Traditionally, stocks of defense industry companies (and other firms that are heavily reliant on the government for their business) are good places for investors to seek safety and play, well, defense.
When economic fears are high, investors often turn to such stocks, knowing that they have more reliable revenue streams–i.e., Uncle Sam–than other companies.
That is, unless the economic fears involve soaring federal deficits and a seemingly inept Congress, as they do now. By failing to come up with a plan to slash the nation’s deficit last year, Congressional leaders left the budget at the mercy of automatic, dramatic cuts that will go into effect in 2013 if no compromise is reached–and the cuts are to be split 50/50 between defense spending and other domestic spending.
With that threat looming, defense stocks are now being viewed as anything but defensive. Many are trading at very low valuations, with investors expecting their earnings to shrink, perhaps dramatically.
To be sure, defense companies and other firms that get their business from Uncle Sam are indeed facing a profit pinch. But keep two things in mind: First, the threat to profits for these companies is known; and second, investors have a penchant for overreacting to negative news. Because of that, some pretty bad scenarios have already been baked in to aerospace and defense firms’ numbers, as well as those of other firms that get a lot of their business from the government.
Many of these stocks are trading at extremely low valuations. Investors are expecting little from them, which means that they don’t need to perform great for their stocks to make solid gains; for many, they just need to do “not that bad.”
Because of their attractive valuations, a number of these types of stocks have been popping up on the radars of my Guru Strategies, each of which is based on the approach of a different investing great. Here are a handful that investors seem to have gotten too dour on.
Harris Corp. (HRS): Florida-based Harris provides communications technology, products, and networks for government and commercial markets. Its products range from wideband-networking tactical radio systems for defense and security forces to secure telecommunications networks for air traffic control, and the firm is active in more than 150 countries.
Harris ($5 billion market cap) gets strong interest from my Peter Lynch-inspired model. Its 16.7% earnings per share growth rate (I use an average of the three-, four-, and five-year EPS figures to determine a long-term rate) and multi-billion-dollar sales ($6.0 billion over the past year) make it a “stalwart” according to the Lynch approach–the kind of large, steady firm that Lynch found offered protection during downturns or recessions.
To find stocks selling on the cheap, Lynch famously used the P/E/Growth ratio, adjusting the “growth” portion of the equation to include yield for stalwarts, since they often pay solid dividends; yield-adjusted P/E/Gs below 1.0 are acceptable to my Lynch-based model, with those below 0.5 the best case. Harris’ 10.2 P/E ratio, 16.7% growth rate, and 3% yield make for a very solid 0.52 yield-adjusted P/E/G, a great sign.
ManTech International (MANT): Based in Fairfax, Va., ManTech is one of the U.S. government’s leading providers of technologies and solutions for mission-critical national security programs. It serves numerous federal agencies, including the intelligence community, the Departments of Defense, State, Homeland Security and Justice, and the space community. Its products and services range from systems engineering and integration to software development services and cyber security to critical infrastructure protection and information warfare support.
ManTech gets high marks from the model I base on the writings of hedge fund guru Joel Greenblatt. Greenblatt’s approach is a remarkably simple one that looks at just two variables: earnings yield and return on capital. My Greenblatt-inspired model likes ManTech’s 18.2% earnings yield and 58.9% ROC, which combine to make the stock the 16th-best in the entire U.S. market right now, according to this approach.
Northrop Grumman (NOC): One of the country’s largest defense contractors, this Virginia-based firm’s products include unmanned aircraft systems, B-2 stealth bombers, the James Webb space telescope, radar systems, 911 public safety systems, and cyber security solutions, to name just a few. The $16-billion-market-cap firm is a good example of a defense company with low expectations–it trades for just 8.3 times projected 2012 earnings, and that’s assuming an 11.3% decline in earnings. (Looked at another way, at its current price, earnings would have to fall more than 40% next year for the stock’s P/E to hit 15–a still-reasonable multiple.)
Grumman gets strong interest from three of my strategies. My Lynch-based model likes Grumman’s solid 18.6% long-term EPS growth rate and its low 0.38 yield-adjusted P/E/G. My Kenneth Fisher-inspired model, meanwhile, likes that it trades for just 0.59 times sales, and that it is generating $3.85 in free cash per share. Finally, my Greenblatt-based model likes the stock because of its 19.8% earnings yield and 48.6% return on capital.
Rockwell Collins (COL): This Iowa-based firm makes communication and aviation electronics, specializing in flight deck avionics, cabin electronics, mission communications, information management, and simulation and training. It has an $8.1 billion market cap.
Collins gets high marks from my Warren Buffett-inspired strategy. My Buffett-based model looks for firms with lengthy histories of earnings growth, manageable debt, and high returns on equity (which is a sign of the “durable competitive advantage” Buffett is known to seek). Collins delivers on all fronts. Its EPS have increased in all but two years of the past decade; it could pay off its $774 million in debt in less than two years, if it wanted to, given its $589 million in annual earnings; and its 10-year average ROE is an impressive 36.3%. Its shares also have a 7.2% earnings yield, which more than triples the yield on a 10-year Treasury bond, another reason this model likes the stock.
CACI International (CACI): Based in Arlington, Va., CACI provides IT and professional services in the defense, intelligence, homeland security, and IT modernization and government transformation arenas. The $1.6-billion-market-cap firm has taken in more than $3.7 billion in sales in the past year, and has more than 120 offices across North America and Western Europe.
CACI gets strong interest from my Martin Zweig-, Joel Greenblatt-, and James O’Shaughnessy-based models. My Zweig-inspired strategy likes CACI’s long-term EPS growth (16.7%), and the fact that growth has increased recently (39.8% in the most recent quarter vs. the year-ago quarter). It also likes that earnings growth has been driven by revenue growth (15.2% over the long term) rather than cost-cutting or other unsustainable measures. While Zweig was a growth investor, he also wasn’t willing to pay too high a price for a stock. With CACI, that’s not an issue: Shares trade for just 11.1 times earnings, well below the market average.
My Greenblatt model, meanwhile, likes CACI’s 14.1% earnings yield and 64.6% return on capital. And my O’Shaughnessy-based growth model likes that it has upped EPS in each year of the past half-decade. It also likes the firm’s combination of a solid 66 relative strength and low 0.43 price/sales ratio.
By John Reese
April 24th, 2012