It’s official: defense stocks are a boring investment. So say several Wall Street analysts who issued dour assessments of the sector last week. The most respected, Morgan Stanley’s Heidi Wood, said sector equities would perform in line with the broader market over the next year. The other analysts were more negative. Not surprisingly, defense stocks sold off.
Some of the reasoning behind these calls is shaky. Based on his firm’s polling data, Smith Barney analyst George Shapiro says the public has turned negative on defense spending. That’s misleading on two levels: public opinion doesn’t drive defense spending, and what the public is really upset about is Iraq, not defense spending. A review of survey results since World War Two indicates the public almost always thinks the current amount of defense spending is about right (regardless of what the amount actually is).
Nick Fothergill of Banc of America Securities has it wrong too. He thinks budget pressures caused in part by spending in Iraq and Afghanistan will undercut weapons purchases. Actually, the precise opposite is true. The Bush Administration has requested a huge supplemental budget that takes all the pressure off of weapons accounts. In fact, it contains billions of dollars in new acquisition money, mostly for secret intelligence systems. The administration is also sliding some previously-planned operations spending into the supplement, further reducing pressure in the regular budget. What this all means is accelerated defense spending, not cutbacks.
Morgan Stanley’s Wood captures the dynamics of defense spending more convincingly, arguing that it is driven by threats, the availability of funds, and the agenda of whatever administration is in power. She isn’t sanguine about the sector’s prospects — she thinks spending will peak in 2006 — but she still recommends the shares of several big players.
The real problem defense companies face isn’t public opinion or spending on Iraq. It’s the fact that they have allowed themselves to be boxed into a small market with a single unpredictable customer — the U.S. government. The portion of national wealth allocated to military spending has declined in every decade since the 1940s. The actual buying power of military budgets has fluctuated within a well-defined range, but because the economy has grown, defense represents a shrinking share of national wealth.
The big companies have tried every tactic in the book to cope with this challenge — horizontal integration, vertical integration, getting into services, growing overseas, etc. Some of the moves have worked and some haven’t, but the survivors are running out of options. How much more consolidation can the sector stand, when there are only half a dozen players left who matter?
The only way out of this box is the dreaded d-word: diversification. Defense companies have to escape the military ghetto. Wall Street will hate the idea, but Pentagon policymakers keep saying they want to do more business with the commercial sector, where most new innovations originate. Maybe the big defense companies should listen to their customer and get there first.
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