Are Defense Stocks Recession Proof?

Some investors consider defense stocks to be good investments during any market condition. But are defense stocks really recession proof?. An recent article titled A nations that merely wants peace in the New York Times says that “Despite a recession that knocked down global arms sales last year, the United States expanded its role as the world’s leading weapons supplier . . . The United States signed weapons agreements valued at $37.8 billion in 2008, or 68.4 percent of all business in the global arms bazaar, up significantly from American sales of $25.4 billion the year before.

Italy was a distant second, with $3.7 billion in worldwide weapons sales in 2008, while Russia was third with $3.5 billion in arms sales last year — down considerably from the $10.8 billion in weapons deals signed by Moscow in 2007.”

The total value of global weapons trade in 2008 was $55.2 B. Out of this, sales to developing countries accounted $42.2 B. The US was the top supplier to developing nations with sales of $29.6B or 70% of all deals last year.

Similar to other goods clearly developing countries are the major consumers for defense items as well. Many of these countries spend huge amount of funds on acquiring foreign military technologies to maintain national security. The top three arms buyers in the developing world last year were: United Arab Emirates, Saudi Arabia and Morocco. Next to US, Russia and France were the major exporters of arms to the developing world in 2008.

Charts:

US Arms Sales from 2001-2008
US-Arms-Sales-till-2008

Major Arms Suppliers to Developing countries in 2008
Arms-Transfer-Agreements-Worldwide-by-Suppliers-Developing-Nations

Arms Transfer Agreements Worldwide by supplier percentage of value

Arms-Transfer-Agreements-Worldwide-by-Suppliers-Value

Source: Conventional Arms Transfers to Developing Nations, 2001-2008

US companies dominate global arms trade. The US accounted for 42.6% of all arms agreements between 2005-2008. The second ranked Russia’s sales was less than half of the US share.

The Top 10 U.S. Defense Contractors based on revenue as of 2008 are as follows:

1. Lockheed Martin (LMT)
2. Boeing (BA)
3. KBR Inc (KBR)
4. Northrop Grumman (NOC)
5. General Dynamics (GD)
6. Raytheon (RTN)
7. SAIC (SAI)
8. L-3 Communications (LVLT)
9. EDS Corporation
10. Fluor Corporation (FLR)

Source: WashingtonTechnology.com

Half of the above companies are engaged in the design, manufacture, sale and services of large military equipments such as plans, missiles, ships, etc. Lockheed Martin (LMT), Boeing (BA), General Dynamics (GD), Northrop Grumman (NOC) and Raytheon (RTN) fall in this category.

In addition to military items, Boeing (BA) makes commercial jetliners and space flight systems.Total revenue last year was $61B and the annual earnings growth is 34%. Currently the stock pays a 3.27% dividend.

The world’s defense contractor Lockheed Martin (LMT) is involved in the manufacture of advanced technology products including ballistic missile defense systems and nuclear weapon. It also makes the famous F-16 fighter jets, the Hellfire missile, the C-130 transport plane, etc. The average annual earnings growth is 27%.

Los Angeles, CA-based Northrop Grumman (NOC) is the maker of the B-2 bomber, the F-14 fighter, Global Hawk unmanned aircraft, Airborne Warning and Control Systems (AWACS) and other systems.

Lexington, MA-based Raytheon (RTN) makes the famous Tomahawk cruise missile, the 5,000-pound “bunker buster” bomb GBU- 28, etc. The average earnings growth is 25% and the profit margin is about 8%.

General Dynamics(GD) manufactures the famous M1 Series Abrams Main Battle Tanks. In the civilian space, it owns Gulfstream Aerospace unit and the shipbuilding and repair unit National Steel and Shipbuilding.

KBR Inc (KBR), SAIC (SAI), L-3 Communications (LVLT), EDS Corporation
and Fluor Corporation (FLR) provide a variety of services to the military and civil sectors. These services include construction, engineering, technical, software among others. Though these companies are not as large as the five products makers above, they still win huge contracts from the military and civilian agencies alike.

The chart below shows the 5-year performance of the top five large defense product makers:

5-year-chart-best.png

Lockheed Martin(LMT) leads the group in the 5-year stock performance. Despite being one of the world’s largest makers of commercial planes Boeing stock has lagged in performance relative to others.

Comparision of Government Expenditures: USA vs. Norway

How do the government expenditures of USA and Norway differ?. USA follows the capitalist economic model whereas Norway is a socialist country. It is a general notion that the US spends less on social entitlement programs compared to socialist countries. When we compare the expenditures of Norway and US using the charts below, there is not much difference between these countries especially when it comes to social programs.

