The two industries are the best performers among 68 groups in the Standard & Poor's 500 Index when adjusting for volatility, beating groups such as biotechnology stocks and Internet retailers, the Bloomberg Riskless Return Ranking shows. Northrop Grumman rose the most with a risk-adjusted gain of 4.2 percent and volatility that's about 20 percent less than the average for producers of military and commercial aircraft.
While American lawmakers reduced spending amid troop withdrawals from Iraq and Afghanistan, defense companies have responded by cutting staff and using cash stockpiles to buy back stock and increase shareholder payouts. The top five U.S. weapons makers, a group that also includes Boeing, General Dynamics and Raytheon, raised their earnings forecasts in October as cost cutting helped them boost profit margins.
"Everybody is streamlining and maximizing profitability as the outlook for defense spending declines," said Brian Ruttenbur, an analyst with CRT Capital Group in Stamford, Conn. "Cash flows are at record levels, and the companies are deploying those cash flows back to shareholders."
Northrop shares have rallied 63 percent this year, on pace for the best annual performance since the records began in 1980. Historical volatility for the Falls Church, Va.-based company was 16.1 in 2013, compared with 20.1 for the average S&P 500 stock in the aerospace or airline industry, according to data compiled by Bloomberg.
Lockheed and Raytheon have risen more than 50 percent this year with volatility below the group average, producing a risk- adjusted return of about 3 percent for both companies.
Airlines did best with a risk-adjusted gain of 3.7 percent, followed by aerospace and defense industries, with a 3.4 percent risk-adjusted return. The airline group has only two members, Southwest Airlines and Delta Air Lines.
The risk-adjusted return, which isn't annualized, is calculated by dividing total return by volatility, or the degree of daily price variation, giving a measure of income per unit of risk. Higher volatility means the price of an asset can swing dramatically in a short period, increasing the potential for unexpected losses.
Investors piled into defense shares this year, taking advantage of cheap valuations amid a budget standoff in Washington that led to Pentagon cuts totaling $500 billion over a decade. Government officials have shielded major weapons systems from cancellation since the reductions took effect in March, opting to delay maintenance work and scale-back troop exercises instead.
The Pentagon has preserved funding for programs such as Lockheed's F-35 jet, the costliest weapon system, and the Littoral Combat Ship. Congress has prevented cuts to Northrop's Global Hawk drone program and General Dynamics' Abrams tank.
"The cuts haven't been nearly as bad as the companies warned they would be," said William Loomis, a Baltimore-based analyst at Stifel Nicolaus & Co. "There haven't been many significant contractor reductions. There's definitely some relief around that."
Defense contractors are seeking to increase overseas sales to cope with less military spending at home. Raytheon got 26 percent of its sales from outside the U.S. last year, compared with 11 percent a decade earlier, according to data compiled by Bloomberg. International revenue made up 24 percent of Boeing's $33 billion in defense revenue in 2012, up from 7 percent in 2004, spokesman Daniel Beck said.
Northrop has divested low-margin businesses such as shipbuilding and government consulting and cut its workforce in anticipation of federal budget cuts. It sold TASC Inc., its advisory unit, to private-equity investors for $1.65 billion in 2009 and spun off its aircraft carrier construction business as Huntington Ingalls Industries Inc. in 2011.
The company's operating margin, a measure of how efficiently sales are converted into profit, rose to 12.9 percent last quarter, from 6.7 percent at the end of 2009, data compiled by Bloomberg show.
Lockheed in November said it would cut 4,000 jobs and close facilities from California to Pennsylvania. The Bethesda, Md.-based company has raised its dividend 15 percent in the past year, giving the shares a 3.4 percent yield, exceeding the S&P 500's 2 percent payout.
The five biggest weapons companies by U.S. Defense Department contracts each raised their full-year earnings forecasts in October. Northrop said it expects profit of $8 to $8.15 a share, up from a July forecast of $7.60 to $7.80, even as revenue slid 2.6 percent last quarter.
"They performed well because they are high-return businesses that trade at cheap valuations and they pay a dividend," said Timothy Pettee, chief investment officer for SunAmerica Asset Management Corp., which owns shares of Northrop, Lockheed and Raytheon.
Northrop, Lockheed and Raytheon trade at an average price- earnings ratio of 13.7, a 19 percent discount to the S&P 500, according to data compiled by Bloomberg.
Improvement in the U.S. economy may weigh on defense stocks as investors shift to industrial companies that benefit more from economic growth, according to Ruttenbur of CRT Capital. Military spending may continue to slide in the next 10 years, hurting defense contractors' profits, he said.
"We're coming out of wars," he said. "Eventually, we're going into a down cycle in defense."
Northrop added $4 billion to its buyback program in May and said it plans to acquire 25 percent of outstanding shares. The company spent $6.7 billion on share repurchases, about 28 percent of its current market value, in the past five years, according to data compiled by Bloomberg. The average industrial company in the S&P 500 used $1.5 billion on buybacks in the period, or 7.2 percent of current market value.
Weapon makers have thrived amid budget cuts in part because their business model allows them to protect profit margins even as sales slide, according to George Ferguson, a senior defense analyst at Bloomberg Industries.
The Pentagon covers many research and production costs for weapons systems, so contractors don't risk severe losses when production slows or ends, Ferguson said. If the Pentagon decides to buy fewer tanks or fighter jets, contractors usually can adjust their pricing to maintain profit margins, he said.
The defense industry has "been incredibly resilient," said Gerry Sullivan, portfolio manager of the $225 million USA Mutual's Vice Fund that invests in defense, tobacco and gambling stocks. "I don't put myself in a position to bet against it."
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