0:02 looking to invest in defense stocks and
0:04 you don't know where to start. The best
0:06 defense stocks aren't the ones that
0:08 everyone's talking about. Today, I'm
0:10 going to show you how to get the best
0:13 exposure to defense stocks using a
0:15 transparent and proven methodology. And
0:17 as with any investment theme, we always
0:19 start by looking for leaders. That's
0:22 because market share is a lot easier to
0:24 defend than it is to capture. Economies
0:27 of scale, moat, all that rigomearroll.
0:29 And in the defense industry, your
0:31 barrier to entry or biggest moat is
0:33 probably the fact that you're a defense
0:35 contractor. So, who are the largest
0:37 defense contractors? Now, index
0:40 providers do a great job of classifying
0:43 companies based on industry and size.
0:45 And since they don't charge for their
0:47 data, we can just pull up the largest
0:49 ETF and have a look at it to see what
0:51 the largest constituents are. And the
0:54 particular types of companies that we're
0:56 interested in are called aerospace and
0:58 defense firms. And you can see here this
1:00 is the global industry classification
1:04 standard that MSCI built with S&P
1:06 Global. And it's a very effective tool
1:08 when it comes to classifying companies
1:10 by what they do. So we want companies
1:12 under this particular classification of
1:14 aerospace and defense which falls under
1:17 industrials. And I think this diagram
1:19 here shows it really well in terms of
1:22 the percentage of companies within
1:24 industrials that are aerospace and
1:25 defense. It's the highest. It's around
1:28 23%. At least when this measurement was
1:30 taken late last year. These don't change
1:32 that much. Then you have machinery. Then
1:34 you have ground transportation. So when
1:36 we're looking at aerospace and defense
1:38 ETFs, we always like to look for the
1:40 largest ETF. Typically that means it has
1:42 lower fees because they have more assets
1:43 under management. And this is the
1:47 iShares US Aerospace and Defense ETF.
1:48 Now, it's worth noting that a year ago
1:51 when we looked at defense stocks last,
1:53 there was about $13 billion in these top
1:56 three ETFs, that's about $19 billion
1:58 today. So, money is gravitating towards
2:00 this particular sector. And when we open
2:02 up this ETF and take a look at the top
2:06 constituents, very interesting. 45% of
2:08 defense and aerospace is in three
2:12 companies. GE Aerospace, RTX, and
2:15 Boeing. RTX you may remember is Rathon.
2:17 Now to understand how these companies
2:20 are being selected, we want to take a
2:22 look at the index providers methodology.
2:24 We've pulled that up here and they refer
2:26 to a modified market cap waiting. What
2:29 they seem to be doing here as I dug into
2:31 the methodology is that they're using a
2:33 capping function and that's normal for
2:35 industry ETFs where you have highly
2:37 concentrated constituents. You can see
2:40 that here as I said 45% of the index in
2:42 three names. Now, we're more interested
2:45 in defense than aerospace. So, that's
2:47 really going to change the direction
2:49 that this analysis takes. And in order
2:51 to guide us down this path, I've pulled
2:54 up this excellent data table which shows
2:57 the top 100 defense companies by
2:59 revenues, 2024 revenues that is. You
3:02 see, they've sorted on that column here
3:04 and there's a list of names, some
3:06 familiar, but the column that I want you
3:08 to focus on for right now is to the
3:11 right. It says 2024 revenue from
3:13 defense. So as an example, Loheed
3:17 Martin, 96% of total revenues came from
3:19 defense. That's great, right? That's the
3:21 exposure that we want. But what about a
3:24 company that only has 20% of their
3:25 revenues coming from defense? Do we
3:27 really want that in our portfolio? Is
3:28 that really a bet on defense or is it a
3:31 bet on the other 80% of business
3:33 activities they're conducting? So what
3:35 is the minimum percentage of revenues
3:37 coming from defense that we're going to
3:38 require? Well, I've taken this table and
3:41 simply sorted on the percentage of
3:43 revenue from defense from smallest to
3:44 largest. You can see a couple
3:46 interesting things. First of all, Parker
3:48 Hannifan, that happens to be an
3:50 industrial company that we hold as part
3:52 of our dividend growth strategy. So,
3:53 it's interesting to see we're getting
3:55 some incidental exposure to defense
3:57 there around 9% of their revenues
4:00 apparently. And then GE Aerospace,
4:01 remember that was the largest
4:05 constituent over 20% of that ETF. Turns
4:07 out only 16%
4:09 of their revenues come from defense. The
4:11 other 84%
4:14 come from presumably aerospace, right?
