How New Legislation Will Affect Gun Makers

Adam is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Note: A previous version of this article mistakenly referenced ammunition sold on eBay. In fact, eBay's policy does not allow the sale of live ammunition on the site. This has been corrected below.

My heart goes out to the families and friends of the victims at Sandy Hook Elementary School in Newton, Connecticut. The events of last Friday can be described as nothing less than horrendously tragic.

Unfortunately, Friday was just one incident in a string of many this year: A movie theater in Aurora, Colorado, a Sikh temple in Oak Creek, Wisconsin, and a small university in Oakland, California are just the beginning. One would think, with the apparent rise in gun violence throughout America, gun makers would be having a hard time these days.

Certainly, Smith & Wesson (NASDAQ: SWHC) and Sturm, Ruger & Co (NYSE: RGR) have seen dramatic declines in their stock prices since the news from Newton came out last week. Yet, Smith & Wesson’s stock price has still more than doubled in the last year, and Sturm Ruger is up about 30% in the same period.

Why is This Time Different?

The events in Newton, once again thrust gun control law into the limelight. Investors, fearing that tighter gun control would negatively affect gun makers and related companies earnings, started selling out of the stocks immediately.

Sadly ironic, teachers are getting hurt by the sell-off and the decline in stock prices. The California teachers’ pension fund is urging Cerberus Capital to sell its shares in privately held Freedom Group, the gun maker that made the rifle used in the Connecticut shooting. Additionally, other public employee pension funds are examining their positions in firearm related companies.

All this stands in contrast to previous market reactions from the mass shootings earlier this year. While gun makers may have seen some slight pessimism after the events in July and August, for the most part their stocks continued to rise in price. The selling pressure dissipated quickly, and pension funds didn’t much raise the issue of selling large portions of a company’s stock.

Why This Time Isn’t Much Different

It’s a sad truth to accept, but gun sales typically rise after tragedies like Newton. Gun owners and prospective gun owners rush out to buy a new firearm before any sweeping legislation prevents them. The events at Sandy Hook have shown a similar effect.

Wal-Mart (NYSE: WMT), one of the largest firearm retailers, is reportedly sold out of semi-automatic rifles in many locations. All the data points to a surge in demand for guns, and more fear now than ever that legislation will curb gun purchases.

Gun Control Law Reform

It seems inevitable that President Obama or the Democrat-controlled Senate will propose new legislation around guns. President Obama announced this week, that he will propose reforms by January. Any proposal will likely move through the Senate easily, but may face a roadblock from the Republic-controlled House. If new legislation does pass, it will likely be similar to the Federal Assault Weapons Ban that expired in 2004.

That law would have banned the sale of firearms like the AR-15 used last Friday. Most of the weapons banned by the law fall under a category called “modern sporting rifles.” The law also limited magazine sizes to 10 rounds.

If similar legislation makes it through the house, Smith & Wesson and Sturm Ruger would certainly see a negative impact on sales. The question is, how badly will a ban on modern sporting rifles affect the two companies.

In my estimation, the market is factoring in a larger negative impact than it should, presenting a buying opportunity for investors. Smith & Wesson reported $75.1 million in sales of modern sporting rifles in the last fiscal year. That number represents just over 18% of total revenues. Sturm Ruger receives 25% of revenues from rifle sales, but doesn’t break it down any further. However, the company reports that its main entrant in the modern sporting rifles market, the SR-556, comprises an insignificant amount of sales.

Currently, share prices of Smith & Wesson and Sturm Ruger are trading down about 14% and 9% respectively from the day before the shooting. This implies investors foresee a complete shut-down in modern sporting rifles. I believe, however, just as gun makers found ways to sell similar rifles to consumers during the previous ban, they will find a way again with new legislation.

Stocking Up on Arms

With short-term fear and pessimism causing share prices to decline, I believe investors ought to consider a medium to long-term position in either Smith & Wesson or Sturm Ruger. Gun control legislation making it through congress will only help to drive sales in the near-term. In the long-term, these companies are strong enough to tweak their products and continue selling them as they did from 1994 to 2004.

I consider Sturm Ruger slightly safer than Smith & Wesson. The company has lower exposure to a modern sporting rifle ban, carries a debt-free balance sheet, and the company has grown sales 48% year-over-year in the last four quarters. Additionally, the company pays out a 3.5% dividend that it has raised significantly in each quarter of this year, and has increased every year since 2009. Finally, the company is selling at a P/E of about 14, a significant discount to its historical P/E of 15.5. If you’re considering buying a gun company, Sturm Ruger is your best play. 

adamlevy has no positions in the stocks mentioned above. The Motley Fool owns shares of Sturm, Ruger & Company. Motley Fool newsletter services recommend eBay. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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