By JACK HOUGH
Military suppliers have gotten clobbered. Among S&P 500 members, aerospace and defense firms have lost 22% of their value in six months, versus 16% for the broader index. These companies were cheap to begin with relative to their earnings, so some of the discounts are now striking.
Trouble looms for these firms, of course. U.S. military spending is conspicuously high at a time when big deficits are forcing cuts. The country accounts for 43% of the world's military budget. It spent 5.4% of gross domestic product last year on its military, the highest percentage in NATO by a large margin. Greece is second at 2.9%, but that's misleadingly high because of its shriveled economy. A better comparison is No. 3 Great Britain at 2.7%.
Big spenders are supposed to achieve something called economies of scale, which means that, if anything, the U.S. should spend less than smaller peers relative to its economy, all else held equal.
That has Democrats and Tea Party Republicans finding rare common ground on the issue of defense cuts. The Budget Control Act of 2011, the deal made to avert a U.S. Treasury default, calls for $1 trillion in spending cuts over 10 years, including defense and non-defense spending. It also requires a committee to find another $1.2 trillion in cuts, or trigger a $600 billion slashing of defense spending.
Sort of. Technically, little of the initial cuts must come from defense; law-makers have plenty of flexibility. And the $600 billion trigger applies to future spending, which is projected to be larger than today's spending. So cuts might mean slower growth rather than, well, cuts.
That means investors might be too bearish on defense stocks, some of which carry 4% dividend yields at a time when the 10-year Treasury yield has slipped to a historic low of around 2%. Treasury coupons don't increase over those 10 years. Dividends often do.
"Most of these companies are paying a third of their earnings or less in dividends," says Howard Rubel, who covers the group for Jefferies & Company, an investment bank. "If the defense budget declines at a manageable rate, dividends will be safe."
Rubel is optimistic about the committee -- and opinionated about defense cuts. "Everybody's decided that the committee can't cooperate," he says. "I'm not sure why Congress would put together a committee that would fail. Maybe I'm begin too optimistic." Cutting defense creates a drag on the economy because it puts soldiers, sailors and machinists out of work, he says. "The rocket scientists from the Tea Party don't get it. I don't think they've studied more than Neanderthal economics."
Sudden cuts might even increase costs. Many defense contracts have terms that say that the government must absorb sunk costs in the event of cancellations. So policy makers might decide on a more gradual path to spending reductions.
Rubel has "buy" recommendations on Raytheon, Northrop Grumman and General Dynamics (GD),