Scary World Thesis - Buying LMT
“Don’t let these changes in the market, even the big ones [like the financial crisis] … change your mind and never, never, never be all in or all out of the market. Always be in at a certain level."
- Jack Bogle founder of Vanguard Funds
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Scarry World Thesis
· Israel – Palestine War
· Implications for oil
· Defense contractors
Israel – Palestine War
I’m sure all my readers are well-versed in the weekend's events. Just to recap, on the morning of October 7, at the beginning of the Jewish holiday Shemini Atzeret & Simchat Torah, hundreds of Palestinian or Hamas invaders broke through the barrier between Israel and Gaza and spread into more than 20 locations, killing 600 Israelis on the streets, in their homes, and at an outdoor festival, hostages and injuring more than 2,000.
I can’t express in words the horrific cruelty of this event. This blog has never been about politics, war, or religion. I have always worked to stay focused on the job at hand, helping my readers build a long-term portfolio to build a nest egg for themselves and their families. I don’t ignore or dismiss what’s happening in the world, but geopolitical events and risks have always existed and always will. My job can’t be suspended as another horrific conflict escalates. To protect and grow the portfolio, I have an idea to explore.
Implications for Oil
Israel and Palestine are not important producers of oil. The West Bank and Gaza Strip are essentially void of resources, and Israel only has two refineries with no oil production. Today's significant move in oil and oil services stocks reflects the market pricing in a different risk. The greater risk is that other countries, particularly Iran’s support of the Hezbollah militia, may enter the conflict. Disruptions to the oil industry in Iran, Saudi Arabia, Lebanon, or Egypt would have global implications, which I must address in the blog portfolio investments.
Defense Contractors
I have had Lockheed Martin (LMT) in the bullpen for a long while as a new industrial name I wanted to add. My first look at LMT was as a diversifier within our industrial positions. A deeper look under the hood revealed that military spending is rising globally, and the numbers are significant. Certainly, Russia’s war in Ukraine triggered aggressive military spending, especially in countries closest to Russia. However, years before the Ukrainian war, analysts talked about the need for all nations to upgrade their weapons, communications, ground troop equipment, and supplies.
Global military spending grew for the eighth consecutive year in 2022 to an all-time high of $2.24 trillion. The United States has been focusing military expenditures on research and development for next-generation technology, while the rest of the world’s military budgets look to be acquiring armaments to upgrade and restock.
· Iran’s military budget increased to $24.6 billion, the first increase in four years.
· Eight NATO countries have reached the 2 percent of GDP spending target.
· Nigeria increased military spending by 56%.
· Germany stands out as the country reduced military spending to 1.4% of GDP due to inflationary pressures.
· Qatar’s spending was up over 400% in 2021 and ranked as the 5th largest military spender in the. Middle east.
· India is the world’s third-largest military spender behind the United States and China, with the country's military budget increasing by 33% since 2012. India has allocated about 64% of their budget to arms manufactured within its own borders.
Each defense contractor has strengths and weaknesses with respect to what they make and what countries are investing in now. For the purposes of the Stay Invested portfolio, I’m interested in selecting a company that can be held for at least five years, generates a reasonable and reliable dividend, and shows consistent profitability. As I’ll illustrate, I didn’t have to dig too deep to select Lockheed Martin.
If you’re unsure about selecting a single defense contractor for your portfolio, I’ll direct you to three ETFs that can diversify your holdings and provide a simple way to allocate across more companies.
· SPDR S&P 500 Aerospace & Defense ETF (XAR)
- This fund has the lowest fees.
· Invesco Aerospace & Defense ETF (PPA)
- This fund has the best 1-year return.
· iShares U.S. Aerospace & Defense ETF (ITA)
- This is the biggest fund, which makes it the most liquid.
The companies I selected for my comparative analysis were:
· Lockheed Martin (LMT)
· RTX Corp (RTX)
· Boeing (BA)
· Northrop Grumman (NOC)
· General Dynamics (GD)
· L3Harris Technologies (LHX)
· Textron (TXT)
Step 1
My first pass was to compare how each company performs with respect to their capital cost and their return on invested capital. For this, I look at the Weighted Average Cost of Capital (WACC%) compared to the Return On Invested Capital (ROIC%). LMT stands out with a very low cost of capital and the highest return on invested capital. The annual growth trend is also important to note. The trend for LMT is down, meaning their capital costs are being reduced while their ROIC is trending up. NOC and GD have positive ROIC, and their WACC is declining, but the returns are simply too low.
Step 2
My next pass was to look at past and present revenues over a 3-5-year time frame. These companies are cyclical, and their revenues tend to filter in over long periods due to the nature of government budgeting. I’ve compared trailing earnings to forward earnings in the first two columns. Five of the companies have improving earnings, and two, Boeing and Northrup Grumman, have declining earnings. In columns three and four, I’ve compared the last 3-5-years to the projections for the next 3-5-years. BA and NOC should be eliminated at this point. From Step 1, we see that neither company delivers a great return on invested capital; in Step 2, we see that BA and NOC are not improving earnings, followed by a ridiculously large improvement in revenues for BA and declining revenues for NOC. The average earnings per share growth can be misleading, so I tend to focus on the last column, where I show the next 5-year annualized EPS growth. LMT is showing a solid 12.28%, Boeing, I don’t believe, NOC and TXT are too low to consider; the rest of the group looks okay.