4:16 So we're not looking for aerospace
4:19 exposure. So that would be a company we
4:21 drop off. Again, what's the minimum
4:23 exposure that we expect? Now, there's
4:26 clearly synergies and overlap between
4:28 these two categories, defense and
4:29 aerospace. And I think that's why that
4:31 table is such a rich source of
4:33 information and we need to make a
4:34 decision here. So really there's three
4:36 paths that we can take. The first is
4:39 that we can invest in near pure plays.
4:42 Let's say 75% defense or higher. We can
4:44 take a different approach and invest in
4:46 companies that are about 50/50 between
4:48 the two. Or we can go down a path where
4:50 we're going to invest in companies where
4:52 defense isn't a majority. Now we would
4:54 argue that if you're going to invest in
4:56 defense stocks, you're going to take one
4:58 of the first two paths. So there's
4:59 really two cohorts of leaders that we
5:01 want to look at here. You have the pure
5:04 play names. Lockheed, Northrup, General
5:06 Dynamics, Bay L3. Then you have the
5:09 50/50, so RTX and Boeing. But what I
5:11 found interesting is that five of these
5:13 seven names have something in common
5:15 that really makes them stand out. The
5:17 names that you see highlighted here have
5:20 not only paid a dividend, they've
5:23 increased it for at least 20 years in a
5:25 row. That sort of accomplishment
5:27 requires a lot of financial discipline,
5:29 and it translates into consistently
5:31 growing your earnings over time. That's
5:32 how they're able to do that. That's
5:34 where dividends are paid from, earnings.
5:37 Right now, I wanted to touch on RTX or
5:40 Rathon's disputed status as a dividend
5:44 champion. And I've listed out the simple
5:45 explanation here. This came up before
5:48 and basically SNP doesn't believe that
5:51 they retained their champion status.
5:53 Well, we believe that they did. This
5:56 refers to a merger and acquisition event
5:59 that took place. Actually, numerous M&A
6:01 events. and things get complicated in a
6:03 hurry there. That's the power of having
6:05 a methodology and really digging into
6:08 this stuff. So, we believe that RTX has
6:10 retained its champion status. That would
6:12 be 27 years of increasing when they were
6:16 UTX. And then as RTX 5 years increasing
6:18 as well. So, we would choose RTX over
6:21 Boeing for this reason. When you look at
6:23 Boeing, this is rather interesting. So
6:24 you see where they were having some
6:27 years of increasing their dividend and
6:29 then we had COVID hit in 2020 and that
6:32 seems to have really rocked this firm.
6:33 I've pulled up their operating margins
6:36 here and anytime you have a company that
6:38 hasn't been able to operate at a
6:41 positive operating margin for four
6:43 years. I think that's very concerning
6:45 especially given that all their peers
6:47 don't seem to have this problem. But
6:49 what's interesting about Boeing I find
6:50 is when you look at Bess andBinder's
6:52 study of the highest performing stocks
6:55 ever that have ever existed. Look here
6:57 on the top names here. I don't know 20
6:59 or 30 top names here. You see there
7:01 General Dynamics, Boeing, Northrup,
7:03 Grumman. War is a profitable business,
7:05 right? And we're not going to get into
7:09 the ethical elements, the sort of ESG
7:11 bits around investing in defense stocks.
