Investors looking for exposure to the defense sector have traditionally bought shares of big blue chip military contractors and aircraft makers. Companies like Lockheed Martin (LMT), Boeing (BA), Northrop Grumman (NOC), Raytheon (RTN) and General Dynamics (GD) can be found in many ETFs and mutual funds, including the $1.06-billion Fidelity Select Defense & Aerospace Fund (FSDAX), which is the only fund mandated specifically to buy stocks in this sector.
However, the tragic events of September 11 and ongoing wars in Iraq and Afghanistan, along with terrorist strikes in Madrid, London, Bali and the continued threat of terrorism, introduced another aspect to defense investing: homeland security. Efforts by the U.S. government and corporations to increase security and surveillance, and to prevent further terrorist strikes, created a new subsector of companies providing homeland security services. This follows the Homeland Security Act of 2002 and the establishment of a Department of Homeland Security.
While Standard & Poor’s does not currently isolate ‘homeland security’ as a subsector, several homeland security companies fall under its coverage, mainly in the aerospace/defense and technology sectors. One example is Harris Corp. (HRS), a communication equipment company that provides products and services to the government and commercial customers. Harris recently received a one-year design contract for the secure wireless transmission system architecture of the U.S. Army’s warfighter information network-tactical program.
Kenneth Leon, a telecom equipment analyst for Standard & Poor’s, thinks Harris’ sales, which rose 19% in fiscal 2005, will gain another 14% this year and 11% next. “This reflects our view of strong government-related product demand — 53% of estimated total sales in fiscal 2006 — from increased spending to support the war on terrorism, as well as improved capital spending for microwave and broadcast equipment,” he said. “We believe the U.S. government will remain an important driver of future orders.”
Some investment managers have taken to buying companies whose products help protect the homeland. George Schwartz, president of Schwartz Investment Counsel Inc., was early to identify “homeland security” as a legitimate investment theme. As portfolio manager of the $75-million Schwartz Value Fund (RCMFX), he currently has about 7%-8% of his assets invested in these companies. “We began studying homeland security as an investment idea about two years ago,” he says. “We concluded that even after the wars in Iraq and Afghanistan wind down, homeland security will be an issue Americans will have to face for generations to come as long as terrorism remain a global threat.”
Schwartz believes budgets of both the U.S. government and corporations will keep a significant allocation to homeland security initiatives, thereby solidifying revenue streams for years to come. Indeed, Harris Corp. is also a top holding in the Schwartz Value fund. “They have a very successful product called the ‘Falcon-II tactical multi-band radio,’ which has been used by soldiers in Iraq and Afghanistan,” notes Tim Schwartz, an analyst with Schwartz Investment Counsel. “Harris dominates this niche business. While they have a few other divisions, about 65% of their sales are tied to U.S. military contracts.”
Leon thinks Harris’ shares, currently trading at about $45, could reach $55 in twelve months. “Our target price is further supported by our view of the company’s strong public sector franchise, with recurring sales and growing orders,” he adds. Leon recently upgraded the stock to a “strong buy” from a “buy.” Standard & Poor’s also has a “buy” recommendation on L-3 Communications (LLL), which makes electronics and communications equipment for the defense industry.