Is The Party Over For Gun Stocks?

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

On December 14, a Friday, a young gunman by the name of Adam Lanza took a Bushmaster rifle and in cold blood massacred 20 innocent and helpless small children along with 6 equally helpless adults at Sandy Hook Elementary School in Newtown, Connecticut. Adam murdered his mother before heading to the school and committed suicide before law enforcers could close in.

On December 24, while millions of Americans were preparing to celebrate Christmas, a much older convicted criminal by the name of William Spengler lured Firefighters to a blaze that he had started and then shot and killed two of our Heroes and wounded two more before killing himself.  The gun that this man employed was the same Bushmaster rifle that Adam Lanza deployed. William Spengler left a note stating that he wanted to “kill as many people as possible” -- a task the rifle was apparently well capable of performing.

For lack of a better way to vent their frustrations, many Americans have sought to punish the stocks of publicly traded gunmakers over the recent gun violence.  However, is it realistic to expect that the nearly four year run up for stocks of gun manufacturer's is really over?  It doesn't appear to be so.

Cost of Freedom

Bushmaster Firearms is owned by the Freedom Group, a gun company that owns other recognizable brands such as Remington and Dakota Arms among others.  Freedom Group is a privately held company that is controlled by Cerberus Capital Management, a hedge fund. Following the outrage over the Newtown massacre, CALSTERS (California State Teachers Retirement System) exerted pressure on Cerberus to divest itself of its investment in Freedom Group.  Cerberus obliged, promising to hold an auction sometime next year to find a buyer to take over its investment in Freedom Group.

The decision by Cerberus shows how investments in gun manufacturing companies might become quickly unattractive, at least in perception.  Cerberus Capital Management is run by Stephen Feinberg and has the likes of former Vice President – Dan Quayle and former US Treasury Secretary – John Snow among their senior leadership team. 

Cerberus manages money invested by several other pension funds including another California public employees’ pension fund called CALPERS and New York State Common Retirement Fund.  While investing in gun manufacturers either through mutual funds or directly may or may not be a moral question, it is helpful to be aware of these otherwise hitherto extremely lucrative investments. In anticipation of strict gun control laws in  the horizon, sales of high capacity magazines and rifles have gone through the roof.  Expect to see gun makers rake in the dough at least in the short term.

Publicly Traded Companies

While the Freedom Group is privately held and reportedly a bonanza for the Cerberus Group, there are a couple of publicly traded manufacturers that have profited handsomely over the past few years thanks to a boom in gun ownership. This spike has been largely due to the much-anticipated, but little-materialized tough gun control laws that the Obama administration was expected to champion.

Two names stand out and they are Smith & Wesson (NASDAQ: SWHC) and Sturm, Ruger and Company (NYSE: RGR).  Although the media reported that these two companies saw their stock prices drop sharply after the Newtown shootings, in fact they have stayed remarkably flat over the days after Dec. 14. 

Sturm, Ruger and Co.

In contrast to its stock price performance over the days after the Newtown shootings, RGR has appreciated nearly 9 fold since December 2008. That’s a whopping 900% return for someone savvy enough to have invested right after President Obama won the 2008 election.

One might have expected gun stocks to have tanked due to the widespread indignation over the recent gun violence, it is an unrealistic expectation. Why?  Because there is a huge market in the United States for firearms and the right to gun ownership is protected by the Second Amendment .  Robust gun sales are backed with an even greater manufacturing backlog for a handful of manufacturers.  The market for potential gun buyers is not restricted to new buyers alone.  Existing buyers go out and buy more varieties and spend additional money on ammunition.  News of future gun control laws only serve to accelerate more purchases, creating more tailwinds for gun stocks.  In their Third Quarter 2012 results, Sturm, Ruger and Co., reported earnings of $0.88 per share, compared to $0.56 cents per share over the same quarter in 2011. In addition to spectacular stock price movement, this company has also declared steadily rising, healthy dividends with $0.38 cents per share in their most recent quarter.  That’s amazing, when compared to a measly $0.08 cents per share in 2008!  Suffice it to say that an Investor in this company in 2008 would have made out nicely. 

What are the prospects for this company going forward?  Don’t expect the stock to go on a downward spiral anytime soon, despite any new gun control legislation.  However, the company cautions that the dividends it hands out is not a fixed amount per share, but rather a percentage of earnings.  In other words, don’t consider this stock as a valuable dividend play.  However, the presence of a dividend for this stock does give it an edge over its publicly traded competitor - Smith & Wesson.

Smith & Wesson

The other beneficiary of Obama’s first Presidential term is Smith & Wesson with a stock appreciation of about 5 fold over the same time period as Sturm and Ruger.  However, Smith & Wesson doesn't offer a dividend so the returns don't look as robust as their competitor.  In terms of performance since the Newtown shootings, one might consider the nearly 10% drop in the stock price, but in terms of long term impact over the next several months, it is likely to be minimal for the same reasons cited above. Over the next four years of President Obama’s second term, despite anticipated tougher gun laws, this gun maker is certainly not going back to the $2 levels last seen in 2008!

In their most recent Second Quarter Fiscal Year 2013 report, the company announced a $332.7 million firearms backlog, nearly double from the same quarter last year. The company also announced a $20 million stock repurchase program until June 2013.  Furthermore, the company's board authorized an additional $15 million share buyback on Dec. 27.  According to Yahoo Finance, the company has 61.48 million shares in float.  With a $35 million buyback program, and the stock at a current price of about $8.18, the float should reduce by about 4 million shares.  Even if the shares don't substantially appreciate, expect the share buyback program to provide downward resistance to the stock price.

malayappan has no positions in the stocks mentioned above. The Motley Fool owns shares of 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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