7:13 or assume that you've already done that
7:16 work yourself and that you're interested
7:17 in investing in defense stocks for
7:19 whatever reason. Now, what we can then
7:22 do is start to look at operating margins
7:26 across the board. The point here is that
7:28 operating margins over time, the
7:31 consistency is highly desirable and when
7:33 there's a deviation in trend, that
7:35 merits a closer look. So, if you were
7:36 going to invest in any one of these
7:39 stocks, you'd want to plot that out over
7:40 time. We've done that here for Lockheed
7:42 and Northrup. The first thing to notice
7:44 is that in 2020, they didn't seem to be
7:46 impacted much by CO. Well, that's
7:48 because they're more defense than
7:51 aerospace, right? And for Lockheed,
7:53 you'd certainly want to look at the
7:55 recent drop there in their operating
7:57 margins. And Northrup, you'd want to
7:58 look at the volatility that's being
8:00 displayed. And when we look at two more
8:02 names here, you have L3 Harris. There
8:05 was a large M&A event in 2020 that led
8:07 to that drastic drop in operating
8:09 margin. though that consistency since
8:11 then is great. Same thing with general
8:14 dynamics. Look how consistently it's
8:17 floating around that 10% mark and you
8:18 have that exception back in what looks
8:21 like 2013. You'll better understand a
8:23 business when you understand the causes
8:25 for these deviations. They're usually
8:27 related to accounting. But what this
8:30 means for these firms is that despite
8:33 all the fluctuations in operating
8:35 margins, what's very impressive is that
8:37 all five names that you see here have
8:39 managed to increase their dividends for
8:41 greater than 20 years. You have really
8:43 two categories. The first two names,
8:45 General Dynamics increasing for 28
8:47 years, RTX for 32 as I talked about
8:49 earlier. Then you have upcoming
8:52 champions here. So in our 30 stock DJI
8:54 portfolio, we only consider champions
8:56 and above. But for those looking at
8:58 building a dividend growth portfolio
9:00 that would lax that requirement, you
9:01 might want to consider some upcoming
9:04 champions, we define those as firms that
9:06 have increased their dividend for 20
9:08 years or more. And you see here that
9:10 Lockheed L3 and Northrup aren't that far
9:12 away from having official dividend
9:14 champion status. So some takeaways,
9:17 defense pure plays were more resilient
9:19 to COVID in terms of the impact on their
9:21 operating margins and profitability.
9:23 Seems like the bearish on airlines
9:26 thesis comes into play here. All
9:28 defensive pure plays that we've looked
9:30 at enjoy operating margins around 10%.
9:32 Well, that's great. That gives us a
9:34 benchmark, right? Aerospace and defense
9:36 really are two different exposures even
9:39 though it's too granular to be reflected
9:41 in their GIS classification. And many of
9:43 these companies are supplementing their
9:45 defense revenues with commercial. And I
9:47 think that diversification is a
9:49 double-edged sword, right? But with any
9:52 defense exposure, one thing that you can
9:53 be sure of is that you're heavily
9:56 reliant on the United States Department
9:58 of Defense budgets. And you see here
9:59 this great diagram showing how the
10:01 United States spends more on defense
10:03 than the next nine countries combined.
10:06 So you're going to have a real heavy
10:08 dependence on the United States with
10:10 these large defense contractors. And the
10:12 question is, well, how much? Well,
10:14 you'll see this great table here which
10:17 shows the Pentagon contracts to top arms
10:21 firms from 2020 to 2024. So, 5 years of
10:22 data. First thing to notice, I've
10:24 totaled them all. On the left, you see
10:27 Lockheed Martin, by far the largest
10:29 contractor of them all when it comes to
10:31 revenues coming from the US government.
10:33 But on the right here, I've taken this
10:36 data for 2024 and then compared that to
10:38 the previous table that showed 2024
10:40 revenues, which lets us see what
10:42 percentage of their defense revenues are
10:44 coming from the United States. And I
10:46 particularly like General Dynamics and
10:48 Northrup for the reason that it's only
10:51 around half, right? So that means that
10:54 not entirely reliant on the United
10:55 States as opposed to other firms like
10:58 Lockheed. 75% of their revenues coming
10:59 from the Department of Defense. And
11:02 since they have 96% of their revenues
11:03 coming from defense, they're heavily
11:05 dependent on the US government.
11:07 Double-edged sword, right? The way we
11:10 look at that is when you're a vendor for
11:12 the US government, you really have no
11:15 power at the negotiation table. So,
11:16 another thing that we did, this was
11:19 about a year ago, is we looked at common
11:22 names across the top four defense ETFs.
