The year 2016 was yet another year of sluggish growth for the U.S. economy, with the fourth quarter being the most challenging. The economy grew at an annual rate of 1.9% this past quarter, the slowest since 2011. As far as the defense sector is concerned, the final quarter of 2016 has been quite favorable, courtesy of the budgetary amendments by President Donald Trump.
Evidently, major indices of this sector – the S&P 500 Aerospace & Defense Index as well as the Dow Jones U.S. Aerospace & Defense Index – rallied over 9% during the fourth quarter. Surprisingly, Trump’s cost-cutting crusade against America’s top defense contractors could not dampen the sector’s outlook as other inherent factors boosted growth.
Trump Effect on Defense Stocks
Though the startling win of Trump sent jitters across the global stock market, defense investors remain unperturbed for reasons more than one. Apart from slamming the two top players in the sector, Boeing and Lockheed Martin, for their “out-of-control cost” projects, Trump’s primary agenda has been in favor of defense stocks.
In fact, Trump has vehemently criticized Obama administration for imposing budget caps on the U.S. military. The new President’s promises to expand the military troop as well as plans to ramp up funds for major defense players have largely supported the upside in the stocks since the release of election results on Nov 8, 2016.
Also, soon after taking office, Trump almost waged war against ISIS and other Islamic terror groups, clearly stating his stand point of no tolerance toward terrorism. This in turn must have raised hopes of increased demand for defense products, thereby buoying optimism for this sector.
Q4 Performance & Other Factors
With the bulk of the Q4 earnings behind us, almost 90% of the total S&P 500 companies in the Aerospace and Defense sector have reported their earnings as of Feb 10, 2017. With a beat ratio of 88.9%, total earnings for these companies improved 13.6% year over year. Revenues, also, increased 2.7% from the year-ago quarter.
Given that most of the leading defense players have come up with better-than-expected results so far, the entire sector is expected to perform far better than the overall index. Evidently, the Q4 earnings growth expectation for the sector as a whole is pegged at 13.6% versus 7.3% for the S&P 500 Index.
In this regard, it is worth mentioning that apart from the Trump effect, the intrinsic strength of the sector has always offered a level of stability amid widespread uncertainties. The primary growth drivers in this sector include the recent rise in geopolitical uncertainty, both in developed as well as emerging nations.
Moreover, demand for more fuel-efficient aircraft, growing international market and increasing application for unmanned aircraft in warfare today have driven sales for the primary players in this sector. Another positive trend for these defense contractors is that overseas demand remains strong for missile systems, aircraft, radar technology and other military hardware, with more countries across the globe expanding their defense budget.
Weighing the pros and cons, it might be prudent to zero in on a handful of defense stocks that are poised to beat earnings estimates this quarter. An earnings surprise should help these stocks outperform in the near term.
How to Pick the Right Stocks?
Selecting the most lucrative stock is undoubtedly a daunting task. This is where the Zacks methodology comes to the rescue. One could narrow down the list using positive Earnings ESP as a guide, along with a favorable Zacks Rank #1 (Strong Buy), 2 (Buy) or 3 (Hold).
Earnings ESP is our proprietary methodology for identifying stocks that have high chances of surprising in their next earnings announcement. It shows the percentage difference between the Most Accurate estimate and the Zacks Consensus Estimate.
Our research shows that for stocks with this combination, the chances of a positive earnings surprise are as high as 70%.
Let’s take a look at our top picks…
Curtiss-Wright Corp. (CW): Headquartered in Charlotte, NC, Curtiss-Wright is a global diversified industrial company. It is an innovative engineering company that offers high-tech, critical-function products, systems and services to the commercial, industrial, defense and power markets.
The company has a long-term earnings growth expectation of 9.90%. Curtiss-Wright currently has an Earnings ESP of +1.35% and a Zacks Rank #3. You can see the complete list of today’s Zacks #1 Rank stocks here.
The company is slated to report fourth-quarter 2016 results, after the markets close on Feb 15.
Kratos Defense & Security Solutions, Inc. (KTOS): Headquartered in San Diego, CA, Kratos Defense & Security Solutions provides mission critical products, solutions and services primarily for the Government and commercial customers. Its primary focus areas are unmanned systems, satellite communications, microwave electronics, cyber security/warfare, missile defense and combat systems.
The company reported an average positive earnings surprise of 75.35% in the trailing four quarters. Kratos Defense & Security Solutions currently has a Zacks Rank #3 and an Earnings ESP of +66.67%. You can uncover the best stocks to buy or sell before they’re reported with our Earnings ESP Filter.
The company is expected to report fourth-quarter 2016 results on Mar 9.
Orbital ATK Inc (OA): Headquartered in Dulles, VA, Orbital ATK designs, builds and delivers space, defense and aviation-related systems to customers around the world both as a prime contractor and as a merchant supplier. Its main products include launch vehicles and related propulsion systems; satellites and associated components and services; composite aerospace structures; tactical missiles, subsystems and defense electronics; and precision weapons, armament systems and ammunition.
The company has a long-term earnings growth expectation of 10%. Orbital ATK currently has an Earnings ESP of +0.69% and a Zacks Rank #3.
The company is expected to report fourth-quarter 2016 results on Mar 6.
The U.S. aerospace and defense sector set a new record for international sales in 2016, delivering $146 billion in exports, up $3 billion year over year; as per recent reports by the Aerospace Industries Association. As per “Defense News”, in the first quarter of 2017, the U.S. State Department approved foreign military sales worth an estimated $45.2 billion — more than total foreign military sales for all of 2016.
Moreover, Senate Armed Services Chairman John McCain made a $640 billion proposal for the base national defense budget (including Department of Energy nuclear activities) for 2017, $54 billion higher than Obama’s estimates. Naturally, these facts underline substantial scope for improvement for the defense stocks in the days ahead.
With other macroeconomic factors like improving manufacturing output, lower unemployment rate along with the recent hike in interest rate buoying optimism, this earnings season is the right time for investors to rake in handsome gains from the aforementioned stocks.
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