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Defense Stocks to Put on Your Watch List

In this episode of Industry Focus: Energy, Nick Sciple and Motley Fool contributor Lou Whiteman start a new basket of defense stocks. They discuss the need for new defense spending, which areas to watch specifically, and why you should invest in defense stocks. Lou shares his favorite defense stocks and tells you about each companies' operations, why he likes them, what risks they face.

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This video was recorded on November 5th, 2020.

Nick Sciple: Welcome to Industry Focus. I'm Nick Sciple. We've got a great show planned for you this week. By listener demand, Lou Whiteman joins me to share his favorite picks for a defense stocks basket. Lou, welcome back on the podcast.

Lou Whiteman: Great to be here, Nick.

Sciple: I'm excited to have you on, if you can't tell. Before we dive into the basket, I want to give some context on the defense industry, how big is the global defense industry today?

Whiteman: So, the global defense industry expenditures topped $1.9 trillion in 2019, that's 3.6% up from 2018 and 7.2% from 2010. It's the highest level of spending since 1988, which of course, coincides with the Berlin Wall falling. All this, according to Stockholm International Peace Research Institute.

Sciple: Yeah. So, the biggest level of defense spending since the Berlin Wall falling obviously is significant, just to get some additional context on those numbers. U.S., the biggest player in the world by a significant margin, 38% of global military spending. No. 2, China, they're at 14% of global military spending; significantly their military expenditures are up 85% from 2010 to 2019. When you look at the third place, India, it would surprise a lot of folks. What is the role of India, how significant is that country when it comes to the global military industry moving forward?

Whiteman: Yeah, I think it's interesting, because I think both China and India are very key to this conversation. China is obviously the reason we're seeing a lot of defense spending out of the U.S. right now. But India has long been a tough nut to crack for U.S. contractors. They've traditionally leaned heavily on France, some on Russia. We've run into tech transfer issues. Recently there's been a thawing of relations, as far as military-to-military, especially because India is looking North to China and sees the U.S. as a good counterweight. We had a $3.5 billion helicopter sale earlier this year. The Administration hopes it's the beginning of something.

But yeah, I mean, a lot of what's going on in the industry, China is kind of feeling us to counterweight, and markets like India are opening up as global power shifts. So, that's a lot of the growth story for these companies.

Sciple: Yeah, you see a lot of folks throwing around this idea. I had Daniel Yergin on the podcast maybe a month or two back, talked about this idea of a new Cold War developing between the U.S. and China. You look at this level of defense spending, at the highest it's been since what many view as the end of the Cold War, the fall of the Berlin Wall.

When you look at military defense stocks as a sector, historically, how have these investments performed?

Whiteman: So, this has been a good sector to be a part of. I pulled out real quick, before we came on, Northrop Grumman (NYSE: NOC) was the easiest one to track back to the '70s. They have outrun the S&P by almost 8X, 25.9,000% return compared to the S&P's 3,000. Just since the turn of the century, Lockheed Martin and Northrop are both just crushing by 10X or more the S&P 500. This is a growth industry, [laughs] unfortunately, and it continues to be so.

Sciple: Right. And just to throw another number out there, 2.2% of global GDP in 2019 was spent on the defense industry. So, certainly a significant chunk of change. But when we look over the past several years, some of these bigger defense stocks, over a five-year timeframe, are trailing the market. What's behind that and what would be outperformers in the sector?

Whiteman: So, if you look at the chart, you'll see everything was going real well until earlier this year, over the last five years, they were handily beating the market. I think the SPADE Index is larger, but it's heavily influenced by the primes, who are up, I think, 40% or 50% on the S&P 500. We've had a one-two shot of COVID, because some of these companies do have commercial aerospace exposure, so that has brought it down and there's been uncertainty. And it's an election year, and we've seen a lot of uncertainty heading into this election, in particular, which we can talk about a bit, but things were going along fine until this year, and then we've fallen off the cliff like a lot of sectors in 2020.

