Should investors looking for safety park money in the defense sector?
That's question that has arisen as a standoff over Ukraine has intensified in recent days. While most stock markets around the world sold off Monday, shares of major U.S. defense firms including Lockheed Martin (LMT) and Northrop Grumman (NOC) were eking out modest gains.
Certainly, the situation in Ukraine alone is unlikely to translate directly into revenue for those defense companies, especially with no evidence that the U.S. will get involved militarily. But it's a reminder that the risk of military conflict remains a reality, with tension looming in regions from Africa to Afghanistan.
Indeed, while U.S. defense budget cuts have made headlines recently, experts say significant military spending will be necessary in coming years as the government invests in new technologies. The annual U.S. defense budget is likely to hover around $500 billion for the next several years, estimates Mike Lewis of The Silverline Group, a defense industry consulting firm.
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That's a good reason to consider investing in an industry leader like Lockheed Martin, which generates the vast majority of its revenue from U.S. government contracts. The company's sales are expected to grow at a roughly 4 percent annualized pace through 2018, according to consensus estimates.
Much of that growth will come from sales of the F-35 fighter, which accounted for 16 percent of the company's sales in 2013. At a presentation in February, Lockheed said F-35 sales may ultimately account for 25 percent of its revenue when the plane reaches full-rate production.
With such a reliable revenue stream, Lockheed has been able to use its significant cash flow for dividends and buybacks to make its shares more attractive. The company tends to return about 90 percent of free cash flow through dividends and buybacks. That helps the company maintain a 3 percent dividend yield and an expected 10 percent growth in earnings per share for 2014.
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Lockheed hasn't been complacent. As early as 2008, when it became evident that defense spending may have plateaued, the company was more aggressive than peers in reducing middle-management positions and excess capacity, Lewis points out.
And yet Lockheed's shares trade around 15.3 times consensus forward earnings. That's far below multiples for consumer staple stocks that many investors have chased in the last year for their perceived stability: Colgate Palmolive (CL) trades at 20.3 times consensus forward earnings and Coca-Cola (CCE) at 17.9 times.
Both of those consumer stocks have declined this year as it became apparent that they were more vulnerable than many expected. Concerns about emerging markets in South America have weighed on Colgate, which generates much of its revenue from sales of personal care products in the region. Coca-Cola, meanwhile, has been hurt by a slowdown in its mainstay U.S. carbonated drinks division.
Given the impressive 32 percent rally in Lockheed's shares in the last six months, investors may feel late to the game. But with dependable drivers of profit growth behind it, Lockheed may keep on firing for some time.
-By CNBC's John Jannarone. Follow him on Twitter @jannarone.
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