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Opening Shot

How to Play Defense

Start building your own defensive position by investing in firms that benefit from military spending.

On September 18, 1939, 17 days after the start of World War II, a bold headline on the front page of the Sarasota Herald-Tribune proclaimed, "Peace Scare Hits Stocks." Such are the risks of investing in companies that make weapons. But this particular peace scare -- like most others over the past century -- was brief. Within eight months, Germany invaded France. On December 7, 1941, Japan attacked Pearl Harbor, bringing the U.S. into the most devastating and expensive war in history.

Big spending. War and preparation for war are now a built-in part of our existence. U.S. military expenditures will total about $690 billion in the current fiscal year, which ends this September, and more than $700 billion in the next. Add about $100 billion for the departments of Homeland Security and Veterans Affairs. The total amounts to about 5% of the nation's gross domestic product. That's less than the U.S. spent during the Vietnam War period, but it's still a big number.

Some investors avoid putting their money into weapons stocks on principle. And even if you're not troubled by providing capital to munitions makers (I'm not), investing in the defense sector has its drawbacks. For instance, one continuing theme is that the government keeps trying to spend less, whether by limiting cost overruns, closing unneeded bases or ending obsolete weapons programs. Weapons programs canceled in recent years include the DDG 1000 destroyer, the General Dynamics ship that fires guided missiles; the C-17 Globemaster, Boeing's long-serving military-transport plane; and the F-22 Raptor, a jet fighter built by Lockheed Martin and Boeing.

But despite green-eyeshade scrutiny and those pesky peace scares, defense remains a growth industry. An investment of $10,000 ten years ago in Fidelity Select Defense & Aerospace (symbol FSDAX) would be worth more than $25,000 today; the same amount invested in Vanguard 500 Index (VFINX), which tracks the broad market, would now be worth about $9,400 (funds and stocks in boldface are ones I recommend).

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Over the past few years, though, the stock market has been treating defense firms as if they were like any other kind of business. From mid May 2008, as the financial crisis was beginning to intensify, until the market's March 2009 bottom, stocks of defense contractors fell along with virtually everything else. General Dynamics (GD) dropped from $95 to $34, Northrop Grumman (NOC) fell from $76 to $35, and Raytheon (RTN) went from $66 to $34.

In glorious hindsight, the prices of two years ago seem absurd today. General Dynamics ended up earning $6.20 per share in 2009, so its effective price-earnings ratio at the market's nadir was less than 6. And that was for a company that has generated average annual profit growth of 14.5% over the past ten years, that has seen its cash flow (earnings plus depreciation and other noncash charges) rise every year since 1994 and that has boosted dividends every year since 1997. Like most other stocks, shares of defense companies have bounced back over the past year, but many of them may still be underpriced. For example, at $78, General Dynamics trades at a modest 12 times estimated 2010 earnings of $6.55 per share (all share prices and related ratios are through April 9).

General Dynamics, like most defense firms, also makes some products for the business and consumer markets -- in this case, Gulfstream jets. Sales have suffered in the recession, but the jets represent only one-sixth of the company's annual revenues of $34 billion. Last year, Boeing (BA) derived half of its $68 billion in sales (though none of its profits) from commercial aircraft. Rockwell Collins (COL), a highly regarded maker of aviation electronics, made 58% of its sales ($4.5 billion in 2009) to the government. So if you want to invest in a pure defense company, or something close to it, you will have to look elsewhere.

Consider Northrop Grumman. The government accounts for 92% of its $34 billion in annual sales, and the company has its hand in one of the biggest weapons projects of all time: the F-35 Joint Strike Fighter. Although Lockheed Martin is the prime contractor for the F-35, Northrop provides about one-fourth of the plane's components. The U.S. alone plans to buy 2,443 of the fighters, and eight allies may buy thousands more.

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Northrop is also a major player in a fast-growing part of the defense business -- systems that keep soldiers and pilots from being exposed to harm. The best-known are unmanned aerial vehicles (UAVs), or drones, which can watch the enemy from a height where they can't easily be shot down and can fire weapons at precise targets (such as individual terrorists). Northrop makes one of the largest drones, the Global Hawk, for the U.S. Air Force.

The current Pentagon budget includes $3.5 billion for UAVs -- a figure that will continue to rise. The Army alone, according to National Defense magazine, is "on a fast track to build its own high-tech air force," planning to buy 300 Shadow and Sky Warrior drones in the next five years to augment a current force of about 100. The Shadow is made by Textron (TXT), a diversified company that also makes Cessna light aircraft and Bell helicopters. The Sky Warrior is made by drone pioneer General Atomics, which, alas, is not publicly traded.

Also in the unmanned department: a helicopter from Boeing to supply the Marines, and helium-filled tethered airships, from Lockheed Martin and Raven Industries (RAVN), to look for roadside bombs, among other things. Raven, based in Sioux Falls, S.D., sports a market value of just $512 million. The stock, at $28, sells for 17 times estimated 2010 earnings, and -- surprisingly for a small, on-the-move defense company -- pays a decent dividend, resulting in a 2.3% yield.

If you watched The Hurt Locker, this year's Oscar winner for best picture, you saw another unmanned vehicle -- a little robot on wheels used to defuse bombs in Iraq. It's made by iRobot (IRBT), a small company based in Bedford, Mass., that also sells robot floor washers and underwater vehicles. At $15, the stock trades at 66 times projected 2010 earnings and is clearly expensive. But the company has no debt, its revenues have roughly quadrupled in six years, and analysts expect profits to rise at an annual clip of 20% over the next three to five years.

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As military systems get more sophisticated, demand for engineering and consulting expertise is swelling. Contractors in these areas have become multibillion-dollar businesses. Four of the biggest, all based near the Pentagon, are SAIC (SAI), CACI International (CACI), ManTech International (MANT) and SRA International (SRX). All are nicely profitable and carry P/Es in the mid teens.

How to buy the sector? You can choose iShares Dow Jones U.S. Aerospace & Defense (ITA), an exchange-traded fund that I prefer slightly to a similar but more costly offering from PowerShares. Both were launched in the past four years. The iShares fund, which charges annual fees of 0.5%, holds a portfolio led by United Technologies (UTX), Boeing, General Dynamics, Lockheed Martin and Raytheon. Many of its holdings derive large chunks of their sales from non-defense businesses.

It's difficult, however, to pass up Fidelity Select Defense & Aerospace, which has been around more than a quarter-century and which relies on human beings, rather than index-based algorithms, to choose the stocks. The fund has returned 13% annualized over the past 15 years -- an average of five percentage points per year better than the return of Standard & Poor's 500-stock index.

Fidelity's portfolio also contains large positions in United Technologies, Boeing, Lockheed Martin and Raytheon. In addition, it has significant stakes in solid midsize companies, such as Transdigm Group (TDG), which makes parts for both military and commercial aircraft; Esterline Technologies (ESL), which produces infrared decoy flares and chaff to confuse enemy radar; and Alliant Techsystems (ATK), which produces bullets and rockets.

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You can wait until the next peace scare (or bear market) to invest in defense stocks, or you can start building your own defensive positions now. Every portfolio could use some.

James K. Glassman is executive director of the George W. Bush Institute in Dallas. His next investing book will be published later this year. In the past, he has consulted for SAIC.