Is the sky the limit for Defense Stocks (LMT)?

For years, I have studied the stocks of defense contracting companies. These companies are technology companies who have an unusually favorable characteristic. In the case of most technology companies, research dollars are spent developing products that the company hopes will be met with consumer approval. As such, net incomes are often fully retained to fund future spending cycles. In the case of defense contracting companies, the research costs are to more effectively produce a product that has already been approved for purchase with the best consumer of all: the U.S. Government. This lower risk expenditure on R&D translates into an ability to pay out almost all of the net income to shareholders in the form of dividends and share repurchasing.

Over long periods of time, the defense contracting companies have experienced relatively slow growth and have merged in order to reduce the likelihood of being left out of the dance. The result has been a small group of companies, each with areas of specialization and all characterized by fairly low single digit revenue growth. For this reason, the rapid increases in market value over the past 10 years is astonishing. For example, Lockheed Martin (LMT), outside of the Sikorsky helicopter acquisition, has seen almost flat growth. Yet during the same period, the stock of LMT is up over 300%.

What gives here? It seems like there are four explanations. The first is based on the above mentioned characteristics. In a market that loves bonds, these companies have bond-like financial characteristics. Second, these companies do extremely well when the US Dollar is strong - as has been the case from 2013. Third, for whatever reason, margins have been allowed to expand. This may be due to an increased absence of bidding. Normally, the bidding and cost plus approaches have kept margins at 12% or less, but lately these have been allowed to expand. Fourth, there is a Trump bump - which is sensible due to a 20% increase in this year's budget combined with hawkish rhetoric.

There is some regret in all of this as we had come extremely close to a purchase of LMT about six years ago, but were dissuaded by their pension complexities and liabilities. Now it appears that LMT will be allowed to retain its corporate tax cut to put $6 billion towards an underfunded pension plan.