Step 3
To dig deeper, I ran a Discounted Cash Flow analysis. In the chart below, my DCF analysis shows earnings per share (EPS) and Free Cash Flow (FCF) results. I’ve also included the results for three different discount rates. The discount rate has the biggest impact on the results. My perspective is that a discount rate of 11% is reasonable right now and that 6% and 14% are at the opposite extremes. I’ve color-coded the rows to make it easier to see the results. Only LMT delivers an acceptable return on our investment at every discount rate in both EPS and FCF approaches. NOC is a viable candidate using only an EPS DCF analysis, but given all the other factors so far, I’m not sure I want to take the risk.
Step 4
Finally, which company best fulfills my objective of receiving a reasonable and reliable dividend? In this step, I looked at three metrics: the stock Beta, the tax rate, and the 13-year median dividend growth rate.
Beta is a concept that measures the expected move in a stock relative to movements in the overall market. A beta greater than 1.0 suggests that the stock is more volatile than the broader market, and a beta less than 1.0 indicates a stock with lower volatility. Beta is probably more useful for short-term movements in a stock, but in mature, reliable companies like these, the Beta tends to stick.
BA, at 1.58, is more volatile than the overall market, has an unreasonable tax rate due to write-offs, and shows no growth rate in the dividend over the past 13 years. TXT, at 1.25, is more volatile than the broad market and has a higher tax rate than LMT and one of the lowest dividend growth rates in the group. Boeing doesn’t have the lowest Beta, but 0.34 is very low, suggesting it's nearly uncorrelated to the broad market. The tax rate is reasonable, and the 13-year growth rate of the dividend is excellent.
Step 5
We’ve taken a good look at value; now we can look at price. The DCF analysis above suggests an upside price range of $520.58 (20% upside) to $665.72 (53% upside). But what do the analysts think, and do we have any upgrades given recent events?
Quote: 10-9-23 price quoted.
Low: Analysts' lowest price target for the next 12 months.
Consensus: Analysts’ consensus (average) price target for the next 12 months.
High: Analysts’ highest price target for the next 12 months.
Consensus G/L%: Gain or loss based on quote and consensus price target.
Independent source: A service I use to track stocks and analyst's estimates.
If all we did was look at the price and what the buy-side and sell-side analysts say a stock is worth, we would jump on Boeing, RTX, and L3Harris. But given everything else we know about the financial performance of all these companies, those price targets look lofty, even unrealistic. Remember that those price targets don’t include the return from dividends.
Analyst’s estimates vary widely, so I’ve included another Independent Source in the chart below. The numbers aren’t so rosy anymore for RTX, BA, and LHX, but have improved for LMT.
Conclusion
There are many more factors that go into selecting a company for inclusion in the portfolio. For instance, what does the company make? Are they a leader in their sector, do they have a backlog of orders, does the company have strong profit margins, are there risks from supply chains, and more? Lockheed Martin and the rest of the group check all the right boxes, but LMT stands out to me as a safer, steady grower who can sit in this portfolio for the next five years.
Lockheed Martin provides the best return on invested capital with acceptable earnings per share and revenue growth projections backed up by the company’s historical revenues. In fact, I think the revenue projections are light. LMT is the only company in the comparison to produce satisfactory returns under all six DCF analysis tests. The volatility is low, the tax rate is reasonable, and the dividend growth rate is excellent. I would like to see higher price target projections, and I think analysts will soon revise their numbers to give LMT more credit for their solid business.
Action
BUY LMT 20 @ $433.88
"Markets don't go to zero, Portfolio's do.
Buy quality, be patient...and look twice for motorcycles."
- Clay Baker
Stay Invested,
Clay Baker
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Clay's Rules
Rule #1: Don't lose money
Rule #3: Portfolios go to zero, markets don't, Stay Invested
Rule #4: When good stocks you own drop 10% below your cost basis, add shares
Rule #5: Bull markets aren't sustained without the Transports
Rule #6: When Forward P/E is lower than TTM P/E, expect earnings to increase
Rule #7: When an investment bank sells below book value, buy it
Rule #8: Tips are for waiters. Do your own homework.
Rule #9: Don't sell a stock because you're bored with it. Do your own homework.
RULE #10: Being early and being late is the same as being wrong...move on.
Rule #11: Investing is easy. Waiting is hard; waiting is the hardest part.
Disclosure: I am personally invested long in some or all of these stocks or funds that appear in the Stay Invested portfolio and may purchase or sell shares within the next 72 hours. I am also invested in other stocks and funds that do not appear in the Stay Invested portfolio but may be mentioned or related to this article. It is not my intention to advise or encourage the purchase or sale of any security. I am invested long in these securities mentioned in this post:
AMD, AMZN, AAPL, ARKK, ARKG, CNRG, ENPH, FB, GNRC, GBTC, GLD, HRTX, HD, MSFT, NVDA
I am invested short in these securities mentioned in this post:
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. This article is not intended to offer investing advice, guarantee 100% accurate predictions, or to be interpreted as providing a personal recommendation.
