Northrop Grumman Corp., maker of Global Hawk drones, and L-3 Communications Holdings Inc. (LLL), a supplier of electronics for weapons systems, also were upgraded by Noah Poponak, a New York-based defense and aerospace analyst at Goldman Sachs.
Military contractors are outpacing the Standard & Poor’s 500 Index, even after automatic federal budget cuts too effect. An index of the 10 biggest Pentagon suppliers has advanced 18 percent since March 1, when the reductions began, double the pace of the S&P 500’s 9 percent advance.
“While defense stocks have outperformed the market over the past three months from their February lows, the group has cumulatively underperformed the market by a very significant amount from the 2008 total investment spending peak,” Poponak wrote in a note to clients today. “Most known defense spending pressures are now largely priced in.”
Poponak raised Bethesda, Maryland-based Lockheed, the Pentagon’s top contractor, to buy from neutral and increased his price target to $127 from $94. Both Falls Church, Virginia-based Northrop Grumman (NOC) and New York-based L-3 were also lifted to buy from neutral.
Waltham, Massachusetts-based Raytheon was upgraded to neutral from sell.
The automatic cuts, part of a process known as sequestration, will slice the federal budget as much as $1.2 trillion over nine years if President Barack Obama and U.S. lawmakers fail to agree on a broader deficit-reduction strategy.
Defense contractors may continue to benefit as investors seek to invest in companies with above average dividend yields that also use cash to buy back shares, Poponak wrote.
Defense stocks are cheap compared with sectors such as large-cap pharmaceuticals and consumer staples that also shares similar characteristics, Poponak said in the note.
Companies including Johnson & Johnson (JNJ), the world’s biggest maker of health-care products, and beverage maker PepsiCo Inc. (PEP) have lower dividend yields and higher price-earnings ratios than weapons makers such as Lockheed and Raytheon, according to Poponak.
“While defense often trades at a discount to these sectors, the gap is wider than ever today,” he wrote. “Defense trades at a discount to its 10-year average P/E while those two sectors both trade at premiums to their 10-year average P/E.”
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