The government fiscal year is set to end soon, and it appears likely that a continuing resolution will not be put in place to avoid a shutdown. While this may cause concern for some, investors focused on the defense sector should not be swayed by the drama. Instead, they should carefully analyze the potential short- and long-term impacts, if any, from such an event.
Rob Stallard, an aerospace and defense analyst at Vertical Research Partners, does not hold much optimism about avoiding a shutdown. In a report published on Wednesday, Stallard expressed his view, stating that there is little progress being made by the government officials.
However, there is a glimmer of hope as the House has agreed to initiate the debate regarding the fiscal 2024 Defense Department Appropriations bills. This step can serve as a key to unlock funding for the government as well as drive sales within the defense sector.
In the case of a shutdown, it’s important to note that national defense funding would not completely cease. Instead, it would continue at the levels set in fiscal year 2023. While this is a more favorable outcome compared to other government departments, it still leads to delays, inefficiencies, and uncertainties within the Pentagon. Stallard emphasizes that any new programs would have to be put on hold until the shutdown ends and an appropriations bill is passed.
Historical data suggests that investors have remained relatively unaffected by previous shutdown dramas. Stallard’s research reveals that defense stocks typically underperform the S&P 500 by only one percentage point during shutdowns. However, they tend to outperform the S&P 500 by two percentage points after shutdowns come to an end.
In conclusion, investors in the defense sector should remain calm amidst the potential government shutdown. While uncertainties may arise, diligent analysis of the impacts and historical patterns can guide investment decisions effectively.
The State of Aerospace and Defense Stocks
Despite being a crucial sector, Wall Street’s sentiment towards aerospace and defense stocks remains lukewarm. The average Buy-rating ratios for these stocks in the S&P 500 are nearly identical across the board, with approximately 54% to 55% of analysts recommending a buy. However, when excluding companies like Boeing and Honeywell International, which are more focused on commercial aerospace rather than defense, the Buy-rating ratio drops to 50%.
Interestingly, Lockheed Martin and Northrop Grumman are the least popular stocks among analysts, both having Buy-rating ratios in the range of 30%. On the other hand, Textron emerges as the top choice among analysts, with an impressive 63% of them recommending a buy.
Raytheon Technologies (RTX) had a Buy-rating ratio of over 60% just a few weeks ago, but it has since fallen to 54%. This decline can be attributed to issues with its geared turbofan engine that powers certain A320-family jets.
L3Harris Technologies and Huntington Ingalls Industries fall somewhere in the middle, with Buy-rating ratios of 50% and 45% respectively.
Unfortunately, even investors don’t seem overly enthusiastic about defense stocks at the moment. Year to date, these stocks in the S&P 500 have seen a decline of approximately 12%. The only exceptions to this trend are Boeing and Textron, which have managed to see upward movement.
However, there might be a silver lining amidst these drops. Defense stocks, excluding Boeing and Honeywell, are currently trading at around 14.5 times their estimated 2024 earnings, down from the historical average of about 17 times in recent years. It’s worth noting that Boeing’s earnings are still recovering from the impact of Covid-19 and 737 MAX issues, resulting in its stock trading at approximately 38 times estimated 2024 earnings.
In terms of specific recommendations, Stallard favors L3Harris as a pure-play defense investment and rates the stock as a Buy with a price target of $237. He also recommends buying RTX and General Dynamics.
Perhaps the relatively low valuations combined with a resolution of the ongoing debt ceiling standoff could serve as a catalyst for the aerospace and defense sector.