11:24 And I think that sort of reaffirms our
11:27 findings today. You see Lockheed, RTX,
11:29 Northrup, and L3 Harris there. Those
11:32 four names were found in all four of the
11:35 top four defense ETFs. And then found in
11:38 three of four. We have General Dynamics,
11:40 of course, another name on our list, but
11:42 also Boeing. Now, we dismissed them
11:44 earlier. And then you have Helmet and
11:47 General Electric. Both have 16% of the
11:49 revenues coming from defense. Not pure
11:52 play enough for us to consider. So, the
11:54 other thing that you might argue here
11:55 would be, well, if you're going to
11:58 invest in these five names, then they're
12:00 highly correlated. Why invest in all of
12:01 them? Well, actually, they're not as
12:03 correlated as you might think. I found
12:05 this very interesting. So, I would say
12:08 somewhere around a 0.7 correlation or
12:10 higher, or where you might say that two
12:13 assets or two stocks are starting to
12:15 appear quite correlated. And you see
12:17 here in numerous cases that these firms
12:19 aren't really that correlated. So I
12:21 found that to be rather interesting. So
12:23 different aspects we've looked at
12:26 largest US vendors, diversification of
12:28 defense revenues, we've looked at
12:31 various sizes of companies, pure play.
12:33 So these five names that we've narrowed
12:36 it down to on average 79% of the
12:38 revenues come from defense. Margin
12:40 consistency is 10% really across the
12:42 board. So that gives us sort of a
12:44 benchmark. And when it comes to revenue
12:46 growth, they all ought to be enjoying
12:48 that, right? with all the war that's
12:50 happening. But that doesn't really
12:51 appear to be the case, at least
12:53 according to Grock's analysis of their
12:55 5-year compound annual growth rate. You
12:57 see only RTX there is sort of
12:59 approaching double digits. But this sort
13:02 of begs the question, why do you want to
13:04 invest in defense? Is this spending
13:06 cycle just getting started? Maybe so.
13:08 And if you believe that defense is going
13:10 to outperform in the long run, then
13:13 creating a mini portfolio of these five
13:15 stocks is a good idea because you're
13:17 avoiding the fees that are associated
13:19 with an ETF and you're getting better
13:21 pure play exposure to defense stocks
13:23 than you would be with an ETF. So if you
13:25 created a mini portfolio, you can decide
13:28 if you want any rebalancing rules or you
13:30 just want to let your winners run. What
13:32 I done here is put these tickers into
13:35 Excel. I then chose the convert to
13:36 stocks function. By the way, we have a
13:38 piece that shows you exactly how to do
13:41 this. You can pull up their market caps
13:42 easily and then start to calculate
13:45 percentages. So, I've done that here.
13:47 You see, you would have 27% of this
13:50 portfolio would be RTX, then Northrup at
13:53 11, etc., etc. Now, you can monitor this
13:56 over time. And if you're thinking about
13:59 risk, then if this mini ETF is 10% of
14:01 your assets, then your RTX exposure
14:04 really is just 2.7%. So I always think
14:06 of that quite holistically. You can
14:08 either let your winners run here or put
14:10 a cap on them. So you say, "Well, what
14:13 should the cap be? 30%, 25%, we have a
14:17 cap in our own tech portfolio of 25%."
14:18 But if you were to do that here, then
14:20 that means you're going to underweight
14:23 RTX and overweight whatever others you
14:25 choose to put that money into. So
14:27 simplest thing to do here is to buy
14:29 these assets in these amounts. Let
14:32 market cap dictate waiting. Turn on
14:33 drips and let it ride. And of course
14:35 consider your bigger picture here. You
14:38 know what overlapping exposure do you
14:40 have in other portfolios or ETFs? I mean
14:43 you're now overweight industrials and
14:45 whatever comes with that. What would
14:47 make you remove this overweight? So
14:50 don't invest or go in a particular
14:52 direction unless you can answer that
14:54 question. Are you permanently bullish on
14:55 defense stocks? Fine. Then you will
14:57 always retain those positions. If not,
14:59 what would make you not bullish on
15:01 defense anymore? So, the goal of this
15:04 exercise is to get defense exposure
15:06 that's comprehensive and manageable. You
15:08 can't really just break open one of
15:09 those ETFs, buy all the constituents,
15:11 and then adjust every quarter as that
15:14 ETF rebalances. What you're going to do
15:17 is save yourself a lot of money over the
15:19 long run by doing it yourself. Just
15:21 remember that every 100 basis points
15:24 results in 28% less money over the
15:26 lifetime of an investment. So, what
15:28 you're trying to do here is not find the
15:30 best defense stock. You're trying to get
15:32 the cheapest pure play exposure
15:34 possible. And to those who think they're
15:37 able to find the best defense stock,
15:39 picking stocks is a really bad idea.
15:41 That was the topic of a presentation we
15:43 did recently on the topic. You ought to
15:45 watch that next. It's quite good. Thanks
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