If we asked you where you would have earned 16% annualized returns over the past 10 years, you’d probably say technology. And you’d be correct. But that’s not the only area of the market that has delivered such outsize returns.
The S&P Aerospace & Defense index has returned 359%, including reinvested dividends, during the past 10 years, or 16.4% annualized, narrowly edging out the S&P 500 Information Technology Sector index’s 355% return—or 16.3% annualized—during the same period. The S&P 500 has returned a “paltry” 190%, or 11.2%, during the same period. Defense stocks aren’t tech, but they might as well be, if their returns are anything to go by.
While market observers fret over whether tech stocks are in a bubble, nary a whisper is heard about defense stocks, despite their similar gains. There are obvious reasons for that. Defense is a much smaller group of companies, and none has the size or scope of tech behemoths like Apple,Alphabet (GOOGL), or Facebook(FB). The largest company in the S&P 500 Aerospace & Defense Industry index, Boeing(BA), has a market cap of just $211 billion. The largest pure defense company, Lockheed Martin(LMT), is worth a mere $60 billion.
But that doesn’t mean investors shouldn’t be asking the same questions of defense as they are of tech. The defense sector has benefited from forces that are now starting to reverse, at a time when valuations are historically high. If nothing else, investors should ready themselves for less-robust returns.
If you really want to see how strong defense stocks have been, you have to go back 25 years. It was then, says Melius Research analyst Carter Copeland, that the Department of Defense told a group of large defense companies that spending would be falling and that most of them would be forced to either exit the business or combine.
The meeting was known as the “last supper,” and it brought about a wave of mergers and acquisitions. In 1996, Defense introduced so-called performance-based payments, which had the effect of paying companies sooner on large projects with a fixed price.
Now Defense wants to change this arrangement. In a proposal released in August, performance-based payments, rather than being fixed at 80% of costs, would instead be paid in a range that starts at 50% and could rise as high as 95%. That would probably force defense companies to put up more cash at the beginning of big projects, something that would lower their returns on invested capital.
“By definition, if you have to put up more of the up-front investment, and that doesn’t equal a higher profit, then return on investment will be lower,” says Copeland, who points to Lockheed and Raytheon(RTN) as two companies that could be most affected.
The stocks had a delayed reaction to these concerns last Thursday, when Raytheon fell 2.1%, Lockheed Martin declined 1.8%, and Northrop Grumman (NOC)dropped 3.5%. Some analysts argue that the drops were an overreaction. UBS analyst Myles Walton, for one, notes that the rules would be phased in over time, and only on certain large projects, so the impact would be far smaller than it seems. There’s also a good chance that the proposal doesn’t get implemented as written.
“Obviously, a 30% cut to the progress payment rate would be a hard pill to swallow, but the DOD’s analysis in the supporting documents suggest that is not a realistic expectation,” Walton writes. The stocks rebounded on Friday.
But even small changes can have an impact. And the proposal would be added to the list of potential problems for defense companies, including high profit margins and the potential for slower spending growth as the budget deficit increases. It might not mean the end of defense’s run just yet, but for investors who have benefited from the industry’s 25-year stretch, it might be time to play a little defense.
Write to Ben Levisohn at Ben.Levisohn@barrons.com