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How Will the Sequester Hit Defense Stocks?

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So we're a little more than a month away from yet another round of Capitol Hill-induced economic chaos. I'm speaking of course, about the reappearing sequestration. The sequester is a set of automatically occurring cuts to federal spending that will hit both defense and social budget items. The idea was to make the cuts so horrible that the politicians on Capitol Hill would work hard to avoid them.

We know, now, that they can't avoid them. All they did at New Year's Day was to kick the can down the road again. Worse, they didn't even kick it very far. We're just come off the last round of panicky negotiations and in March the sequester is back. And defense contractors, the companies that benefit most from federal spending, are beginning to both sweat the sequester and prepare for it.

It can't be an easy thing for a large company, with tens of thousands of employees, to contemplate seeing a huge chuck of your business suddenly drying up because someone else can't do their jobs. But that's the situation in which they find themselves. They can lobby, the can have trade associations like the Aerospace Industries Association complain and moan, but nothing's going to do any good. At best, at this point, it seems we can only hope for a series of short-term actions. It makes it difficult to plan.

Lockheed Martin (NYSE: LMT)

CEO Marillyn Hewson recently told analysts that upcoming defense cuts (which I wrote about earlier) will hurt the company. However, she and her team are denying that the sequester will actually go into effect. She may be right, as congress continually passes the buck. But ongoing uncertainty can only hurt the firm's stock price going forward. The firm does have a very high dividend yield at 5.21%, but a part of that calculation is the drop lately in the price forcing the yield up. Lockheed Martin provides more than federal contracts, of course, but it's a big part of the business. They could be hurt if the sequester comes about.

Booz Allen Hamilton (NYSE: BAH)

Many people don't think of Booz Allen Hamilton as a provider of defense services. Yet they are a defense contractor, make no doubt. They're just going to have access to better accounting practices to deal with the uncertainty of the sequester should it come about. The firm's stock has had a rough run, dropping more than 30% in one day in September. It also say 3Q profits and revenue decline. For the moment, the news and the uncertainty should be pushing you away from BAH. Even with a 2.61% dividend you'd do better somewhere else.

Northrup Grumman (NYSE: NOC)

Another defense contractor who issued less-than-happy earnings, NOC saw its net income drop three percent but still beat predictions. Before you get happy, that just shows how low the analyst's expectations were. Really, the whole sector is in trouble. Northrop Grumman stock has trended up this year and the dividend is good. But I think this is one where the uncertainty is damaging the stock value and the actual sequestration could be disastrous. Invest here if you think you want to put some long-term money into a slightly risky play. But don't bet anything that could get you faster returns elsewhere.

L-3 Communications (NYSE: LLL)

Of all of these, the lesser-known L-3 has probably had the best year. The stock has been up and the dividend is good at about 2.5%. Still, I think it's another one that could be hammered by the actual sequester. The support services the company provides to other contractors could take a real hit if other defense contractors see their contracts cut. This is another one to avoid until there's a final decision on the sequester.

So I don't know. Defense stocks are generally reliable stocks. But the way congress is acting nothing that relies on the federal coffers can be considered reliable anymore. It might be better to make plans to invest but take a wait-and-see. Or, if you feel like making the play, wait for the sequester to occur, watch the stock values drop, and then start buying. These firms will eventually recover from anything congress can do to them. But it might take a few years. Be warned.

Good luck!

Follow Nate on Twitter: @natewooley

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Nate Wooley has no position in any stocks mentioned. The Motley Fool owns shares of L-3 Communications Holdings, Lockheed Martin, and Northrop Grumman. 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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