Three Defense Stocks to Watch as Global Tensions Rise
This week, we use AAII’s A+ Investor Stock Grades to provide insight into three defense stocks gaining momentum. With tensions rising in Ukraine, and China becoming more aggressive toward Taiwan, should you consider these three defense stocks of General Dynamics Corp., Lockheed Martin Corp. and Raytheon Technologies Corp.?
Defense Recent News
Early in 2014, Russia invaded and took control of the Ukrainian peninsula, Crimea. Since then, Ukraine and Russia have been in a stalemate. Things changed in October 2021, when Russia began moving troops and military equipment near its border with Ukraine, reigniting the possibility of another invasion. Since then conflicts have escalated, leading many to be concerned over a potential war.
In early February, President Biden ordered nearly 3,000 U.S. troops into Poland and Romania, which are North Atlantic Treaty Organization (NATO) countries that border Ukraine. The Biden administration has said the deployment is intended to be temporary and that U.S. troops will not enter Ukraine. Recent satellite imagery showed the largest deployment of Russian troops to its border with Belarus since the end of the Cold War. Tensions remain high as negotiations between Russia and the U.S. and other European powers continue without any apparent progress toward a formal agreement. Earlier this week, Russia officially ordered troops to enter Eastern Ukraine.
Amid these rising tensions, defense stocks have surged as most of the rest of the market has fallen. This trend could continue if Russia decides to launch a full-fledged invasion of Ukraine. Historically, defense stocks have performed well during pre-war times, even when the stock market experiences large amounts of volatility and losses.
The U.S. aerospace and defense sector is one of the largest in global infrastructure and manufacturing activities. In 2019, the total industry sales revenue left a significant footprint on the American economy, contributing to a combined economic value of $396 billion, representing 1.8% of the nation’s gross domestic product (GDP). The market is primarily driven by investments in the aerospace and defense (A&D) sector and is supported by the rising demand for the products by both commercial and military end users. The market is also bolstered by the presence of leading industry incumbents in the U.S., whose manufacturing and research and development (R&D) capabilities support the growth of the industry.
The space sector could be a lucrative opportunity for defense companies to take advantage of. Space capabilities provide the U.S. and its allies with unprecedented advantages in national decision-making, military operations and homeland security. While a handful of private companies has driven the most recent space exploration efforts, there are ongoing discussions for establishing a space force as the sixth branch of the U.S. military. This would drive public-sector investments toward space technologies in the future. The creation of the U.S. Space Command is likely to benefit the U.S. Department of Defense and the U.S. A&D industry alike.
Grading Defense Stocks With AAII’s A+ Stock Grades
When analyzing a company, it is helpful to have an objective framework that allows you to compare companies in the same way. This is one reason why AAII created the A+ Stock Grades, which evaluate companies across five factors that have been shown to identify market-beating stocks in the long run: value, growth, momentum, earnings estimate revisions (and surprises) and quality.
Using AAII’s A+ Stock Grades, the following table summarizes the attractiveness of three defense stocks — General Dynamics, Lockheed Martin and Raytheon Technologies — based on their fundamentals.
AAII’s A+ Stock Grade Summary for Three Defense Stocks
What the A+ Stock Grades Reveal
General Dynamics Corp. (GD) is a global aerospace and defense company. The company offers a portfolio of business aviation products and services, including ship construction and repair; land combat vehicles, weapons systems and munitions; and technology products and services. Its operating segments include aerospace, marine systems, combat systems and technologies. Its aerospace segment produces business jets and is the standard bearer in aircraft repair, support and completion services. Its marine systems segment designs and builds nuclear-powered submarines and offers surface combatants and auxiliary ship design and construction for the U.S. Navy. Its combat systems segment manufactures land combat solutions, including wheeled and tracked combat vehicles, weapons systems and munitions.
General Dynamics has a Momentum Grade of A, based on its Momentum Score of 85. This means that it ranks in the top tier of all stocks in terms of its weighted relative strength over the last four quarters. This score is derived from high relative price strengths of 18.7% and 4.4% in the first and fourth quarters, respectively, offset by moderately low relative price strengths of –5.4% and –2.5% in the second and third quarters. The scores are 88, 47, 71 and 74 sequentially from the first quarter. The weighted fourth-quarter relative strength rank is the relative price change for each of the past four quarters, with the most recent quarterly price change given a weight of 40% and each of the three previous quarters given a weighting of 20%.
The company has a very strong Quality Grade of A based on an F-Score of nine. The F-Score is a number between zero and nine that assesses the strength of a company’s financial position. It considers the profitability, leverage, liquidity and operating efficiency of a company. General Dynamics also has a very strong buyback yield (the number of shares repurchased divided by market capitalization) of 2.8%.
General Dynamics has an A+ Growth Grade of C. The growth grade considers both the near- and longer-term historical growth in revenue, earnings per share and operating cash flow. The company reported fourth-quarter 2021 revenues of $10.3 billion, down 1.8% from $10.5 billion in the year-ago quarter. The company reported quarterly diluted earnings per share of $3.39, falling 2.9% from $3.49 per share year over year.
