Defense stocks could soar again in 2020 after massive defense spending jump

WASHINGTON — Geopolitical uncertainty coupled with a colossal uptick in U.S. military spending could make defense stocks a winning trade once again in 2020.

Under the Trump administration, the space has left the broader stock market in the dust. The iShares U.S. Aerospace & Defense exchange-traded fund (ITA) has rallied more than 70% since Nov. 8, 2016. The S&P 500, meanwhile, is up around 50% in that time. This year has been no different. The ITA ETF has surged more than 30% in 2019 while the S&P 500 has gained around 27%.

Also, a historic boost to the U.S. defense budget should be a boon for defense stocks in 2020. The Pentagon’s spending power has never been larger at a cool $738 billion, up from $717 billion in 2019.

The rise in defense spending comes as the Trump administration has pulled the United States back from global commitments and pushed forward on ambitious projects like the denuclearization of North Korea, rising tensions with Iran, a bitter trade war with China and an ongoing effort to negotiate the end of the U.S. war in Afghanistan.

“Global attention is directed toward the US and China but the Gulf is more dangerous for the world,” said Neil Dwane, global strategist at AllianzGi. “Any escalation in the Middle East can become a full crisis as the effects ripple through the region.”

Despite sharp gains, analysts think valuations for defense stocks remain attractive as investors overestimate the impact a more left-leaning presidency could have on the sector.

“Although the 2020 elections remain an overhang on Defense stocks, we think the risks are way overstated and have hampered Defense multiples from expanding despite continued end-market growth,” said Buckingham Research Group analyst Richard Safran in a note.

Democratic presidential hopefuls Elizabeth Warren and Bernie Sanders have both spoken out against the $21billion increase to the Pentagon’s 2020 budget.

In a tweet, Warren said: “The Pentagon’s budget has been too large for too long. I cannot support a defense bill that’s a $738 billion Christmas present to giant defense contractors & undermines our values and security.”

Sanders, meanwhile, said earlier this month in a joint statement with congressman Rohit Khanna, D-Penn., the bill was of “astonishing moral cowardice.”

“It’s a widely held view (and we think an overhang on Defense) that the leading Democratic progressive candidates (Warren and Sanders) would likely slash Defense budgets,” Buckingham’s Safran noted.

However, he also pointed out that President Donald Trump would likely preside over the fiscal 2021 defense budget, meaning Warren or Sanders would not influence the budget immediately after taking office.

Nobody spends money on arms like the United States, and it shows in the bottom lines of the biggest defense contractors.

Lockheed Martin’s annual earnings surged by more than 155% from 2017 to 2018. Northrop Grumman also saw its bottom line expand by 61.2% in that time.

And while defense stocks may not be cheap, they are not expensive either.

The ITA’s price-to-earnings ratio, one of the most widely used valuation metrics on Wall Street, sits around 24.3. That’s well below its 2018 peak of 28.4. However, it’s also above its early 2019 trough of 18.9.

“It’s not the start of 2019 when multiples had de-rated on fear of a DoD budget decline. But its also not post 2016 election when multiples were somewhat stretched,” said Goldman Sachs analyst Noah Poponak in a note. “We continue to broadly favor Defense stocks. During periods of budget growth, which is the current environment, Defense stocks tend to outperform the market.”

Lockheed Martin, Northrop Grumman and General Dynamics are among Poponak’s top defense picks for 2020.

He pointed out Lockheed’s new order bookings have “substantially outpaced” those of its peers, “which should lead to much stronger than average growth near-, medium and long-term.” Lockheed Martin shares have been on fire this year, surging nearly 50%.

Last month, the Pentagon announced a $34 billion F-35 contract with Lockheed, the largest contract yet for the defense company’s costly fighter program. The F-35, a fifth-generation stealth jet, is the crown jewel in Lockheed’s portfolio and remains the Pentagon’s most expensive weapons system.

Read more: Lockheed Martin has become a stock market juggernaut under CEO Marillyn Hewson

Northrop Grumman’s exposure to weapons “modernization programs,” along with its favorable pension dynamics and falling capital expenditures make the stock a buy, according to the analyst. Northrop Grumman shares shot up more than 40% in 2019.

As for General Dynamics, the headwinds that led to the stock’s underperformance in recent years have started to subside and “can start to drive upside to consensus.” General Dynamics shares are only up 15.2% in 2019, well below the ITA’s gains for the year.

Fred Imbert contributed to this report from CNBC’s global headquarters in Englewood Cliffs, New Jersey.

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