For the last year, sovereign debt has been the most influential force on the markets. The focus has rightly been on Europe, most notably Greece, but other nations like Spain and Portugal are in precarious situations.
The U.S. debt situation isn’t as critical as Europe’s, but there are plenty of concerns here as well. Remember last summer when the debt ceiling needed to be raised before the U.S. began defaulting on some of its debt? Gridlock in Congress took the situation right up to the deadline. Default was avoided, and part of the agreement included formation of a Congressional “super committee” to figure out ways to reduce the deficit. As you may also recall, they couldn’t agree to a plan, so forced spending cuts are supposed to be coming in many areas.
One of those areas is defense, which is supposed to see $500 billion in cuts over the next 10 years. This is in sharp contrast to the precipitous rise in spending over the last 10 years after the 9/11 terrorist attacks and with the wars in Iraq and Afghanistan. The defense industry is at a critical juncture right now as the wars wind down and deficit concerns increase, yet threats to U.S. security clearly remain.
Total actual defense expenditures in the 2011 budget year, which ended last September, were $687 billion, including $158 billion for the wars in Iraq and Afghanistan. This amount is expected to decline 6% to $645.7 billion in 2012, reflecting a decline in war spending to $115 billion. Spending on the “base” budget remains relatively flat at $530.6 billion, up slightly from $528.2 billion in 2011. The Defense Department has proposed further cuts for 2013, with total spending expected to shrink 5% to $613.9 billion, including further cuts in war spending to $88.5 billion, and we also see projected spending in the base budget fall to $525.4 billion. Current expectations are for further cutbacks in the coming years.
Interestingly, the expected cuts have not yet hit defense-related stocks too hard. One exchange-traded fund (ETF) that tracks the industry is the iShares Dow Jones US Aerospace & Defense (NYSE:ITA). This ETF is up 6% over the past 12 months and 9.7% year-to-date. The one-year numbers are below both the S&P 500 and Dow, but year-to-date, the ITA is right in between the Dow and S&P 500.
Many of the companies in this ETF, such as Boeing (NYSE:BA) and United Technologies (NYSE:UTX), benefit from being diversified in other areas like commercial aerospace. Purer-play defense companies, such as General Dynamics (NYSE:GD), Raytheon (NYSE:RTN), Lockheed Martin (NYSE:LMT) and Northrop Grumman (NYSE:NOC), are on average under performing the ETF, though they have hardly been disasters. I don’t see these stocks getting wiped out with the looming defense cuts, but I would avoid the pure-play defense contractors for the foreseeable future, as I do think upside will be limited.
I think the key point for us as investors is that the defense industry is changing, but it is not going away. We will always have the need to defend our nation and its borders. Trillions of dollars still flow into this sector, and the key in investing is very similar to that of the trend in national defense: a more targeted approach. You have to look in specific segments of the defense industry to find good opportunities — stocks positioned to do well even with pending budget cuts. One of those segments is unmanned aircraft systems (UAS).
The Sky’s the Limit
Unmanned aircraft systems, also known as unmanned aerial vehicles (UAVs), have actually been around for a long time. The U.S. military used them as far back as the Vietnam War, when they were known as drones (which they’re still called) and were basically radio-controlled aircraft. Forty years later, they are much more sophisticated, with control and guidance systems and the ability to perform low-level human pilot duties such as speed and flight-path stabilization.
UAVs may be best-known in recent years for spying on terrorists and firing missiles at them. They are a critical reason the U.S. gained military superiority in Afghanistan, and it’s understandable why the demand for UAVs from troops is insatiable, according to Brig. Gen. Kevin Mangum, special assistant to the commanding general of Army Special Operations. Gen. Mangum says ground forces rely on UAVs to do everything from hunting human targets to protecting forces to watching warehouses where balloting is taking place. UAVs have been similarly valuable in Iraq. Col. Donald Hazelwood, who runs the U.S. Army’s unmanned aerial systems project office, called them the unsung heroes in the war. The Pentagon could not actually meet the demand for them and had to ask commanders to separate wants from needs.
The last two Secretaries of Defense have made it clear that U.S. investment in UAVs will not stop. The current secretary, Leon Panetta, in a speech earlier this year outlining cuts in the Defense Department’s proposed 2013 budget, specifically mentioned unmanned systems (along with intelligence systems and Special Forces) as areas where the Pentagon would like to protect or even increase spending. Total expenditures on UAVs are expected to nearly double in the next decade from $5.9 billion to $11.3 billion, according to a study by defense consulting firm the Teal Group. This growth will be driven by the changing needs of the U.S. military, including increased intelligence, surveillance and reconnaissance. It’s also expected that more technological advancements in the future will improve the military capabilities of UAVs.
So demand is growing for UAVs and there is some spending certainty in the otherwise uncertain defense industry, but have you also heard about the move to use UAVs domestically? In mid-February, President Obama signed a law that will expand their current use and allow police and first responders to employ UAVs that are under 4.4 pounds and flown at 400 feet or lower (among other restrictions). In addition, the Federal Aviation Administration needs to come up with plans to safely integrate UAVs into U.S. airspace by or before Sept. 30, 2015, opening up the way for commercial use.
There are many situations in which they could be valuable, from dusting crops to finding lost people or criminals on the run to monitoring traffic, wildlife, and disasters like oil spills, just to name a few. Much of the current debate focuses on privacy and safety concerns (unmanned aircraft crash more often than manned aircraft), and those are serious issues to be worked out, but it’s clear that UAVs will see more and more use inside the United States in the coming years as well.