Military Contractors May Thrive Under Obama

With Democrats coming back in power, many investors are being lured into choosing butter over guns. Infrastructure and consumer goods companies are abuzz. Military contractors? Not so much.

But in the past, the aerospace and defense sector has actually done better during Democratic administrations, according to Merrill Lynch. And typically during recessions national security stocks are a good hedge against losses in the broader market. In the past two recessions, the sector has beat the S&P 500 index by an average 17%.

Granted this doesn't sound plausible now as Wall Street's herd mentality sets in. Boeing (BA) and Northrop Grumman (NOC) have lost about 50% of their value over the past year; Lockheed Martin (LMT) is down more than a third from its 52-week high. Raytheon (RTN) has lost more than 20%. Shareholders in these guys probably don't feel too insulated.

"Investors are nervous about [President-elect Barack] Obama, as many think that while defense spending might not slow, there's going to be a shift in priorities in Washington," says Tom Lydon, president of investment advisory firm Global Trends Investments.

Yet with recession and political worries arguably priced into these stocks, what should matter going forward are earnings. Since President Bush has already signed the 2009 fiscal year defense budget, how many bad surprises can there be in defense contractors' reports next year?

Once we're in an Obama administration, cuts to military spending could presumably hurt the industry's profits. Merrill Lynch estimates that the overall defense budget will fall by $30 billion in fiscal 2010, from more than $500 billion in 2009. However, national defense spending declined under Bill Clinton, and yet shares of Northrop, Boeing and Lockheed all enjoyed a steady climb for a good chunk of the former president's term.

"Despite the traditional view that Republicans favor defense companies, paradoxically, the sector has outperformed more during Democratic administrations," Merrill Lynch investment strategist Jose Rasco wrote in a recent research report. By his analysis, the aerospace and defense industry has historically beat the S&P 500 by an average 2.6% under Democrats vs. 0.5% under Republicans.

Meanwhile, Joe Biden, the incoming vice president and a foreign-policy guru, has assured us that it won't be six months before some rogue state "tests" the new president. With India and Pakistan on the brink of serious conflict, Russia thumping its chest and Osama bin Laden still at large, there's enough geopolitical uncertainty in the world to keep defense companies relevant, and busy, Iraq withdrawal notwithstanding.

What's the best way to wade in? An ETF focused on the sector isn't a bad choice because it provides diversification. Two out there include iShares Dow Jones US Aerospace & Defense (ITA) and PowerShares Aerospace & Defense (PPA), both of which Morningstar currently considers "undervalued."

If you want to play it safer, consider diversified mutual funds that have exposure to large-cap defense companies. You can go with funds holding a noteworthy stake in such companies (more risk) like Vice Fund (VICEX), or funds that own a relatively sizable percentage of these companies' shares (less risk) like Fidelity Contrafund (FCNTX), which is reopening to new investors on Dec. 16. You'll notice in the chart below that some of the funds have hefty expense ratios and/or loads, which detract from returns. Weigh the costs against your conviction to the idea -- and against the alternatives. Right now there aren't many.