USA – The Federal Budget for 2008

USA-The-Federal-Budget

Norway – Government Expenditures in 2008

Norway-Government-Expenditures

Source: Statistics Norway

The top 3 areas of US expenditures are : Defense and Security, Social security, Medicare and the like. The US spent 21% of the budget on defense and security compared to under 5% by Norway in 2008. This is understandable since the US maintains hundreds of military facilities worldwide and currently runs two wars.

Norway spent about 55% on social benefits and health-care. The total expenses spent on Social Security, Medicare, Medicaid and CHIP and Safety Net Programs equaled 52%. This comparison clearly shows that the US spends more than half of the budget on social programs. Despite being a capitalist country, it shows that the government has become socialistic over the years. Though the “public” option has been eliminated from the health care reform, Uncle Sam is the main provider of health insurance for most of the senior citizens thru Medicaid and Medicare. All these entitlement programs cost the government a lot of money and will continue to grow in the future. Some say that the government run entitlement programs such as the Social Security is the largest ponzi scheme of all as majority of the funds needed for these programs are borrowed from lenders or paid out of tax revenue from workers.

Since Norway is a surplus country it does not have interest payments. As of July this year the US budget deficit amounted to $1.3 Trillion. This US borrows heavily from other countries including the major lenders China and Japan to fund its operations. As a result , 8% of the US budget goes to the payment of interest on national debt. In 2008, the total interest payments were $253 B. As more funds of borrowed to finance additional social welfare programs and the various corporate bailout programs like TARP, this part of the budget will definitely increase. From another perspective, one can say that 8% of the national expenditure went to waste unnecessarily in the form of interest payments.

The remaining 19% of the US budget went to all other areas such as education, transportation infrastructure,scientific research, etc. It would be better if a higher percentage of government spending is allocated for these areas.

How Costly are Financial Crises?

Financial crises are very costly according to an article in the latest edition Finance and Development magazine of the IMF.

Financial crises occur more frequently in emerging countries than developed countries.Between 1972 and 2007 emerging markets have been hit with more currency crises than banking and debt crises. Developed countries have had virtually no debt crisis in the same period.

Costly-crises


The average fiscal cost of banking crises is under 10% of GDP for the developed world compared to more than 15% of GDP for the emerging countries. Output lost is similar to both emerging and developed countries.

On the causes of a financial crisis, the article notes:

“Whereas each differs in its details, nearly all reflect a confluence of some underlying economic vulnerability and a specific crisis trigger. The underlying vulnerability
is often a credit or asset price bubble, a balance sheet mismatch (excessive borrowing in foreign currency, at too-short maturities, or with inadequate capitalization), whereas the crisis trigger can be almost any event—political turmoil, terms of trade shocks, contagion from other countries, or, to take the example of the current crisis, the collapse
of the subprime market (see table)”

The table below shows the vulnerabilities and triggers of some of the past crises:

Crisis-Triggers

On the recent credit crisis that started in the US, the vulnerabilities were the credit and the house price boom. In addition weaknesses in financial regulation resulted in a buildup of leverage and mispricing of risk. The trigger for the crisis was the collapse of the sub-prime mortgage market. Will the financial reforms that are being proposed block astronomical leverages among financial institutions and consequently prevent future crises?.Only time will tell.

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Three Nasdaq-listed Argentina ADRs

Argentina is the second largest country in South America after Brazil. It is classified as a
upper-middle income market by the World Bank. Like Brazil, Argentina is blessed with an abundance of natural resources. Agriculture is one of the main export sectors.

Argentina had been plagued with financial crisis for many years. From the Wikipedia: “By 2002, Argentina had defaulted on its debt, its GDP had shrunk, unemployment reached 25% and the peso had depreciated 70% after being devalued and floated”. However after 2003 the economy started to improve after the implementation of effective expansionary policies.

Three Argentina companies trade on the NASDAQ market. The following is a brief summary on these ADR stocks:

1. Cresud (CRESY) is an agricultural company with interests in crop production, beef cattle raising and milk production. In addition the company involved in the real estate business. Cresud owns 19 farms. As a commodity sector stock, it has a high beta of 1.6. The 5-year average annual earnings growth is 57% and the P/E ratio is 21.43. YTD Cresud is up 42%. Since agricultural products is one of the top exports of Argentina, Cresud is an attractive stock at lower levels.

2. Alto Palermo (APSA) is a real estate company engaged in the leasing, ownership and operation of shopping centers. It operates 11 shopping malls in Argentina. The current yield is 15.5% and the beta is 1.3. The stock ha grown by 27% YTD.

3.Grupo Financiero Galicia S.A. (GGAL) is a financial services holding company engaged in offering banking, financial and investment services. GGAL closed at $4.5 yesterday and it pays no regular dividends.