Reduced Defense Spending Looms

Investing Daily Article of the Week

by Philip Springer, Investing Daily

This week, Defense Secretary Chuck Hagel proposed a defense budget that would reduce the US Army to its smallest force since before World War II, when we were woefully under-prepared for that war.

The proposals will face powerful resistance from members of Congress, veterans’ organizations, arms manufacturers and more. Complete details of the proposed federal budget are to be released next week.

The timing is unfortunate. Just consider this headline from lastweek: “Russia says it will respect the ‘territorial integrity’ of Ukraine.” Maybe. But such statements are meaningless as we are finding out.

Amid considerable other global unrest these days, reducing our spending on defense seems imprudent. However, various constraints that have built up over time require it, or reductions elsewhere.

Fifty years ago, the military made up nearly half of government spending. Now it’s about 17 percent. Entitlements were one-third of the budget then. Now they’re approaching two-thirds. Hagel said,

“This is a time for reality” .

Under the new approach, the emphasis is to shift from the longstanding goal of being able to fight two wars simultaneously, such as in Europe and Asia; and toward such threats as cyber warfare and terrorism.

For instance, the size of the active-duty military would decline by 13 percent and the reserves by 5 percent in coming years. But Special Operations forces would grow by 6 percent.

Inevitably, this would mean increased risk in the event of a second crisis. Hagel said,

“You have fewer troops, fewer ships, fewer planes. Readiness is not the same standard. Of course there’s going to be risk.”

The Army currently is scheduled to drop to 490,000 troops from a post-9/11 peak of 570,000. Under the new proposal, the Army would decline to between 440,000 and 450,000 based on the current mandate to impose a military spending cap of about $496 billion for fiscal year 2015.

But if the across-the-board federal spending cuts known as sequestration continue in 2016, even more significant cuts would be required in later years, and the Army would shrink to 420,000.

Regardless, the US would still spend considerably more on defense than any other nation. Hagel said,

“We’re still going to have a very significant-sized Army. But it’s going to be agile. It will be capable. It will be modern. It will be trained.”

Reduced defense spending has been on the horizon for a long time. However defense-related stocks have done very well over the last 12 months or so, after generally spending a long time in a relatively narrow trading range.

The biggest players in this field are Boeing Co. (NYSE: BA), Lockheed Martin (NYSE: LMT), General Dynamics (NYSE: GD), Precision Castparts (NYSE: PCP), Northrop Grumman (NYSE: NOC) and Raytheon (NYSE: RTN).

Boeing and Precision Castparts are generating strong growth. The others are not. In fact, their revenues are declining. But they’re all aggressively buying back their outstanding stock, particularly Northrop and Raytheon.

As a result, all four have solid growth of operating earnings. And they pay respectable dividends, with yields ranging from 2 percent to 3.3 percent.

Even as defense spending drops, the world remains a dangerous place. And there will still be a need for more advanced equipment and technology, intelligence and information systems.

For example, the entire fleet of older Air Force A-10 attack aircraft would be eliminated. But Lockheed Martin’s controversial, costly F-35 stealth fighter is still proceeding, with the military committed to buy 365 aircraft for $400 billion.

What’s more, the US (and its defense contractors), right or wrongly, continues to supply many countries with sophisticated military equipment.

As a group, these stocks provide modest but stable growth, financial strength and shareholder-friendly policies, at reasonable valuations.