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A Good Defense

Defense spending is due to increase regardless of which party is in the White House. Alas, the stocks of most contractors already look pricey.

Rob Wherry, 08/01/2016

Terrorism and armed conflicts are becoming a regular occurrence in certain parts of the world. Their impact has been heightened here in the United States during a particularly heated presidential election season that has partly centered on the country’s standing in the global economy. It’s natural to think that such rhetoric would lead to increases in defense spending on everything from next-generation submarines and airplanes to cyberwarfare technology, regardless of which candidate winds up in the White House.

Equity analyst Chris Higgins, who covers defense contractors for Morningstar, says that a lot of the campaign debate is largely noise, however. Indeed, a better barometer for defense spending is not what candidates say on their soap boxes, but rather an assessment of global threats and government deficits. Adding a layer to Higgins’ analysis of U.S. contractors is a raft of spending on share repurchases and hefty dividends, which have helped push valuations above Morningstar’s fair value estimates.

We sat down with Higgins in June to get his thoughts on the sector. His answers have been edited for length and clarity.

Rob Wherry: We are talking about defense contractors during an election year. I realize you don’t have a crystal ball—and Morningstar doesn’t weigh in on elections—but can you give readers an idea of how you assess the impact of having a Republican or a Democrat in the White House?

Higgins: It’s a question we’ve gotten from a lot of clients. If you look at the historical data, it’s pretty clear that elections don’t matter as much as everyone thinks.

Yes, they matter at the margins. But it’s more about: What’s the threat environment look like and the public perception of that threat environment? What’s the fiscal health of the U.S. budget—not the defense budget, the overall budget? Are we running deficits or surpluses? And what does the defense budget cycle look like? So are we at a trough in defense spending or at a peak relative to recent history? That’s a much better predictor of a long-term view—four or five years out—of where the defense budget is going.

Wherry: So, that chest-pounding—the I’m-going-to-make-the- sand-glow comments—you process them, but you also chalk them up to more short-term rhetoric?

Higgins: If you’re going to hold these stocks longer than, say, two or three years, then all that is noise. There will be a difference between a Donald Trump administration and a Hillary Clinton administration. If you look underneath what the defense spending is doing, you might see some differences there and some programs suffering and other programs winning to a certain extent.

Rob Wherry is a mutual fund analyst with Morningstar.

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