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