Multiple geopolitical and American political events are likely to push down defense stocks going forward. As a result, I believe that investors should take the lion’s share of their profits in defense stocks, including Lockheed Martin (NYSE:LMT), General Dynamics (NYSE:GD) and Northrop Grumman (NYSE:NOC).
Defense stocks spiked recently due to America’s conflicts with Iran. But in the wake of Iran’s economic difficulties and the accidental destruction of a plane by the Iranian military, the Iranian government has been facing intense, widespread domestic problems.
Moreover, the architect of its previous proxy military incursions in the Middle East, General Qasem Soleimani, was killed by the U.S. It’s unclear if his successor will be up to the task of inspiring and managing the multiple proxy militias that Iran has used to wreak havoc on the Middle East in recent years.
Finally, Tehran almost definitely would have trouble bankrolling and sustaining a direct war with another major regional power like Saudi Arabia or Israel, let alone the U.S.
So at the very least, the growth of defense spending by the Gulf States and Israel is likely to decelerate. Much more importantly for defense stocks, the need for huge U.S. defense spending increases will decline.
In the years to come, multiple other factors will also keep a lid on U.S. defense spending. In recent years, the country just spent a great deal on modernizing its armed forces. With that task largely completed, defense spending growth is likely to slow.
President Donald Trump has shown an inclination for removing U.S. troops from the Middle East and has pushed Europe hard to spend more on its own defense, rather than effectively letting America pay most of the continent’s defense costs. In a potential second term, Trump is likely to feel freer to push those initiatives harder. Also, if Trump wins a second term, I think he will look to make a deficit reduction deal, since he will not want the U.S. to enter a fiscal crisis on his watch. Such a deficit reduction deal will almost definitely include relatively large defense spending cuts.
Finally, if Trump loses, defense stocks will take a hit. A Democratic president will probably cut defense to fund his or her domestic programs. And even if Trump wins, but the Democrats take control of the Senate, the president will probably have to agree to some pretty big defense cuts.
Here’s more company-specific information about why I think investors should take profits in Lockheed Martin, General Dynamics and Northrop Grumman .
Lockheed Martin (LMT)
In 2018, Lockheed Martin got only 28% of its sales from foreign countries, making it vulnerable to an American deficit reduction package or Democratic election victories. Also making LMT stock vulnerable to negative catalysts — including a more peaceful world, an economic recession and DC budget cutting — is the sky-high cost of its crown jewel, the F-35 stealth fighter plane. The planes have a price tag of between $89 million and $115.5 million each.
It will be very tempting for a Democratic president or even a Democratic Senate to try to fund domestic priorities by slashing the Pentagon’s purchases of the plane. Early in his term, Trump said he pushed LMT to cut the plane’s cost. If he gets reelected, he may renew that effort even more forcefully.
Hardly a bargain, LMT stock’s trailing price-to-earnings ratio stands at 21, while its 2.2% dividend yield is nothing to get excited about.
General Dynamics (GD)
Like LMT, GD stock is quite dependent on Washington. In 2018, 65% of the company’s revenue came from the U.S. government.
General Dynamics makes a great deal of money selling land-based vehicles to the Army. In 2018, its revenue from military vehicles came in at $4 billion. Among the vehicles it sells are tanks, “tracked combat vehicles” and “tactical vehicles.”
Additionally, the company sells “weapons systems, armament and munitions.”
If Trump or his successor pulls U.S. troops out of Iraq and/or Afghanistan, the Pentagon’s demand for vehicles and weapons is likely to drop sharply. That would clearly hurt GD stock.
For 2018, GD reported $5.7 billion of revenue from nuclear-powered submarines. The Navy’s nuclear-powered submarine programs is expected to cost a whopping $128 billion. That’s another hugely expensive program that would be ripe for cutting under the aforementioned (for defense stocks) adverse conditions.
GD stock has a trailing P/E ratio of 15.8, and it has only gone up 13% over the last year. Still, I think its risk-return ratio is unfavorable at this point, given its high leverage to the U.S. Army’s combat operations and very costly nuclear submarines.
Northrop Grumman (NOC)
Northrop Grumman is even more dependent on the Pentagon than LMT and GD. In 2018, foreign military sales only made up 14.6% of the company’s top line, according to Seeking Alpha.
Even with Trump’s defense buildup, the company, which specializes in aerospace, hasn’t been setting the world on fire. Its third-quarter revenue rose just 5% year-over-year and the operating income of its main businesses actually dropped 4% YoY. In the first six months of the year, its net earnings rose only 6%, although the operating income of its main businesses jumped 26%, likely due to its acquisition of Orbital ATK which closed in June 2018.
Still, the lackluster Q3 results, trailing P/E ratio of 21.7 and price-to-sales ratio of nearly 2 make it quite unattractive. Moreover, the stock has jumped nearly 50% in the last year. It’s definitely time to take some profits on NOC stock.
As of this writing, the author did not own shares of any of the aforementioned securities.