Sciple: Yes, so you mentioned the election, I was going to bring it up later, but I'll bring it up now. How does the election fit into this narrative for defense stocks and does it change it at all in your view? It looks like, you know, for the purposes where we are right now, we're going to have a divided government with a Democratic President, a Republican Senate and who knows what, I think it's going to be a Democratic House as well. So, how does that impact the defense industry?

Whiteman: So, investors have long memories, obviously. And the last time we had a divided government this way, ended up with sequestration and budget caps. The defense industry didn't do well at all. And I think that's what you're seeing built into these stocks. The more it looked like things were going to change, the worst these stocks did.

Looking at the election, I think, overall, it's a modest sigh of relief. You know, I'm of the mindset, and we've talked about this on this podcast before, that the election wasn't really going to change the trends, the Pentagon budget was flattening. I think the fact that it wasn't a "blue wave," the GOP Senate should quash any talks that some of the big Pentagon priorities are going to be set aside or put on the backburner. But to be honest, I think a lot of that talk was overstated to begin with. If there was a loser, the current administration has really talked up a huge navy, doubling the size of the navy. So, shipbuilders, I think, would be the loser. But worth noting myself, and I'm hardly alone here, we've always been skeptical of those goals, and there still will be navy growth.

So, again, I think it's a modest sigh of relief and business as usual, hopefully, post election.

Sciple: So, that podcast we did, kind of, toward the beginning of the year talking about those plans for our nuclear triad and those sorts of things, that's still relevant, if folks want to go check that out.

Whiteman: Yeah, definitely. Nuclear triad, great power conflict -- which we've talked about before -- and then, I guess, autonomous or technology; ways to get more out of your money, kind of, by saving on personnel cost. Those are the real themes driving the Pentagon, and that's not going to change no matter who's in the White House.

Sciple: Right. So, that comes to the basket, so when it comes to putting together this basket of stocks, what was your process that you went through when making these picks?

Whiteman: So, this is kind of a weird sector, because defense companies by their nature, they're going to trade together, because so much of their fate is tied to one customer. So, to outperform, this industry either outperforms or underperforms together, kind of, based on the macroenvironment. To try and pick stocks, it's important to try and look at growth expectations, to look at differences in these companies that either have led them to be undervalued, that you think could soon mend itself or advantages they have. And so, I think a basket in this regard, instead of trying to pick a winner or loser, try and get a group of companies that appear to have advantage and, kind of, hedge your bets that way instead of putting all your eggs in one basket, you have a bunch of different companies that you think have a potential to win, and you should have upside no matter how it plays out, assuming one of them does.

Sciple: Right. I mean, there's significant volatility in this industry when it comes to -- there might be multiple companies bidding for one contract, and so there can be some lumpiness when it comes to who wins that contract. But being able to have exposure to some of these major trends that are playing out, can help you sleep at night, whether depending on a few key programs might concern you.

And just for context, one customer is important when it comes to the U.S. You know, for a lot of these companies are American companies. But also, the U.S.A., in 2019, spent more on military spending than the next 10 highest spenders combined. So, for any business in the world, the U.S. is the most significant player in this industry. When it comes out looking toward the long term, why might now be an exciting time or an interesting time maybe -- it's never an exciting time to invest in the defense stocks -- but an interesting time to invest in this industry?

Whiteman: We mentioned earlier, this is the largest year for military spending since the Cold War, and there was a peace dividend they called it; I think Margaret Thatcher coined the term. Post-Cold War, we did turn our attention away from defense spending. That lull is over. The Pentagon, for a few years now, has been screaming that this so-called era of unquestioned superiority is gone, China is investing, there is an urgent need inside the Pentagon to modernize, to play catchup in areas. And I am very confident that no matter who's in the White House, who's in Congress, there is going to be a lot of money allocated to fund R&D and procurement, which is the part of the Pentagon budget that we care about as investors.

Also, this is an industry that is extremely healthy, and we have clear visibility thanks to the way the government procures. The post-Cold War consolidation has created some very good streamlined companies. I was counting this morning, the top five of the largest contractors have almost $0.5 trillion in their backlog, that is revenue predictability, that is growth into the future even in a flat to declining budget, and that should help you sleep well at night if you're an investor in these companies looking at the election results.

