U.S. defense stocks are supposed to outperform broader market indices in presidential election years. At least, that is what history has suggested for the analysts who ran the numbers. Unless something happens in the coming weeks, 2020 is proving an exception to that rule. It is worth delving into some of the reasons this has happened and what it may say about the plans and narratives for large U.S. public contractors.
The first explanation could be that analysts and investors feared a Biden administration would slash defense spending. There was nothing to suggest that was likely, based on what President-elect Joe Biden and people advising his campaign have stated in 2020, but partisan views may have affected judgments that a Democratic administration would have to cut spending to placate progressive Democrats or to carve out funding for other priorities, including infrastructure and rebuilding of diplomacy and other “soft-power” tools.
These fears may have been tempered by the outcome of the election, which delivered Republicans a greater number of House seats and a likely majority in the Senate, once the Georgia runoff elections are decided in January. Even with the postelection stock market rally, however, large U.S. defense stocks have risen less than the S&P 500: The majority, at the time this was written, have declined from their year-end 2019 levels.
One narrative after the election was that gridlock in Washington could be positive for defense. Democrats might have to trade higher nondefense spending for Republican support for more defense spending. The problem with this narrative, however, is that increased spending could be capped by debt and federal deficit concerns that could come roaring back in 2021, as Congress considers a Biden administration budget requests and plans.
Characterizing Pentagon spending as “flat” could mean anything from it being the same in fiscal 2022-25 as the $741 billion Congress is likely to appropriate for fiscal 2021 to it growing at a 2% annual rate, which is flat with inflation. That 2% rate was already well below the 5-7% annual rate Defense Department leadership stated was needed to meet the requirements of the National Defense Strategy. Furthermore, a reduction below the 2% rate of growth is likely to fall more on Procurement and Research, Development, Test and Evaluation (RDT&E) accounts. The Military Personnel budget cannot be swiftly adjusted, and Operations & Maintenance may be sticky because of the imperative to sustain readiness.
What gets cut if Procurement and RDT&E dip is an open issue. Leaders at defense contractors can confidently state that the portfolios of their companies are aligned with customer priorities, but it is hard to see how any one of the large contractors could be completely insulated from budget cuts. Defense budget reductions will not be known, in any event, until later in 2021.
Another reason large defense stocks have lagged is that they do not narrowly address the priorities that are likely in the 2020s. Here, markets may be correctly signaling “winners and losers.” In 2020, the companies that have outperformed include Booz Allen, whose management has consistently called out its work in artificial intelligence. Its stock has handily outperformed the S&P 500, as has AeroVironment’s, a company that develops unmanned aerial systems and low-cost weapons. Kratos has also kept pace with the S&P—it addresses low-cost autonomous systems and space programs. If there were a pure-play on hypersonic weapons, it would likely be doing well, too.
The narratives that defense contractor managers use to describe their outlooks may also be an issue. Every management team believes its company is “well positioned.” There is room to increase margins and cash flow, which is still mostly being returned to shareholders. Major weapons programs are discussed but not the underlying capabilities or technologies that could differentiate a company from its peers. Investors in 2020 may be more interested in which companies can profitably outgrow their peers or find new markets adjacent to defense where growth could be achieved. Current narratives are not convincing investors.
Investors may also appreciate that heritage contractors could be facing radically different competitors in the 2020s. Anduril, Palantir, SpaceX and a number of smaller startup firms are becoming more visible and could chip away at the dominance that large U.S. primes have enjoyed in some of the Pentagon’s growth segments.
Finally, there may be a simple explanation for investors: It is a matter of where relative opportunity rests. Institutional investors look 6-12 months in the future. The possibility of a major U.S. fiscal stimulus late this year or in 2021 to address the impact of the pandemic would benefit a broad swath of companies, not just defense. The pandemic has accelerated change in remote work and online shopping. Finally, prospects for a vaccine mean that sectors most depressed by the pandemic should recover in 2021 and beyond.
Defense has weathered the pandemic well—but it is hard to see it riding the same wave as other economically sensitive sectors in 2021.
The views expressed are not necessarily those of Aviation Week.
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