Defense industry flying under the radar

While the healthcare debate and signals of an economic recovery have dominated the headlines for much of the summer, issues surrounding the Afghanistan war (Operation Enduring Freedom) have been flying under the radar.

Last week brought news that defense needs more than double the place-marker $50 billion estimate for war spending in fiscal year 2011, and perhaps as much as $125 billion. Today there are several reports (see here, here, or here) that Army General Stanley McChrystal may request an additional 21,000-45,000 U.S. troops in Afghanistan, above the 68,000 already there.

Should this large level of troops be needed, the Afghan conflict may begin to resemble the size of the commitment that Iraq had become. Thus defense stocks, especially those with war exposure, could continue double-digit EPS growth beyond the current expectation of slowing growth by 2010. Our Approved List stocks that would benefit the most include Alliant Techsystems (ATK), General Dynamics (GD), and L-3 Communications Holdings (LLL).

Defense companies’ valuations are still far below that of the market because investors have assumed the defense industry would suffer from a U.S. defense-budget squeeze and the market has largely ignored the rising requirement in Afghanistan. However, national security is critical and there is an awful lot going on in Iraq, Afghanistan, and elsewhere.

Uncertainty plays the biggest role in low valuations as the next 18 or so months will have decisions that will shape the industry for a decade or more. Still, these companies are trading just too cheaply to be ignored, especially if the war in Afghanistan continues to grow.
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Peter J. Lazaroff, Investment Analyst