One of the sectors seeing inflows and breaking out to new highs is defense and aerospace stocks, as evidenced by the more than 5% gain in the  Invesco Aerospace & Defense ETF (PPA) this month, compared to the S&P 500’s 2.5% gain. This outperformance is unusual, as the sector tends to lag the market when interest rates are rising, and economic growth is accelerating. 

Yet, the sector continues to move higher due to its attractive valuation and the Biden Administration’s proposed defense budget, which came in above expectations. Three of the top defense stocks that investors should consider buying are Lockheed Martin (LMT), Textron (TXT), and Booz Allen Hamilton Holdings (BAH). 

Reasons to be Bullish on the Defense Sector

Currently, the defense and aerospace stocks in 2021 remind me of health insurance stocks in 2009. 

In 2009, health insurance stocks reached very low valuations, as many were concerned about the effects of Obamacare. However, these concerns proved to be misguided, as the industry adapted and was able to actually benefit from the implementation of Obamacare. Ironically, health insurance stocks were one of the best-performing groups from 2009 to 2016.

Similarly, defense and aerospace stocks fell out of favor recently as many expected the Biden Administration would cut defense spending in favor of other priorities. However, the proposed Biden defense budget keeps spending at 2020 levels. Additionally, two more catalysts for the sector are the proposed $3 trillion infrastructure bill, which should be a boon for many defense companies, and the return of earmarks which tends to benefit companies in the sector. 

Therefore, I see defense stocks defying expectations and outperforming. Now, let’s dig into some of the best stocks in the sector.

Lockheed Martin (LMT)

LMT is up 15% since mid-February. In contrast, the S&P 500 is flat over this time period. One catalyst has been the company’s strong earnings report which topped analysts’ expectations with 7.3% sales growth and 19.6% earnings growth. The company also has exposure to the space industry which many believe will be the next trillion-dollar industry and is beginning to attract investor attention. 

Despite this above-average growth rate, LMT is attractively priced with a forward PE of 13, while the S&P 500 has a forward PE of 23. It also has higher profit margins than the S&P 500 at 10.4% compared to 6% for the S&P 500.

The POWR Ratings are also bullish on LMT as it is rated a B which equates to a Buy. The POWR Ratings are calculated by weighing 118 different factors. B-rated stocks have a compound annual performance of 19.7%, while the S&P 500 has an annual performance of 7.1%. 

The POWR Ratings also evaluate stocks by different components. It’s not surprising that LMT has a Value grade of B given that its multiples are significantly lower than the market average. LMT also has a high-quality management team which is indicated by the company’s long-term track record of compounding earnings.

Some of the other components that the POWR Ratings evaluate stocks by Quality, Momentum, Stability, Sentiment, Growth, and Industry. To see more, click here.  

Textron (TXT)

TXT is a defense conglomerate with various subsidiaries including Arctic Cat, Bell Textron, Textron Aviation, and Lycoming Engines. Some of its well-known brands include Cessna, Hawker, and Beechcraft. TXT started as a textile company but began supplying the military with parachutes during World War 2.

From these humble origins, it’s continued to expand via acquisitions to become one of the largest defense companies in the United States. Its main source of revenue is supplying engines and parts for military planes. 

The stock is also quite attractive with a forward PE of 16. In 2020, the company experienced an overall decline in revenue due to a drop in orders from its business supplying parts to commercial airlines as this segment was adversely affected by the pandemic. However, this could prove to be a buying opportunity as analysts expect air travel to rebound in 2021 and 2022. 

The stock is rated a B by the POWR Ratings which equates to a Buy. In terms of growth, it’s also rated a B as revenues are expected to quickly return to their 2019 levels. Further, defense spending is also expected to return to its pre-pandemic trend over the next decade. Analysts are expecting compound annual sales growth of 8% over the next 5 years.

Booz Allen Hamilton Holdings (BAH)

BAH has been one of the biggest winners over the past decade with a 788% increase. It has multiple segments with its largest being IT and consulting services for government agencies and defense contractors. However, the company’s fastest-growing source of revenue is its defense intelligence services.

Essentially, defense intelligence provides data analysis tools to help intelligence agencies sort through all the data they collect to find insights. This, in addition to its cybersecurity services, is expected to power BAH’s growth over the next decade especially since BAH faces less competition due to governments preferring to work with trusted partners on national security issues.

Typically, companies with deep moats and impressive growth rates are priced at a premium. However, BAH is slightly cheaper than the S&P 500 with a forward PE of 20. It’s also significantly cheaper than other cybersecurity companies and competitors like Palantir (PLTR). BAH also pays a healthy dividend at 1.8% and has a consistent track record of increasing payouts.

The POWR Ratings rates BAH a B which equates to a Buy. It also has a B for Sentiment as BAH’s multiples have contracted over the past year despite the growth in its high-margin businesses which should command a higher multiple. To see more about how BAH’s other component grades, click here.  

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LMT shares were trading at $369.44 per share on Wednesday afternoon, down $1.10 (-0.30%). Year-to-date, LMT has gained 4.87%, versus a 6.70% rise in the benchmark S&P 500 index during the same period.

About the Author: Jaimini Desai

Jaimini Desai has been a financial writer and reporter for nearly a decade. His goal is to help readers identify risks and opportunities in the markets. He is the Chief Growth Strategist for StockNews.com and the editor of the POWR Growth and POWR Stocks Under $10 newsletters. Learn more about Jaimini’s background, along with links to his most recent articles. More...

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