The One Stock I’m Buying to Defend My Portfolio Before the Election

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

It’s hard to know who to believe these days.  Numbers are thrown around in such a frenzied pace and at such incomprehensible sizes that I don’t think any of those running for office actually know what they are talking about.  One number that we do know with certainty is $500 billion, that’s the number for the defense budget sequestration cuts that will hit starting this January and are spread over the next decade.

This number as well as the winding down of two wars has caused the defense industry to come under a lot of pressure.  The lack of a growth catalyst is being priced into their respective stocks by the market and making them very cheap.  To look across the industry, as you can see from the following chart, it’s hard to tell them apart:

<table> <tbody> <tr> <td>Company</td> <td>Market Capitalization</td> <td>Revenue</td> <td>Net Cash</td> <td>Price to Earnings Ratio</td> <td>Price to  Cash Flow</td> <td>Price to Book Ratio</td> <td>Dividend Yield</td> <td>Payout Ratio</td> </tr> <tr> <td><strong>General Dynamics</strong> <span class="ticker" data-id="203650">(NYSE: <a href="http://caps.fool.com/Ticker/GD.aspx">GD</a>)</span></td> <td>$23.3 Bil</td> <td>$32.7 Bil</td> <td> -$0.4 Bil</td> <td>9.33</td> <td>7.6</td> <td>1.71</td> <td>3.10%</td> <td>21.00%</td> </tr> <tr> <td><strong>L-3 Communications</strong> <span class="ticker" data-id="204330">(NYSE: <a href="http://caps.fool.com/Ticker/LLL.aspx">LLL</a>)</span></td> <td>$7.0 Bil</td> <td>$15.2 Bil</td> <td> -$3.7 Bil</td> <td>8</td> <td>5.7</td> <td>1.03</td> <td>2.80%</td> <td>21.00%</td> </tr> <tr> <td><strong>Lockheed Martin</strong> <span class="ticker" data-id="204339">(NYSE: <a href="http://caps.fool.com/Ticker/LMT.aspx">LMT</a>)</span></td> <td>$30.2 Bil</td> <td>$46.5 Bil</td> <td> -$2.5 Bil</td> <td>10.87</td> <td>7.7</td> <td>13.68</td> <td>5.00%</td> <td>44.00%</td> </tr> <tr> <td><strong>Northrop Grumman</strong> <span class="ticker" data-id="204736">(NYSE: <a href="http://caps.fool.com/Ticker/NOC.aspx">NOC</a>)</span></td> <td>$17.0 Bil</td> <td>$26.4 Bil</td> <td> -$0.3 Bil</td> <td>8.83</td> <td>6.6</td> <td>1.59</td> <td>3.20%</td> <td>26.00%</td> </tr> <tr> <td><strong>Raytheon</strong> <span class="ticker" data-id="205305">(NYSE: <a href="http://caps.fool.com/Ticker/RTN.aspx">RTN</a>)</span></td> <td>$18.2 Bil</td> <td>$24.9 Bil</td> <td> -$2.6 Bil</td> <td>9.53</td> <td>7.5</td> <td>2.11</td> <td>3.60%</td> <td>31.00%</td> </tr> </tbody> </table>

Charts are great but they never tell the whole story.  Digging deeper into the defense industry I saw one company’s excellent track record and technological innovation stand above the rest.  That’s why I am defending my virtual “No Drip, No Mess” Portfolio by adding Raytheon and here’s why.

Leadership

When confronted with the looming sequestration Raytheon CEO Bill Swanson said, “When you look at this situation, I understand the danger, but there’s also an opportunity. And the smart companies, smart leaders, smart businesspeople know how to take advantage of opportunities.”  His counterpart at Lockheed when confronted with the same future warned of massive layoffs.  That's not to say that it won't be a reality that Raytheon might eventually face, however, the fact that their CEO is looking at it as an opportunity as opposed to a disaster bodes well for the company’s future.

The Business

Raytheon’s business spans air, land, sea, space and cyber and is comprised of six business units. These units provide a very diverse and high margin stream of revenue.  They have a broad and deep program base with more than 8,000 programs covering 15,000 contracts.  As pictures speak a thousand words. I thought I’d spare you and instead show some selected slides from their company overview presentation:

<img src="/media/images/user_12784/rtn1_large.jpg" />
    

Raytheon has a very diverse revenue stream across their six business units

<img src="/media/images/user_12784/rtn2_large.jpg" />
 

Notice that they don’t build tanks, planes or ships but systems, security and other higher margin services that are less likely to be hit by budget cuts.

 

<img src="/media/images/user_12784/rtn3_large.jpg" />

A majority of their projects are in defending our nation instead of armaments for wartime.

 

<img src="/media/images/user_12784/rtn5_large.jpg" />

As you can see they have a deep and broad portfolio of products and services that defend our nation and they lean heavily to intelligence, security and services as opposed to war fighting equipment.  This is a key differentiator and is one reason why CEO Bill Swanson can speak of opportunities as opposed to obstacles when it comes to the looming sequestration.

Financials

This broad and deep portfolio has put Raytheon’s financials on very solid ground.  They have excellent margins, a strong balance sheet and a very shareholder friendly management team.  They’ve consistently increased their dividend to the tune of a 10.7% compound annual growth rate over the past decade.  That dividend is currently yielding 3.6% and represents a 31% payout ratio meaning they still have room to grow it over time. 

The Trade

In adding Raytheon to the portfolio I’ll be writing an at-the-money January $55 put which lately can be written for $200 for a 3.7% yield on cash.  That put will represent the single largest position in the portfolio at a 5.5% allocation.  Instead of just buying the shares outright I’m writing the put in order to supply some income for an emerging defense contractor that I’ll be recommending soon.  The option and eventual dividend income that Raytheon will throw off will reduce the risk of buying this and other future rocket stocks.

Risks and Why I’d Sell

Even though Raytheon has a very strong portfolio of necessary products and services it is possible the sequestration cuts are deeper than they market has priced in.  Another risk is a potential wave of mergers in the industry that could cause Raytheon to overpay in order to keep up with their peers.  Finally, if the company rests on its laurels and doesn’t invest enough in future systems and services they could fall behind and lose out on future contracts.

I don’t see any of the above happening to Raytheon.  They have a very smart management team, a deep and broad portfolio and an excellent financial profile.  Combine this with the industry’s knack for being a very, umm, defensive investment and you’ve got the makings for the perfect investment to defend any portfolio from post-election volatility.


latimerburned has no positions in the stocks mentioned above. The Motley Fool owns shares of General Dynamics, L-3 Communications Holdings, Lockheed Martin, Northrop Grumman, and Raytheon 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.If you have questions about this post or the Fool’s blog network, click here for information.

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