If that's the way the military world seems to be shaping up over the next decade, we should logically ask what that means to defense stocks. My answer is: not necessarily a great deal. But they're worth looking at, partly as an object lesson in the continuing process of deciding what's cheap and what's dear. And partly to gain some familiarity with the industry, because all things have their season.

On first blush, representatives of the military/industrial complex have a lot of potential, since was is their business, and business looks to be good. As is usually the case, however, there are conflicting signals. On the one hand, even if there are a lot of Third World wars, police actions, and such, the dollar volume of defense spending is unlikely to rival the monstrous amounts that went into the late Cold War. On the other hand, the stocks are down considerably from the highs they reached at the peak of the spending boom. Question: What will be the nature of military spending in the future? I suspect that war in the future is likely to be much more manpower than equipment intensive (with the exception of electronics) for several reasons.

First, for all the hypocritical blather you hear from politicians about the infinite value of a single human life, they understand that you can afford to lose l,000 grunts a lot sooner than even one B-2 at $500 million a copy.

Second, one of the lessons of Vietnam was that human capital (which Third World countries have in huge abundance) will triumph over hardware every title; it doesn't matter if our soldiers have a kill ratio of l0 to one, because we will run out of money before they run out of people.

Third, whether they want to spend the money on guns or not, there just won't be enough money to lavish on exotic military hardware; it helped bankrupt the Soviets (like the British before them, and the French before them, and the Spanish, and the Romans), and it can surely do the same to the Americans if they continue to try acting as the world's self-appointed policeman. And it could be as profitless for the defense contractors as it will surely be for citizens.

 

The Arms Business

But even if the U.S. remains prosperous, I have a few reservations about the defense contractors. One is that the arms business is one of the most corrupt in the world, which is a natural consequence of several things: One, selling instruments of death and destruction can't help but to distort one's view of humanity. The normal constraints of peer pressure, moral opprobrium, and general feeling of good karma don't go a long way toward ensuring ethical conduct in this business. Second, these companies do almost all of their business with governments. Most of them are more unfettered than our own to start with, and their military and intelligence department are where all the really bad hombres gravitate. Third, most arms company executives are ex-government bureaucrats, many of whom now have cushy jobs with contractors as an indirect reward for favors done while they were supposedly working for the U.S. taxpayer.

It's long been true that contracts don't go to the companies with the best product, but those with the best political connections, and the ability to bribe most subtly. You'll notice that most of the companies in Table l receive 75% or more of their revenues from the U.S. or foreign governments. Profits are the result not of innovation and cost control so much as goldplating and cost inflation. Especially in the big companies, the engineers take a remote back seat to the glad-handing, memo-writing suits.

These companies weren't always that way. They all started as entrepreneurial enterprises selling commercial planes, and were run by engineers with a flair for business like Glenn Curtiss. As late as World War II, military aircraft were built "on spec" rather than on a cost plus basis. That goes a long way toward explaining how the P-5l, by far the finest fighter of that conflict, went from concept to production in just ll7 days, and at a cost of just $50,000 per copy. Of course, today's planes are larger and more complex, but that doesn't account for the P-5l's successor (like F-l4 and the ATF) going for literally l,000 times more in price, and taking so long to develop that they're obsolete by the time they're in service. Especially with the tremendous advances we've seen in computers, materials, and engineering techniques serving to increase efficiency and decreased real costs, the expense lies with the red tape which entwines these companies.

 

Which Companies?

If you assume that even a fair minority of the world's roughly l60 governments will continue to lavish their citizens' wealth on toys for the generals, then what can we do to hedge against the damage this will do? The answer is to buy some of these stocks then the time is right.

My inclination would be to go for small companies with unique proprietary products, which can provide tremendous leverage if they find favor. But, as AeroLift demonstrated, an outfit can be in business for many years and still go under if it isn't big enough to be bailed out"in the national interest", like Lockheed was in the 70s. The ideal scene would be a boutique run by its founder, which has already proven its success in the commercial market - like the aviation companies of the 20s, 30s, and 40s. I'm unaware of any that fit the bill at the moment, but anyone who follows the aviation industry can't help but be impressed with two men in particular. Paul Macready, the inventor of the Gossamer Albatross and the Sun Racer, and Burt Rutan, inventor of the globe-circling Voyager. If either of their companies ever goes public, they can count on me as ready buyer if the price is at all reasonable.

Another reason I prefer small companies is that management is typically the biggest shareholder, and has most of its personal net wealth tied up in it. That's not a guarantee they'll do the right thing by shareholders, but it help.

That brings us to the big contractors. I find little to choose among them except for the degree they depend on government contracts as opposed to commercial orders.

The big companies in this business are subject to intense scrutiny and public pressure; regardless of how much their managements try to pad the bill, it's just not politically feasible for them to show a lot of earning. Unfortunately, it's no socially acceptable for any large company to show large (read "obscene") profits today, but the defense companies least of all, since they feed directly at the public trough. My guess is that not a few managements solve this problem by bleeding off substantial shareholder funds to "consulting" companies located in tax havens, where they discreetly accrue to the benefit of insiders.

