We are pulling around 8%, or $50 billion, from the Biden budget. We’re planning… this is planning that will move away from woke, Biden-era non-lethal programs and instead spend that money on President Trump’s America First, Peace Through Strength priorities for our national budget.
That’s how Secretary of Defense Pete Hegseth described the cuts coming to America’s military in a video last week. He went on to list all the programs that would not be included in the cuts – submarines, border security, drones, etc.
But no matter how you slice it – and assuming it actually happens – that’s a large chunk of change being cut from America’s defense budget.
Maybe you think that’s good. Maybe you don’t. I generally avoid wading into politics in these essays. But I am interested in the markets. And the chatter from the new administration around defense cuts has caused several blue-chip defense contractors to slide.
See for yourself:
That’s Northrop Grumman (NOC) and Lockheed Martin (LMT), two of the largest publicly-traded defense contractors. And as you can see, they’re both down by double digits since election night. Some of the highest-quality companies in this industry are trading down 20% to 30% from their 52-week highs.
The old truism is that you should be “greedy when others are fearful.” Despite being one of the most hackneyed phrases in investing, it’s usually good advice.
Today, we’re going to take a closer look at the defense stocks and try to figure out if now is the time to be greedy.
How Big is 8%?
Hegseth’s plan calls for roughly 8% spending cuts at the Pentagon during each of the next five years.
Last year the Department of Defense’s (“DOD”) budget was $841 billion.
Source: United States Senate Committee On Armed Services
For most countries, cutting 8% of the defense budget probably wouldn’t be news. But most countries are not the United States of America.
According to the Peter G. Peterson Foundation, a think tank that researches the national debt, the U.S. spends more than the next nine largest countries combined, as far as the military budget goes. That’s because the U.S. has consistently devoted the lion’s share of its fiscal revenues towards defense spending.
In 2024, the U.S. allocated roughly 47% of its discretionary spending towards defense. As you can see below, the U.S. government has prioritized defense spending at levels that no other G7 country can match.
President Trump wants this to change.
He’s long called for NATO allies to increase their defense spending so that the U.S. doesn’t have to act as a global police force (at best)… or a babysitter, at worst.
From 1975 through 2024, the average percentage of U.S. GDP that was allocated to defense spending was roughly 4.1%.
That’s far above the low-single-digit figures that many of our European allies have dedicated towards their armed services up until recent years.
The Russian invasion of Ukraine changed things in that regard. Now we’re seeing many European countries talk about spending at least 2% of their GDP on the military. That rough 2% level is where the U.S. spending is expected to head as well.
The question is… why now?
The Debt Can No Longer Be Ignored
The U.S. has the greatest military on Earth, and I don’t think politicians on either side of the aisle want that to change… but current spending levels are unsustainable in the face of mounting fiscal deficits and growing national debt.
Here’s a chart from the Committee for a Responsible Federal Budget showing that during the first seven fiscal months of 2024, interest payments on U.S. debt surpassed major budget items, such as defense spending.
We can’t keep that up. That’s a formula for default. Something has to change.
The writing has been on the wall for DOGE-style cuts for years now. We had to do it at some point. And it was never going to be a popular decision.
That’s why politicians have been kicking the can down the road for decades.
I’m not here to defend the Trump/Musk rhetoric with regard to the DOGE cuts. I’ll be the first one to say that their talking points can come across as callous. And I know that real people, in the U.S. and across the world, are being hurt by these spending cuts.
Austerity is never going to win elections, though. That’s why I think Trump and Musk have rebranded their cuts towards efficiency and even politicized them with their diversity, equity, and inclusion focus. At the end of the day, most Americans love the idea of a meritocracy. And rightfully so.
From a communications perspective, rooting out “fraud and abuse” will be more popular than taking large chunks out of entire departments. But that’s exactly what DOGE is up to, and there’s no indication it’s going to stop.
That’s bad for investors. Wall Street loathes uncertainty. Many companies with exposure to government spending have largely stopped providing forward-looking guidance because of the shaky outlook for government spending.
