Missiles and moats: Defence stocks for a defensive portfolio

The Globe and Mail, Number Cruncher

By Peter Ashton

September 28, 2018

In The Globe And Mail, Peter Ashton uses Strategy Builder to search for U.S. defence stocks demonstrating long-term earnings growth, low debt and reasonable valuations.

What are we looking for?

U.S. defence stocks offering profitable growth and downside protection.
Over the past 10 years, defence stocks have significantly outperformed the broader U.S. market. For this period, the S&P Aerospace & Defense Select Industry Index has a cumulative return of 333 per cent compared with 188 per cent for the S&P 500. This out-performance is because earnings for companies in this industry have grown faster than the market over all as defence spending has increased and the industry has consolidated. These are also very defensive stocks in the investing sense, in that they are highly specialized and offer a strong moat to new competitors. Furthermore, their revenues are tied to government projects which are long-term and not linked to the overall economic cycle.

The screen

We will be using Trading Central Strategy Builder to search for U.S. defence stocks demonstrating long-term earnings growth, low debt and reasonable valuations.

We will start by screening for stocks with a market capitalization of at least US$10-billion. We wish to focus on the giants of this industry with stable long-term businesses.

Next, we will search for stocks that have reasonable valuations. We will filter and include only stocks with trailing price-to-earnings ratios of 25 or less. To find stocks with a track record of growing earnings, we will also include only stocks with five year historical earnings-per-share growth of at least 3 per cent a year. In addition, to focus on efficient and profitable operations, we will require gross margins of at least 15 per cent.

Last, to find stocks that are not overburdened by debt, we will screen for debt-to-equity ratios of two or less. Debt is a drag on corporate earnings and is especially worrisome in a rising interest-rate environment.

What did we find?

number cruncher

The lowest P/E and highest EPS growth rate on our list belongs to Huntington Ingalls Industries Inc., the largest military ship-builder in the United States. After five years of steady growth, the stock took a dip in April owing to a rare EPS miss. The stock is now up 8.3 per cent year-to-date and 14.9 per cent over the past year.

The highest gross margin on our list belongs to Rockwell Collins Inc., a leader in defence avionics and technology. Rockwell has a gross margin of 41.4 per cent and a trailing P/E ratio of 23.1. Rockwell is in the process of being acquired by United Technologies, with the sale expected to close later in 2018.

The largest company on our list is defence giant General Dynamics Corp. with a market cap of more than US$60-billion. The stock price is currently down slightly year-to-date but seems to have bottomed. The stock is up 4.8 per cent in the past month.

Trading Central Strategy Builder provides a back-testing capability to evaluate how well an in-vesting strategy would have worked in the past. Using a five year historical period with quarterly rebalancing, the screen described had a 20.7 per cent annualized return, compared with 11.6 per cent for the S&P 500.

The investment ideas presented here are for information only. They do not constitute advice or a recommendation by Trading Central in respect of the investment in financial instruments. Investors should conduct further research before investing.

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