By Roger Conrad
Today, the military-industrial complex has closer ties to the U.S. government than ever before.
The defense industry's financial performance historically exhibits limited correlation to the rest of the economy because demand for its products doesn't depend on the consumer. And because the military-industrial complex remains one of the country's major employers, Congress often struggles to refuse budget increases.
If the new administration lives up to its promises and increases the defense budget during its time in office, current equity valuations in the industry should be sustainable.
But prospective investors should remember that the new administration's first proposed budget will be for 2018, so the defense industry's financial results won't receive a bump until 2019. And not all companies will benefit to the same degree.
Be patient and focus on bottom-up analysis to maximize your returns. Here are some of our best ideas to play these trends.
The two stocks to own
General Dynamics Corp. /zigman2/quotes/208560027/composite GD +1.93% is our favorite U.S.-based defense stock to own for the longer term because of its exposure to the steadily growing market for private jets.
Although some investors dismiss General Dynamics for this very reason, the Gulfstream business balances the company's revenue. It also doesn't hurt that order flow for jets remains solid and the division has built a healthy backlog.
And defense revenue still accounts for about 60% of the company's total revenue. Given this exposure to a potential ramp-up in military spending and General Dynamics' discounted valuation relative to its peers, the stock should outperform. We also like the company's strong balance sheet and manageable long-term pension liabilities.
General Dynamics has widened its operating profit margins since 2013, a trend that should continue in coming years. The company also boasts the biggest stock-repurchase program in the industry.
With the best and most shareholder-friendly management teams among its peers, General Dynamics rates a “buy” up to $200 a share.
CAE Inc. /zigman2/quotes/200553760/composite CAE +0.55% is one of the world's leading providers of training services and simulation technology for the defense, aviation and health-care markets.
The Quebec-based company's defense and security division continues to grow at a rapid clip and accounts for about 40% of the firm's revenue. This segment operates more than 80 sites in 35 countries, and its military aircraft simulators account for about 22% of the global installed base.
About 35% of CAE's revenue comes from the U.S., with Europe accounting for 25%.
CAE has a solid pipeline of new contract opportunities, including U.S. $4 billion worth of bids in the U.S. and Canada. CAE's market leadership and high-quality products should enable the firm to win a fair number of these contracts. The timing of the awards is uncertain, but the first announcements could be made over the next four to six months.
Not widely recognized or owned, CAE's New York-listed shares rate a “buy” up to $15.