Sciple: Absolutely. So, without further ado, let's get into the basket. I don't know if we planned this, but it's worked out that we've set them up in the order of market cap. So, Lou, what's your first pick for your defense stock basket?

Whiteman: Sure. And I should say, I didn't want to just be boring and pick four primes or something, so we tried to get different sections of the market, but we need at least one prime here. And the choice for me is down to Northrop Grumman or Lockheed Martin. And I'll be honest, I really like both of them a lot, I could've flipped a coin. But I feel like we've talked about Lockheed a lot on here, and not so much Northrop, and Northrop has a lot going in their favor. So, we're going to put Northrop Grumman in here first.

It's a good company, it's one of the world's biggest. They are two-thirds of this nuclear triad that we've talked about, which is the main U.S. defense priority.

Sciple: Yes. So, just to underline for folks that nuclear triad is, bombers, ICBMs and then submarines, correct, nuclear submarines?

Whiteman: Yes. And the idea, this is our defense against ever being attacked. So, this is the No. 1 U.S. priority since the 1950s.

Sciple: So, you mentioned these programs, obviously, appear to be a significant priority when it comes to the military's budget, and when you look at this idea of great power conflict moving forward, these are the types of programs that are part of that. You know, there was a Teddy Roosevelt carrying a big stick, type of mentality. So, when you look at the financial profile of this business, how is that playing out and how is the business generating earnings and rewarding shareholders?

Whiteman: Generally speaking, it was a really good quarter for defense companies. We had a lot of beats. Northrop stood out as, I would say, the best quarter of the major companies; it was a beat and a raise, and more importantly, in this uncertain budget environment, they got it for 4% revenue growth in both 2021 and 2022. The big hit on this quarter, and I wrote about it for Lockheed was, this lack of confidence about revenue growth heading into 2021 due to some of the uncertainties.

Northrop was pretty much exempt from that, and that kind of really makes them a standout, they're not cheap, it's 21X earnings, but I think that's reasonable for this company given what they have and how well it matches up with the Pentagon's priorities.

Sciple: If this investment goes wrong, what happens?

Whiteman: Okay. So, if there is one part of the triad that I would worry about, it's the ICBM. I worry about that less, that we didn't have the blue wave, because I think the ICBM was going to be targeted by, shall we say, further left government. So, I can't imagine it going wrong, but if we do have even delays in the triad funding, it's probably going to come to that, and that's going to hit Northrop Grumman.

Also, while they are projecting revenue growth, they have flatter free cash flow projections. There is a good dividend here, and dividend growth is sort of baked into that price, I don't think we have to worry about the dividend not growing, but should they decide to pause dividend growth, that could spook investors, especially in this environment. So, it could cause a flinch in the stock at least.

Sciple: All right. So, a reminder for folks, that's Northrop Grumman, ticker NOC. So, for pick No. 2 in the basket, what do you have for us, Lou?

Whiteman: We're going to go with L3Harris (NYSE: LHX), which is probably the least well-known prime anyway. This is a new company, largely under the radar. It was formed a few years ago from the merger of two mid-tier companies Harris Corp and L-3 Communications. Some of the rationale behind this deal was, these were second-tier companies that were doing a lot of, what they called non-prime work, where they were contractors to the contractors. With this scale they could compete for more prime work, and importantly for the story, more international work, just because they have to go out and sell.

This is a company, their major business lines are heavy into space and classified. They have little to no international right now, only about 20% of sales. But a lot of the stuff they do, the high-tech communication systems and radios, night vision equipment, these are things that the U.S. increasingly wants their allies to have. And with the communications side, easy plug-and-play with the U.S. systems. With this company, and the bigger size, they have a real opportunity to sell these products internationally to the allies. It's a big part of their pipeline. Management says they have about $20 billion in international bids out there right now. They're playing catch up there, but that's to an investors advantage.

Sciple: So, why is scale so important here when it comes to getting these international deals?

