There was a time when nobody wanted to own defense stocks …
In 2012, the sector underperformed the markets. Investors avoided defense names because the U.S. government was about to cut the defense budget by $1.2 trillion over the next 10 years. That amounts to about a 15% reduction in spending on an annual basis.
These spending cuts were part of the 2011 Budget Control Act. The goal of this legislation was to avoid a debt-ceiling crisis and reduce our huge deficit over time. These cuts would start in 2013 and take place annually through 2021.
The defense sector would see the biggest cuts. That explains why most defense names underperformed the market.
The sector became hated. Industry leaders General Dynamics, Raytheon (RTN) and Northrop Grumman (NOC) traded under 10 times earnings. That was a huge discount to the S&P 500 — which was trading at 15 times earnings.
These companies also paid an average dividend of around 3%. That was a huge yield considering short-term rates were near zero. It was also double the size of the average yield of the S&P 500.
My advice at the time was to buy defense stocks. They were cheap and hated. In other words, most of the risks of spending cuts and lower profits were already priced into these names.
Since my call, the defense sector more than doubled the performance of the S&P 500. The sector is also outperforming the markets year-to-date.
In short, defense companies were able to adjust their spending to these budget cuts. In other words, since the plan was already in place (signed in 2011), they were able to focus on areas within the sector that would see the biggest increases in spending.
Plus, they used their massive cash hoards to repurchase their stock and raise dividends. This helped inflate earnings (reducing the share count) and also provided investors with a safe and steady yield.
Today, the defense sector is at its all-time high. The PowerShares Aerospace & Defense ETF (PPA) is trading at 18 times earnings. To put that in perspective, this ETF was trading under 10 times earnings in 2013.
Sentiment is also extremely positive.
Most sell-side firms (Goldman Sachs and JPMorgan) are bullish on the sector. They see an increase in defense spending in the coming years. Defense companies are also super-optimistic, with most management teams seeing one of the strongest budgetary environments in years.
From my experience, the best time to take profits in stocks is when everyone is positive on them. In fact, I don’t anyone who is bearish on the sector.
Today, defense stocks are trading at 10-year highs based on valuation. Their average yield has also fallen to 1.3%. That’s much less than the 2% yield being offered by the S&P 500. And they already outperformed the market by a more than 2-to-1 margin.
Sure, we are in an election year and our presidential candidates want to build up our military again. They are promising big increases in defense spending. That may explain the reason behind these inflated valuations.
Yet, even if you believe these candidates (since most will say anything to get elected), these changes would not happen for another 18 months at the earliest. By that time, we are likely to see a pullback in many defense names.
I suggest taking profits right away. There are other sectors — including banks and telecom — that are trading at cheaper valuations, pay a much higher yield, and have more growth potential.