Gun Stocks: A Bang for Your Buck or a Shot in the Foot?

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

Investors who follow gun manufacturers such as Smith and Wesson (NASDAQ: SWHC) and Sturm, Ruger & Co. (NYSE: RGR) may think that December's double-digit percentage decline was an exaggerated reaction to the announced effort on stricter gun control. 

2013's rally in these stocks hints that investors may not be as concerned now that more is understood about the proposed gun legislation.  On January 18, The Motley Fool published the article, "Poll Shows Americans Want Stronger Gun Laws... Sort Of.” One of the main points in that article was that most Americans polled were not in support of an assault weapon ban or a high-capacity magazine ban for firearms, although there is a general consensus that background checks in relation to private party sales should be enforced at gun events. Here's what we had to say about this situation after the November Presidential Election.

With that said, legislation for assault weapon restriction could still move in either direction.  This article questions if this legislation is really holding a proverbial gun to long-term investors' heads, and we can look at what some hedge funds doing with their Smith and Wesson and Sturm, Ruger & Co. holdings to get an idea of what bigger players in the market are doing.

Jim Simons’ hedge fund, Renaissance Technologies, has upped its stake in Smith and Wesson by 55% compared to the previous quarter. Simons reduced his Sturm, Ruger & Co. position by about 18%. This is likely just some profit taking on recent highs, however (see Simons’ entire 13F portfolio here). Route One Investment Company, meanwhile, is another major hedge fund that currently keeps 2.2% of its total funds in Smith and Wesson along with 1.34% in Sturm, Ruger and Co (see Route One’s other stock picks). That's a strong vote of confidence from two well-managed hedge funds.   

Let’s get back to the crux of the situation. The estimated market cap for domestic non-military modern sporting rifles, the targeted style of gun in new legislation, represents approximately 18.7% of the total firearm market, and about 18.2% of Smith and Wesson's net sales.  Rifles in general (modern sporting rifles and hunting rifles weren't distinguished in Sturm, Ruger & Co's 2011 financial statements) accounted for about 25% of total sales. It wouldn't be fair to say that all of this revenue would disappear for each company if a ban on assault rifles were implemented, though.  Some of Smith and Wesson's revenues come from military and law enforcement sales, and the same can be said for Sturm, Ruger & Co.

Smith and Wesson's 2010 10-K states: "During the surge in consumer demand after the 2008 presidential election, modern sporting rifles represented the fastest growing segment of the long-gun market." 

Investors can't be led to seriously believe that the big players investing in gun producers didn't see the immanency of an assault rifle ban coming.  With a Democratic Party in control in Washington since 2008, the threat to cash flow in the gun industry has been real and well known for years.  A reasonable guess would be that this risk has already been priced into gun stocks, especially now that an actual bill is floating around Washington.  Smith and Wesson, specifically, was trading at a high of $22.80 in 2006, and Sturm, Ruger & Co. hit all-time highs in December 2012, just before efforts to ban assault weapons were announced. 

Buying these stocks today, you would be betting on the removal of assault weapon-income already being priced into gun stocks by the market if you're looking for a short-term move.  Market participants are probably expecting this legislation to happen, and they're expecting financial performance to suffer as a result.  If gun manufacturers can pull through and beat new expectations (or legislation fails), these companies could certainly be worth having in your portfolio in 2013 and beyond.

Ford (NYSE: F) is exposed to similar macroeconomic risks as Smith and Wesson and Sturm, Ruger & Co. Put simply, cars and guns both use steel and aluminum, manufactured by major producers such as United States Steel Corp. (NYSE: X), and Alcoa, Inc. (NYSE: AA). If prices of these raw materials soar, it could have an impact on profits for gun and auto manufacturers, as input costs will increase. 

If you're an investor in any gun or auto stock at the moment, and are concerned that rising materials prices might hurt your portfolio's performance, it wouldn't be a bad idea to hedge against this risk by owning a raw materials producer such as U.S. Steel or Alcoa.  Both raw materials producers pay a dividend of 0.80% and 1.30%, respectively. For comparison, Sturm Ruger pays a 2.90% dividend and Ford a 2.80% dividend, while Smith and Wesson pays no dividend. 

Both Smith and Wesson and Sturm Ruger have beat the Street’s earnings estimates in each of the past four quarters; Ford and Alcoa have beat three out of the four previous quarters, and U.S. Steel was ahead of quarterly earnings estimates two out of the prior four. All of these companies could be excellent long-term investments, with the former four just mentioned being my personal favorites.  Any group of these stocks would help diversify your portfolio into some interesting sectors that offer good upside.

While the proposed gun legislation is clearly a threat to the gun industry's financial performance, its long-term viability is still intact.  Smith and Wesson and Sturm, Ruger & Co. still have the potential to wow the investment community in 2013, and any future dips could offer a good chance to start or add to a position in these companies.

This duo will always experience Mr. Market’s traditional ebbs and flows, as short-term traders place bets on the outcomes of major events, but looking at the big picture, this industry’s stability over the long, long run is one of the best reasons to pull the trigger on these stocks in 2013.

This article is written by Mark Jones and edited by Jake Mann. Insider Monkey's Editor-in-Chief is Meena Krishnamsetty. They don't own shares in any of the stocks mentioned in this article. The Motley Fool recommends Ford. The Motley Fool owns shares of Ford and Sturm, Ruger & Company. 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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