Whiteman: Well, for one thing, you just need to have the force to go out and pursue them. And a lot of this too, it's a slow sale, most countries aren't dealing with a fraction of the budget that the United States does. It's hard to get them to pick priorities. And these companies, it is kind of a case where these second-tier items, you need to make a lot of noise to get on the radar screen. These are companies that were competing for a lot of these products in the U.S. The night vision, for example, these were the two biggest vendors. Now that they are one voice going out instead of competing with each other, from what I understand and what it seems so far, in NATO, that's a much clearer message to get out, and it's resonating.

Sciple: Yeah. And I'll tell you, just gut feeling as someone with a little bit of a legal background is, you know, there's a lot of legal hoops you have to jump through to do any of these bids to sell military weapons to someone who is not the United States as a United States-based company. And so, being able to consolidate some of those expenses under one roof, I could imagine would produce a lot of savings.

When you look at the business and the integration that's going on here, what does the financial profile of this business look like today?

Whiteman: So, the integration is still going on, but it's about done, it's led to some earnings choppiness, and it hasn't helped their cause to get on radar screens. But you know what, they're selling off some of the product lines they didn't want so much, including in the airport security screening division, which looks like a smart deal to get that done now with COVID. The company said on the third quarter call, they will return 100% of free cash flow in the coming years to shareholders. Doing the math, you know, it's very much an estimate, but I have that at about $30/SHARE worth of cash that can be used for dividends, buybacks, etc.

The dividend yield is 2%, that's pretty good for the market, that's not great for a defense stock. But I very much expect early in 2021 to see that go up, I think that'll help attract investors. It's not a cheap stock, but there is so much growth potential, I believe, that if you're going to hold for a few years, I think, among defense companies, there is real potential for this to be a margin and growth story in the years to come.

Sciple: Yeah. This wasn't in our notes, Lou, but it's something that I am thinking about as we're talking, there seems to be a lot of transactions back-and-forth, spinoffs in these businesses. Why is that the case in this industry?

Whiteman: So, I would argue, it's probably gone down in the last few years, but yes, there is a constant pruning. Kind of, the latter half of this Cold War experience, and the sequestration experience was, when the revenue wasn't coming in, Boards had to take a long look at the businesses they were in and, kind of, where do we want to specialize. So, we're in the latter stages, I think, of the primes saying, alright, we are going to be an airplane maker, but not a shipbuilder. You know, just a very broad thing. L3Harris, the nature of it, because they've done the deal so recently, they're still going through that process. But you've seen Lockheed Martin is the great example of this, where they bought and sold billions of assets late in the last decade to just try and figure out what they want to be when they grow up.

Sciple: Yeah. I forget what the quote is, but there's a famous quote that's like, there's two ways to make money in business, bundling and unbundling. And I think maybe you see some of that in these defense contractors. So, before we move on from L3Harris, we've talked about those catalysts they have in some of these emerging technologies, space, that sort of thing. Again, like I asked earlier about Northrop Grumman, if this investment goes wrong, what happens?

Whiteman: So, some of these products we discussed, like, night vision goggles, they could be described as discretionary in a tight environment. I think that communications is going to hold up really well, I think in general that these are important products. But we're not at war right now. If there really is budget pruning, we could see delays on that. Also, in a worst-case scenario, if we have a fall in the size of force, if we literally decide we need a smaller army, that's going to impact some of the growth projections. I think there's enough potential growth, I don't worry about these things, but this isn't the slam-dunk case that a nuclear triad bomber is. And in an environment where the budget is a little uncertain, that is at least something to keep in mind.

Sciple: All right. So, as we move down this basket list, as we will, we're moving to some of these smaller companies, and maybe we'll see more of that dynamic play out. What's your next company on the list, Lou?

Whiteman: So, the next, I wanted to go with a government services company, and the one I chose is Booz Allen Hamilton (NYSE: BAH), which is about a $12 billion company. These are the companies that do the IT work, outsource services, all sorts of -- they're not building bombers, they're not building tankers, but they're doing a lot of intelligence stuff, and they're doing some of the mundane stuff, like running the internet service for Health and Human Services or some other civilian government.

