You would think that cuts in defense spending would lead to lean times for defense stocks. And you would be wrong.

 

The PowerShares Aerospace & Defense ETF (NYSE: PPA) has risen 65% over the past two years, even as the defense budget is set to fall by 20% in fiscal (October) 2016, compared to 2014 levels.

 

The core defense budget is expected to be $534 billion, while supplemental war-related spending would tack on another $51 billion. That would be the lowest level since 2001.

 

 

Talk of spending cuts in Washington is nothing new. Wall Street analysts have been anticipating them for several years. Yet, the factors that have allowed defense stocks to rally in the face of cutbacks are likely to remain in place.

 

#-ad_banner-#The reasoning behind the rally lies in Congressional control: Republicans take over leadership in the Senate’s 13 committees and Veterans’ Affairs this year. While the Obama administration will still be able to guide policy through the respective departments and cabinet heads, the GOP has already targeted many cutbacks for a fight.

 

There is a precedent for the turnover and its affect on stocks of defense contractors. Both chambers of Congress switched to Republican control in 1995, the third year of the Clinton presidency, following an eight-year run of Democratic control. A portfolio of the three major defense contractors* returned 45% over the following year, outperforming the S&P 500 by 14.3% and returned 73% over the two-years to December 1996.

 

 

Of course, this is only a sample of one period, but three Republicans that have strongly supported defense spending in the past are about to take over powerful positions in Washington.

 

Spending Power And Defense

Spending cuts mandated by the sequestration are set to resume starting October 2016, but Congress has the power to overturn the cuts. While no one can know what Congress will do next year, the change in Senate leadership could help limit the pain in defense cuts.

 

John McCain of Arizona will head the Senate Armed Services Committee. McCain has been critical of the Obama administration’s “weak” stance on countering threats overseas and has stood up against scrapping some weapons projects like the A-10 Warthog. Speaking to a forum about the sequestration cuts to defense spending in November 2014, McCain said, “We have to fix it. I promise you that we will make it our highest priority.”

 

Mississippi’s Thad Cochran will chair the powerful Senate Appropriations Committee that is responsible for drafting a third of the federal budget. He has a reputation for earmarking and his support could be a big boost to Navy shipbuilding. Cochran ran his reelection campaign on the fact that he has been able to craft federal spending that earns Mississippi residents twice the amount in federal benefits than is paid into the system.

 

Bob Corker of Tennessee will chair the Senate Foreign Relations Committee and is likely another positive for military contractors. Corker has been critical of the administration’s negotiations with Iran and how it has dealt with other hotspots such as  Russia, Libya and Syria. He has been supportive of Secretary of State John Kerry’s request for new war powers against the Islamic State (ISIS) group. Corker met with Pentagon officials and the White House last week about wording that would authorize U.S. operations against the ISIS.

 

Stocks in the aerospace and defense industry are not particularly expensive at 18.3 times trailing earnings, slightly cheaper than the 19.2 times multiple on the S&P 500. In addition to the ETF noted earlier, several defense stocks hold appeal, including:

 

General Dynamics Corp.  (NYSE: GD) is a significant supplier to the U.S. military and one of the largest shipbuilders in the country. The combat and marine segments account for 42% of 2013 sales followed by information systems (32%) and aerospace (26%).

 

The company had a backlog of orders totaling $46 billion in 2013, which represents more than 140% of annual sales.  Late last year, the company won a $498 million contract to build a fourth amphibious assault ship for the military. The contract will run through March 2018. Shares are slightly more expensive at 18.8 times earnings and sport a 1.8% yield.

 

Huntington Ingalls Industries, Inc. (NYSE: HII) designs, builds and overhauls ships for the U.S. Navy and Coast Guard. The company is the largest employer in Mississippi and could win big as Senator John Thune moves from the minority party to the majority party.  

 

Ingalls won a competitive bid and signed a 10-year $3.3 billion contract to build five more Arleigh Burke-class destroyers in 2013. The company successfully closed negotiations with union members to ratify a three-year contract through 2018, giving some certainty to labor expense. Shares are relatively cheap at 15.2 times earnings and the dividend reflects a 1.4% yield.

 

Lockheed Martin Corp. (NYSE: LMT) is the world’s largest defense contractor with 61% of sales coming from the Department of Defense and 21% from other U.S. government agencies. The company booked a record backlog of $82.6 billion in 2013, nearly twice its $45.4 billion in annual sales.

 

Of the three companies, Lockheed Martin is the most globally diversified with more than 1,000 global partnerships and nearly a fifth (18%) of sales from international sources. Shares are priced at 19.8 times earnings, but pay an attractive 3.1% dividend yield.

 

Risks To Consider: Defense contractors have had a healthy run over the last two years and talks of budget sequestration could bring volatility. Use any weakness to accumulate shares and be ready for some uncertainty, especially going into the 2016 election cycle.

 

Action To Take –> Take advantage of the power shift in Washington and upside potential in the defense industry. While the GOP will likely not be able to accomplish all of its agenda, the Defense Department appears poised  to benefit from the new congressional leadership and renewed focus on fighting terror.

 

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