Investment Returns in the Defense Industry

This piece was first published on the business blog of Johns Hopkins University. You may view the piece here.

While no investment offers maximum returns with zero risk, stable companies offering growth are available on the market. Defense contractors, like their peers in other established industries, have existed for decades and codified a pattern of stable profits and sustainable dividends comparable to established companies in other industries. These companies also invest heavily in research and development, and are among the largest investors in the world in this category. Given that larger defense companies can give investors the stability of established companies with the growth potential and innovation of many start-ups, defense companies create an interesting investor opportunity.

The clients for defense companies are mostly governments, primarily the United States Department of Defense (DoD), which awarded about $205 billion in defense contracts in 2016. Foreign governments are increasingly turning to U.S.-based contractors. In terms of revenue from foreign sources, Saudi Arabia and the United Arab Emirates (UAE) are the top buyers and both made recent agreements with the U.S. government. South Korea, Australia, India, and Egypt are also among the largest customers of U.S. defense contractors.

The marketplace of defense organizations includes over 50,000 defense contracting companies in the United States. Most of the focus rests on the six largest defense contractors in terms of revenue:

Lockheed Martin (LMT), Boeing (BA), Raytheon (RTN), General Dynamics (GD), Northrop Grumman (NOC), and United Technologies (UTX).

The defense industry is diverse in terms of specialties, encompassing a wide variety of material production, technology, and services. Most companies focus on limited aspects of defense, and their offerings often differ from one another. Lockheed Martin is a diversified provider, and its offerings include aircraft, guided missiles, missile defense systems, submarines, and different classes of warships. General Dynamics and Northrop Grumman are similarly diversified, although Northrop does not produce warships.

Most other contractors specialize primarily in one area of defense. Boeing, a Dow 30 stock, specializes primarily in aircraft. While Boeing is better-known for passenger jetliners, it happens to be the largest manufacturer of military aircraft. Raytheon’s focus is missiles and missile systems, in addition to providing equipment and services related to command, control, communications, and cyber. United Technologies is a Dow 30 stock, a conglomerate whose primary defense-related functions are Pratt & Whitney aircraft engines and UTC Aerospace, systems designed for military aircraft.

The six largest defense contractors accounted for over $100 billion in revenue from the DoD alone. While these companies often perform varying functions within the defense industry, financially these stocks appear more similar in terms of stock appreciation, profitability, and dividend growth. Since the March 2009 low in stock valuations, all have grown in both revenue and profits, and all have a history of both paying and increasing dividends that spans decades.

Current yields neither greatly exceed nor substantially lag the market’s average dividend yield of 2.03%. In terms of stock price increases, all have appreciated between 230 and 675% since 2009, compared with an approximate 260% rise in the S&P 500 in the same period. Lockheed Martin’s stock has seen steady appreciation rising over 375% since its March 2009 low, and currently has a dividend yield of 2.5%. This dividend has grown annually since 2011. Though Boeing brought in less defense-related revenue, it has shown a stronger stock appreciation than Lockheed Martin, rising over 600% from its 2009 low. Their dividend yield is currently 2.75%, the highest of the six stocks discussed here, and has increased annually since 2011.

Raytheon and General Dynamics have both seen their stock price increase over 400% since 2009. Although both have a dividend yield of under 2%, they have increased dividends annually for several years, even through the 2007-09 economic downturn. Northrop Grumman has risen almost 675% from its 2009 low, the highest of the six stocks discussed in this post. Northrop Grumman’s dividend yield is lower than its peers at 1.4%, but that dividend has increased every year for more than a decade. United Technologies is the lowest performer of the six in terms of stock appreciation, rising only 230%. The dividend yield stands at 2.13% and has risen annually.

For investors who prefer a diversified approach to investing in this industry, defense-related exchange-traded funds (ETFs) are also an alternative investment vehicle. Most of the focus of defense-related ETFs are on three top-rated funds, iShares U.S. Defense & Aerospace ETF (ITA), SPDR S&P Defense & Aerospace ETF (XAR), and PowerShares Defense & Aerospace Portfolio ETF (PPA). Since the 2009 low, the highest return of the three is ITA at about 400%, compared with PPA, which increased by about 315% in the same time period. Because XAR was not created until September 2011, 2009 numbers do not exist for this ETF. However, it has risen steadily and has a return of approximately 190% since its inception.

Dividend yields tend to be somewhat lower than the top individual defense stocks. ITA’s 12-month yield stands at 1%, and XAR’s yield is 0.99%. At 1.37%, PPA had the highest 12-month yield of the three. Unfortunately for PPA investors, it also has the highest expense ratio, which is the amount deducted from investor accounts to pay the fund’s expenses. The expense ratio for PPA is 0.64%, compared with 0.44% for ITA and 0.35% for XAR. All three of these ETFs include Lockheed, Boeing, General Dynamics, Northrop, and United Technologies, among their top-10 holdings. ITA and PPA have similar asset allocations, both with larger investments in Lockheed, Boeing, and United Technologies, whose core defense-related function is aircraft engines.

XAR takes a different approach, most heavily weighing smaller companies. Transdigm Group (TDG), an aircraft engineering company, and BWX Technologies (BWXT), which specializes in nuclear components, are XAR’s two largest holdings, with Raytheon positioned as the 11th largest.

With decades of financial stability and technological innovation, defense-related stocks have been a comparatively safe growth opportunity for investors. A diverse set of U.S.-based defense contractors earn hundreds of billions annually in revenue, providing investors with the profit and dividend stability of an established, mature company. In some scenarios, stock appreciation in this market sector is more reminiscent of a newer growth company. For interested investors who do not like buying individual stocks, defense-related ETFs are available and have produced returns in the last few years that often exceed the returns of the S&P 500.

Given the profitability and stability of this industry, U.S.-based defense contractors should remain on investor watch lists.