You know, these are the companies that were really hit hard by sequestration. It was decided that especially with what was going on in the Middle East, we had to keep buying bombs, we can put off our IT upgrade. That didn't work too well last time. There's been a lot of fear baked into these companies this year that that was going to happen again. I don't believe it will. And I think Booz Allen, because of the strength of their business, the classified work that they do, even if that does happen to some extent, they're going to hold up really well.

Sciple: All right, these are the parts of the budget that are becoming more and more important as we move into this more cyber age of military spending.

Whiteman: Right. It's hard to imagine anyone who's followed the news in the last year and talk of state espionage, government hacking, it's hard to imagine that the Pentagon in 2020 is going to say, we're going to put off IT right now, we're just going to backburner that. And I think that plays into some of these companies' advantages.

Sciple: Yeah, I think, one thing that blew my mind, we're talking about Booz Allen Hamilton here, there's another company in that sector I looked at this week called CACI. And in 1982, they were the top-performing stock in the market. Okay, at that point, before they had come public, they had +20 years of earnings growth of +30%. And then since they've become public, I pulled the number down, they're up 174,000% since they came public. Which just goes to show just, there's not that many industries where you can have that type of longtail of growth, where demand is increasing year-over-year and there's ability to grow your business.

And the fact that you've had -- and Booz Allen Hamilton and some of these others have only come public more recently, but to have this track record of the industry of just how long this can grow for, just shows where the opportunity is. And then you add in, like we just talked about this, this idea, that we're entering this world of cyber warfare and that sort of thing, you know, it's maybe not one of these things that is going to explode like a Zoom or some of these tech companies that will triple in a year, but it is an incredibly long tail that these companies are riding when it comes to growth.

So, all that to say, it seems as though that there's a significant opportunity going forward. When we look at the business today, the earnings they're producing today, what does it look like?

Whiteman: So, Booz Allen, again, had a very good quarter, we're going to stick [laughs] with that theme, but they reported third quarter revenue up 11%, earnings up 27% year-over-year. Now, I'll be honest, the guidance was a little slower than that, but we're still talking 7% to 8% growth. And this is a very conservative company, they tend to overshoot. So, I think that's a very hittable bogey if they're doing that. This is a company with very little debt, lots of free cash firepower. And again, just to kind of make your point on CACI, because I think that stock is essentially you saw the beginning of an industry there. No matter where you fall politically, given our deficit, given the budget strain, it's hard to imagine less will be outsourced from the government in the years to come. And that's on the state level too, where Booz Allen is, again, very, very active on the state level. It is easy to see how more and more of this burden is going to be shifted to these companies, and that is a great growth opportunity for them.

Sciple: Yeah, CACI. Thanks, Lou, for catching me; this is why we pay you the big bucks.

Whiteman: Yeah, there we go. [laughs]

Sciple: So, last one on Booz Allen, you buy the stock and the investment goes wrong, what happened?

Whiteman: So, we should point out, this is the company that once employed Edward Snowden. And, kind of, need I say more? These are complicated businesses, they at times deal with very, very complicated issues, ethical questions. It's sort of an opaque business for that reason, that can limit its attractiveness to the broader investing in public. There is a scenario maybe where the Pentagon slows procurement, even if they don't cut off IT. So, that could drag the earnings a bit short-term. So, these are businesses that require a particular -- you know, they have to fit your taste; and if not, you should be worried, or you should, you know, move on. But you know what, this is a company that is going to grow in the future, so I'm not too worried about it.

Sciple: Right. May not be for everyone, but it is an industry that certainly is in demand and probably will continue to be so, if history is any indication.

Lou, for the fourth stock in your basket, what did you come up with for us?