Furthermore, the nationalistic policies coming out of the White House are threatening long-held alliances and globalist establishments, resulting in a murky geopolitical landscape on top of it all.
That’s why defense stocks have sold off… but rest assured, the news is not all bad.
Fear Is Creating Attractive Opportunities
Wall Street analysts have been able to parse through backlogs and insider chatter for months now, pricing in a slowdown in defense spending over the coming years. And, despite the downturn in share prices, earnings per share (“EPS”) across the blue-chip defense landscape are still expected to rise.
This shouldn’t come as a surprise to anyone.
These companies are highly entrenched as partners to our national security apparatus and consolidation in the space over the years has enabled them to establish wide, competitive moats.
These companies produce some of the most cutting-edge technology in the world. And the U.S. is not going to stop buying this tech. The Department of Defense is not looking to lose leadership on land, sea, or in the sky.
Proposed spending cuts are going to take place on the margins within the DOD, on things like administrative expenses and redundant platforms. The U.S. is still going to buy leading-edge jets, tanks, ships, submarines, and missiles. So are our allies.
These companies have backlogs with tens of billions of dollars for a reason.
Demand is sky-high for the best military hardware.
And yet, they don’t carry growth-tech valuations.
Why is that?
Well, the downside to their technology is that it’s largely classified and deemed necessary for national security purposes. So, it’s regulated.
Lockheed, for instance, can’t just sell its stealthy F-35 fighter jets to the highest bidder. Those sales have to be approved by the U.S. government. The same thing goes for the nuclear submarines that General Dynamics produces and the hypersonic missiles that RTX is working on… and countless other weapons platforms that the U.S. does not want to see fall into enemy hands.
Therefore, these companies don’t have the same sort of TAMs (total addressable markets) as the Magnificent Seven companies that focus on enterprise and consumer clients.
Nonetheless, the valuations currently attached to the blue-chip defense stocks are cheap. And they’re trading at significant discounts to their peers in the broader industrial sector.
And more importantly, for the first time in years, they’re trading with valuations that are not elevated compared to their own historical averages.
Today the Vanguard Industrials Index Fund (VIS) trades with a 25.7 times price-to-earnings (P/E) ratio.
On the other hand, Lockheed Martin (LMT) shares are trading for just 16.5 times forward earnings expectations when its 10-year average P/E ratio is 18.3 times.
Northrop Grumman (NOC) is trading for 16.4 times forward expectations when its 10-year average P/E ratio is 17.3 times.
General Dynamics (GD) is trading for 16.8 times forward earnings when its 10-year average P/E ratio is 17.7 times.
When looking at the biggest players in the space, only RTX’s (RTX) valuation remains elevated relative to its own history, at 20.8 times forward compared to a 10-year average of 18.2 times.
That’s because roughly half of this company’s revenues come from commercial operations. But even RTX’s 20 times multiple is still well below that 25 times price tag placed on the industrial sector at large.
For the first time in a long time, the big defense contractors are trading at fair (or better) valuations. And owning these blue chips at levels like these can make for great investments. We (Brad and I) would know.
In September of last year, we locked in returns of 54% and 74% with RTX and LMT, respectively, in the pages of The Wide Moat Letter. And the reason for the profit-taking was straightforward:
Unfortunately, today, LMT shares no longer trade with the same sort of discount that they did several years ago. On the contrary, we believe that Lockheed Martin is trading with a premium valuation which limits its upside potential moving forward.
I’m glad we took profits when we did. LMT is down about 21% since. But that has once again brought its valuation to attractive levels.
We might not know how far these DOGE cuts will go. Or how long they’ll last. But there’s one thing that I am certain of: There’s no better recipe for generating wealth in the stock market than buying and holding wonderful companies at fair valuations. That’s especially true when they have a sturdy moat made possible by the federal government.
Bottom line: There’s an opportunity for long-term investors to capitalize on uncertainty and get greedy with these beaten-down defense names.
Regards,
Nick Ward
Analyst, Wide Moat Research