Defense Stocks: Weighing a Peace Dividend

Can we expect a peace dividend? Or are we entering a new arms race, with volatile nations like Venezuela and Russia using their oil booty to fund military buildups?

Those hoping that a Democrat will win the White House in November expect a slowdown in the growth of the Pentagon's budget. They envision a drawdown of our troops in Iraq and a decline in new military initiatives, with money diverted to other needs, such as education and health care.

As anti-war rhetoric has escalated, defense stocks have stumbled. The promise of a peace dividend perhaps bodes well for the country, but not so much for military suppliers like Boeing (BA $82) and Lockheed Martin (LMT $107). The Spade Defense Index (AMEX:DXS), one measure of industry performance, has been trailing in the past few months as the nation focused on the Democratic campaign, after steadily outperforming the S&P 500 index by a wide margin for eight consecutive years. (Another negative for commercial aerospace stocks has been Boeing's production delays on the 787.) So far this year, the index is down more than 10%, compared to a 6% drop in the S&P 500, and it is off 20% from the all-time high it reached in November.

Are the stocks telling us something?

Maybe not. Countering the optimism about a peace dividend is the view that whether or not we pull out of Iraq, the military needs substantial new investment. A senior research fellow at the Heritage Foundation, James Jay Carafano, says the military is badly undercapitalized, as a result of significant underspending in the 1990s. He has produced a chart that shows national defense spending presently running at roughly 4% of our gross domestic product, 1.5 percentage points below the 45-year average of 5.5%, in spite of our engagements in Iraq and Afghanistan. During the 1990s the share of national spending going to defense was consistently below the historical average, and indeed at the end of the decade it was at a low of 3%.

Providing some context, Mr. Carafano says fighting World War II cost 50% of GDP, while expenditures for the conflict in Vietnam totaled 9% of GDP. Astonishingly, Mr. Carafano points out that the Cold War kept outlays at 7.5% of GDP for 40 years.

"Coming off the war in Iraq and Afghanistan will be similar to what happened after Vietnam," Mr. Carafano says. "Though spending is up, a great deal of it has gone to consumables. The military is in terrible shape."

James Copell of Copell Financial is even more adamant. He points to a looming arms race as an excellent reason to buy defense stocks. Citing a number of sources, he claims that an aggressive buildup by the Chinese, in particular, will require countervailing investment by America. His firm is high on Northrop Grumman (NOC $70) as an especial beneficiary of this trend.

Mr. Copell says China is currently building 60 submarines and that it is simultaneously buying from Russia "the largest class of surface warships in the world." He estimates that the Chinese are spending more than 8% of GDP on military and defense.

This is considerably higher than reported totals for that nation, but most experts suggest that the official numbers are low. (Last year's reported figure was around $57 billion; most sources assume the real number is two to three times higher.)

Without a doubt, China is rapidly ramping up spending. The Stockholm International Peace Research Institute yearbook for 2006 shows that China's military spending grew 165% between 1996 and 2005, by far the fastest expansion in the world. In ranking countries by total military expenditures, SIPRI lists China as no. 4. It is growing rapidly, and in 2006 China surpassed Japan as the largest spender in Asia. China's outlays still pale in comparison to America, which accounts for 46% of the world total.

Mr. Copell also points to the large-scale exports of arms from Russia to countries like Algeria, Venezuela, Libya, and Malaysia as convincing proof that military spending here will not be allowed to decrease. Venezuela is cited by SIPRI as "increasing arms dramatically" between 2003 and 2007, with 92% of its weapons imported from Russia.

Paul Nisbet, who covers defense stocks for JSA Research, says he thinks the stocks could suffer a further drubbing should Senator Obama or Senator Clinton gain office. "Defense budgets suffered under Presidents Carter and Clinton," he says. "The military did not begin to replace inventory that was atrophying under those administrations. It probably wouldn't be very different with today's candidates."

However, he agrees that "we have to keep a very close eye on Russia and China." For instance, he says we are now building about one submarine a year. "We have a total fleet of 60; at this rate it will take 60 years to modernize."

It is that need to update our military that leads Mr. Nesbit to be positive on the stocks. He is recommending "nearly everything," including Boeing, Lockheed, and General Dynamics (GD $87). In his view, the military has made a good case that our force is too small, which is why a buildup of 74,000 is under way. Mr. Carafano concurs: "There's not an area that we're healthy in," he says. "If we continue to build [ships and airplanes] at our current languid pace," he says, "China will catch up as a regional power."

Overall, though military expenditures have risen sharply of late, it appears unlikely that we will see a peace dividend anytime soon. Consequently, the defense stocks, which appear to be discounting a Democrat becoming president, could provide investors with a pleasant surprise. Further good news is that not one of them is in the subprime mortgage business.