Whiteman: So, we went for something with a little more, kind of, off the beaten path, the stayed path, we went with Kratos Defense & Security (NASDAQ: KTOS). This is a much smaller company, under $3 billion market cap. And you know, this is the high-risk, high-reward play. This is a business, they do a lot in defense electronics, but they're best known as a drone maker. Most of their drone revenue today are these, sort of, dumb target drones that you just throw up in the air and shoot down for target practice. But they are moving up the value chain. They have some drones on demonstration with the Air Force that are just the stuff out of science fiction. The Valkyrie is the best-known. They call it the loyal wingman, its prototype. And the concept is that it's going to fly alongside piloted fighters, provide extra firepower and just provide extra radar dots to kind of confuse anti-aircraft systems.

You know, this is a contract that we've been waiting for for a long time, and that is sort of a worry that we haven't gotten it yet. But on the third quarter call, CEO Eric DeMarco said they expect a contract on a "non-specified" drone in the coming weeks and months. That's almost certainly the Valkyrie, and I believe the market will cheer, if not at least breathe a sigh of relief.

They have other platforms. The Gremlins, which is the idea of a swarm of drones launching out of a C-130. They are a finalist in the Skyborg competition, which is where you get really cool. I mean, you're going to use AI to, kind of, have the drone make decisions on the battlefield and adapt to battlefield competitions. There's a lot going on in this portfolio and what we know is the very early days of it. It's really, this is the sci-fi stuff that's kind of really cool to think about, and they are bleeding edge on it, ready to capitalize on.

Sciple: Yeah, this seems like one of those areas, you know, the military was the first to use drones and now drones are something that you see consumer drones and those sorts of things. This feels like one of those where the military is on the cutting edge of this technology. Yeah, and they have to be, because we talked about the budget earlier, and you know, it's important to note as investors, most of that money isn't being spent on equipment or R&D, most of that is the mundane stuff, like, payroll, benefits, all of that stuff.

So, if you expand the military, if you expand the navy, you need at least 100 new people to run the ships. The obvious answer, if you want a bigger, stronger military without all that budget weight is more autonomous, more drones throughout the military. The Air Force, for obvious reasons, is at the cutting edge of that, and Kratos is right there with them making this happen.

Sciple: Yeah. So clearly, I think an industry that you could expect to grow over time when it comes to drones and those sorts of things. When you look at the valuation of the company, it's safe to say the market expects that as well.

Whiteman: Yeah, we're talking about 500X earnings, which is not normal for a defense stock, 3X sales even, which I don't think any of these others are more than 2X sales that we've talked about. Look, it's priced assuming these orders come in. So, maybe some of the jump has already happened, at least initially, with the initial orders, but there is so much potential here, and that first order is just the beginning of it. This is more of the typical Fool tech stock that you talk about, where, yes, it's priced to grow, but yes, it can even grow more than it's [laughs] priced for, I think, if things go right for it.

Sciple: So, this is one of those where I'm going to ask you the question of what could go wrong, but I'm going to ask you another question, though. So, if things go right, what's the exit here, does this company become, you know, a Lockheed Martin of drones or do you think this company gets acquired on its way up? What happens to you as a shareholder if things just go incredibly right?

Whiteman: You know, I think both of those are possible. I think Lockheed Martin is an interesting one to talk about. They have a new CEO, and there's a lot of whispers that they would like to get back to M&A and this would be No. 1 on -- as a current Lockheed shareholder, I would love them to kick the tires real hard on this. I don't know if, on its own it could become Lockheed Martin, which is the world's biggest contractor, but it can be many times bigger than it is right now, it is still a relatively tiny company. And I know darn well based on the potential that they wouldn't sell for $2.8 billion or whatever their market cap is right now, they would want a lot more in a deal.

Sciple: Yeah, so $2.5 billion that I looked at this morning, you know, enterprise value, I don't know yet, you have to look at the specific number. So, on that other side of the equation, right, if things don't go right with this investment, what happens?