Lockheed Martin Corp. (LMT) is the largest defense contractor globally and has dominated the Western market for high-end fighter aircraft since the F-35 program was awarded in 2001. Lockheed Martin’s largest segment is aeronautics, which is dominated by the massive F-35 program. Lockheed Martin’s remaining segments are rotary & mission systems, which is mainly the Sikorsky helicopter business; missiles and fire control, which creates missiles and missile defense systems; and space systems, which produces satellites and receives equity income from the United Launch Alliance joint venture.
Lockheed Martin’s exposure to the F-35 program, hypersonic missiles and the militarization of space is well-aligned with areas of secular growth within the defense budget. The F-35, which accounts for about 30% of the firm’s revenue, will be sustained through 2070. Regulated margins, mature markets, customer-paid R&D and long-term revenue visibility allow the company to deliver a lot of cash to shareholders.
Lockheed Martin has a Quality Grade of A with a score of 97. The A+ Quality Grade is the percentile rank of the average of the percentile ranks of return on assets (ROA), return on invested capital (ROIC), gross profit to assets, buyback yield, change in total liabilities to assets, accruals to assets, Z double prime bankruptcy risk (Z) score and F-Score. The score is variable, meaning it can consider all eight measures or, should any of the eight measures not be valid, the valid remaining measures. To be assigned a quality score, though, stocks must have a valid (non-null) measure and corresponding ranking for at least four of the eight quality measures.
The company ranks strongly in terms of its F-Score and return on assets, ranking in the 94th and 89th percentiles of all U.S.-listed stocks, respectively. Return on assets measures how much net income is generated by a company’s assets. Lockheed Martin generates over three times as much net income from its assets as the industry average. However, it ranks poorly in terms of its gross income to assets, in the 44th percentile.
Earnings estimate revisions offer an indication of how analysts are viewing the short-term prospects of a firm. The company has an Earnings Estimate Revisions Grade of B, which is considered positive. The grade is based on the statistical significance of its last two quarterly earnings surprises and the percentage change in its consensus estimate for the current fiscal year over the past month and past three months.
The company reported a positive earnings surprise for fourth-quarter 2021 of 4.4%, and in the prior quarter reported a positive earnings surprise of 12.0%. Over the last month, the consensus earnings estimate for the first quarter of 2022 has remained the same at $6.33 per share.
Raytheon Technologies Corp. (RTX), formerly United Technologies Corp., is an aerospace and defense company that provides advanced systems and services for commercial, military and government customers worldwide. The company’s operations are classified into four principal business segments: Collins Aerospace Systems, which is a global provider of aerospace and defense products and aftermarket service solutions for aircraft manufacturers, defense and commercial space operations; Pratt & Whitney, which is engaged in suppling aircraft engines for commercial, military, business jet and general aviation customers; Raytheon Intelligence & Space, which is a developer and provider of integrated sensor and communication systems for advanced missions, advanced training and cyber & software solutions to intelligence, defense, federal and commercial customers; and Raytheon Missiles & Defense segment, which is a designer, developer and producer of integrated air and missile defense systems.
Raytheon Technologies is involved in missiles, missile defense systems, space militarization and information technology (IT) services for the U.S. government. Many expect that the military’s increased focus on defending against great powers conflict will drive material investment in each of these areas, excluding government IT services. However, the fiscal stimulus used to support the U.S. economy during the coronavirus pandemic dramatically increased the U.S. debt, and higher debt levels are usually a forward indicator of fiscal austerity.
Raytheon Technologies has a Value Grade of C, based on its Value Score of 59, which is considered to be average. The company’s Value Score ranking is based on several traditional valuation metrics. The company has a score of 44 for the price-to-sales (P/S) ratio, 11 for shareholder yield and 50 for the price-to-book-value (P/B) ratio (remember, the lower the score the better for value). Raytheon Technologies has a price-to-sales ratio of 2.12, a price-to-book-value ratio of 1.87 and a 4.7% shareholder yield. A lower price-to-sales ratio is considered better, and Raytheon Technologies’ price-to-sales ratio is above the sector median of 1.55. The price-to-book value (the lower the better) and shareholder yield are both significantly better than the sector median. Successful stock investing involves buying low and selling high, so stock valuation is an important consideration for stock selection.
The Value Grade is the percentile rank of the average of the percentile ranks of the valuation metrics mentioned above along with the price-to-free-cash-flow, enterprise-value-to-EBITDA and price-to-earnings (P/E) ratios.
A higher-quality stock possesses traits associated with upside potential and reduced downside risk. Backtesting of the quality grade shows that stocks with higher quality grades, on average, outperformed stocks with lower grades over the period from 1998 through 2019.
Raytheon Technologies has a Quality Grade of B based on a strong F-Score of 8 and a buyback yield of 2.5%. The company has an average Growth Grade of C. The components of the Growth Grade consider a company’s success in growing its sales, earnings per share and operating cash on a year-over-year basis for the latest reported fiscal quarter and on an annualized basis over the last five years.
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The stocks meeting the criteria of the approach do not represent a “recommended” or “buy” list. It is important to perform due diligence.
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