years, Northrop and Raytheon have near single digit price-to-earnings ratios. What this means is that the market isn't pricing in growth, and at least at the surface level is discounting for a potential earnings contraction.

NOC Profit Margin TTM Chart NOC Profit Margin TTM data by YCharts

But it's the relatively low earnings multiples that represent a buying opportunity. Northrop pays a 3% yield, and Raytheon pays a slightly higher rate of 3.3%. The rates are paid from a relatively small percentage of profits, called a payout ratio. The payout ratio is under 30% for Northrop and 35% for Raytheon. All else being equal, I find 40% and under safe.

Our takeaway is that these companies are cheap on an earnings basis compared to the S&P 500 ( SPY) average. The stocks that make up the S&P 500 average about a multiple of 14. Where you achieve your advantage is the low earnings growth is counterbalanced with the high dividend growth.

Raytheon and Northrop are ideal for long-term hold investors and not Steve Miller traders (take the money and run). Investors willing to buy and forget may own shares paying a yield over 5% within five years based on the previous dividend growth. We can do better though through options.

By deploying an options strategy, we can reduce our entry price, risk, and begin on a good note. As I stated previously, both charts are extended and all else being equal, the natural ebb and flow of the chart pattern suggests waiting for a buying dip will place our sights on the target. For Raytheon, an entry price near $65 is reasonable and for Northrop, look for a retracement to $78.

With that being said, here are my preferred strikes for an entry based on selling put options as our entry strategy. Look to sell the Northrop August $77.50 strike Put for $4.20 or greater and the Raytheon August $65 strike Put for $3.10 or greater. The entry time window is about 25 days or less. About 65 days from expiration is a sweet spot for option premium collection.

In both cases, an investor lowers the overall risk exposure about 5% compared to buying the shares outright. If the shares never look back and continue gaining after entry, the return is also about 5%. Not bad for a two-month holding period.

Like a sniper slowly and cautiously hunting prey, investors willing to take a reserved and intelligent approach without emotion are the ones with the greatest returns.

I would like to extend my family's deepest gratitude to the men and women in uniform this Memorial day.

At the time of publication the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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