Whiteman: Okay. Well, we just talked about their size, you know, they are a small fish in a big pond. Boeing has its own loyal wingman prototype, it's being done out of Australia, and there's a lot of questions about that. But Boeing has very deep pockets and Boeing can make its mark. Similar with Skyborg, Kratos is up there against Northrop, they are in there against Boeing. You know, we are counting on these coming through. They look like a good chance, but you know, this is an open competition, and if it doesn't, then at the very least, that valuation doesn't look as [laughs] -- if the potential goes out, some of the air is going to come out of that balloon. So, again, this is the high risk, but it is the potential high reward.

Sciple: And is this one of those where it could be, kind of, an event-based thing, where they don't get the contract and everybody realizes that, and it's like, oh, no? There could be some volatility here.

Whiteman: Yeah. I mean, no, the day that comes out that they don't, it's going to be, but what else do you have. And you know, it's a lot like these tech stocks and maybe that works out over time, it tends not to work out over the next few months.

Sciple: Yeah. So, be prepared for volatility. You know, as we talked about earlier, Northrop Grumman is this huge significant prime contractor with lots of different contracts, and is less exposed to that type of risk for some of these smaller ones, like Kratos; that's something to think about and risk to be mindful of.

So, that was our four picks, Lou, Kratos, Booz Allen Hamilton, L3Harris, and Northrop Grumman. So, to run through those tickers for you, the ticker for Northrop Grumman is NOC. L3Harris is LHX. Booz Allen Hamilton is BAH. And Kratos is KTOS. Lou, you also had one honorable mention you wanted to talk about.

Whiteman: Well, I just wanted to put in there General Dynamics. And I guess either General Dynamics or Raytheon, I sort of excluded them because they both have big commercial businesses. But of the two, General Dynamics, for all of its drama, and it arguably doesn't have the defense business that some of these others have, but they do have the nuclear submarine in the triad, they do have Gulfstream on the commercial side that has really underperformed over the last 10 years, but I think is attractive. General Dynamics is the cheapest prime because of Gulfstream. And if and when Gulfstream ever comes back, you're going to see that valuation gap close. It's an intriguing company to watch, but because most of the drama is outside of defense, I figured, let's exclude them from this and focus on a company like Northrop, that's a lot easier of a defense story.

Sciple: Yes, so that ticker is GD. For context in those earnings, so General Dynamics is trading at 12X earnings; Northrop was, I believe, 21X last I checked. So, a significant gap there, and that reflects the market's concern about this more private jet-focused business.

Whiteman: Right. If you believe private jets will come back eventually, you should believe that they can close that gap, and that's an interesting stock. But again, that's sort of a commercial story and it's gotten a lot more complicated with COVID. So, it's kind of hard to say anymore when that's going to happen.

Sciple: Yeah. We'll see how that plays out. General Dynamics, historically, has been a fantastic business to be invested in. Anybody who wants to read an investing book, The Outsiders by Will Thorndike is a fantastic book. And one of its chapters profiles General Dynamics. I highly recommend checking that out. Okay, Lou, before I let you go away, I have to ask you the Highlander question. There can be only one of these [laughs] defense basket stocks, and you have to buy and hold them for the next five years, what would be your pick and why?

Whiteman: So, the boring answer here is probably the right one, and I should probably say Northrop, but you know, let's have fun, I'm going to take L3Harris, because I really, really do like the management, I really like what they have set up. And I think as they come into more radar screens that the stock is really poised to go higher in the years to come.

Sciple: All right. That's L3Harris, ticker LHX. We'll be watching to see how all these perform and maybe we'll come back next year to check in and see how we're doing. Lou, I'll be hopeful that you will be with us to do that.

Whiteman: That would be fun. Let's hope we at least beat the SPADE Index, the defense index, even if I can't beat the S&P, but let's beat both.

Sciple: Yeah. Hey-hey! You know, we'll see what we can do. Always love having you on, Lou; looking forward to having you on again next time.

Whiteman: Thanks, always fun.

Sciple: As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear.

Thanks to Tim Sparks for mixing the show. For Lou Whiteman, I'm Nick Sciple, thanks for listening and Fool on!

Lou Whiteman owns shares of General Dynamics, Kratos Defense and Security Solutions, L3Harris Technologies, and Lockheed Martin. Nick Sciple has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.


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