This is why, in my opinion, most of the big defense contractors sell at that appear to be bargain levels relative to other stocks.

There are several things worth noting about this list as a whole.

First, most of these companies are down 50% to 80% from the peaks reached in the post - '82 recovery; anytime a group is down by that much, it gets my attention as a bargain hunter, and it should get yours - even if this is the first time you've heard of some of these outfits. Any individual company's stock may be down because it's doing poorly, and you may not want it at any price. But when an industry as a whole is off, it's likely because of market fashion; the defense industry isn't going away.

Second, most of these companies reached their peaks, certainly in inflation-adjusted dollars, back in l8l2, when the Reagan armaments build-up against the now defunct Evil Empire was in full swing. This was after a prolonged collapse starting in l8l2, when a major bear market coincided with a wind-down of the Vietnam War. The way I see it, the situation is pretty analogous to that of the early 70s, since we're coming off a major defense spending binge and simultaneously entering a bear market.

How cheap are the defense and aerospace stocks? Should you hold those you may now own? When should you look to buy them? Bottom picking is a dangerous occupation in any event, and I believe it's still too early to try it with these stocks. Sure, they're already down a lot from the peaks. Many of the companies are already selling for 50% or less of book, which is a bear market level. I've tracked them since before the Jan. l7 invasion, and the group is only up about as much as the market as a whole. The best performers have been Northrup and McDonnell Douglas, two of the riskiest and most debt-laden issues.

As I indicated earlier, we can count on a lot of Third World wars to divert capital to these companies, but the nature of the song will different from the patterns established during the Reagan era. My guess is the megacost weapons like the B-l (a $250 million turkey), the B-2, the ATF, aircraft carriers, and submarines will be cut off at the knees, along with the stocks of the outfits that make them. So I'd be most negative on companies like General Dynamics, Grumman, Lockheed, McDonnell Douglas, and Northrop. I would suspect outfits like Logicon (which provides training and electronic services) and Nichols Research (basically a think tank) would do better. Companies selling software and intangibles (like brainpower) can control their costs and fix their prices far more effectively than those who have to rely on $200 hammers and $600 toilet seats for revenues. The smaller companies fitting this description have a consistent history of growing earnings and dividends, as well, something that's completely untrue of the large contractors. Insiders own a significant share of both companies, as well.

United Industrial is in the competition to replace the Army's M-l6 rifle. I've looked at tome of the submissions, and found that exotic hi-tech in the form of caseless cartridges (possibly a good idea, although fraught with potential problems) and flechettes (tiny multiple darts replacing the traditional bullet, which is almost certainly a disastrous idea) seems quite the fashion. This is undoubtedly typical of the whole procurement process. Instead of buying something cheap, proven, unbreakable, soldier-proof, and effective, the Pentagon always goes for some incredibly complex gee-whiz novelty which costs a fortune in overruns to develop, and, assuming the soldiers can even figure out how to deploy it, will break and jam in short order. So it seems that after being stuck with the expensive and unreliable M-l6 for 25 years, American soldiers are now likely to be saddled with something even worse. What they should have is a homegrown version of the AK-47. k But that's neither here nor there, and it's peanuts by comparison to boondoggles like the Acquila and the Sergeant York. C'est la guerre.

When looking to buy any stock (and it's too early in the bear market to buy, notwithstanding the current rally), always check to see if a company offers a convertible. Convertibles almost always offer much higher yield and lower risk than the common, with almost as much upside if they're priced right. EDO, Grumman, Hexcel, Loral, M/A Com, Moog, Rohr, and UNC all have convertible bonds; coincidentally, all of them were issued when the stocks were several times present level, so they just trade as straight bonds for the time being.

 

Boeing

Boeing is the premier aerospace company, and will likely remain so. It generates only 26% of sales to government, and can only expand its market share in defense.

This company will be a premier investment when the market as a whole returns to reasonable levels, since most of the world's commercial air fleet is going to need replacement. Old planes need lots of maintenance, they require more crew, and they burn a lot more fuel. On top of that, passengers will fly a carrier with new equipment every time if there's a choice. Boeing's order backlog, an amazing $l00 billion, is the greatest in history now. That backlog will likely suffer a lot of attrition as the current downturn accelerates, but the longer airlines delay purchases, the more explosive will be the rebound.

Incidentally, the same is true of the market for light commercial aircraft, which has already been completely devastated; shipments of piston aircraft (small Pipers, Cessnas, and the like) are down an incredible 96%, jets and prop-jets are down 50%. In the case of the light aircraft, product liability laws are the main culprit, but the economy will drive another nail in the industry's coffin. Unfortunately, the producers are owned by conglomerates, so there's no direct play on a recovery right now anyway.