According to the Center for Strategic and International Studies (CSIS), if the U.S. were to get into a scrap with China over Taiwan, it would run out of long-range, precision-guided munitions in less than a week.
That’s not a comforting reality. Nor is it reasonable that the defense industry’s innovation and competitive nature have disappeared.
“The defense sector has moved from more than 70 aerospace and defense ‘prime contractors’ that worked directly with the government in 1980 to just five by the early 2000s, the same number as today: Lockheed Martin Corp., Raytheon Technologies Corp., General Dynamics Corp., Northrop Grumman Corp., and Boeing,” Bloomberg’s 20 February article stated.
The efforts to keep Ukraine weaponized have revealed a nasty truth about the American military complex: It’s held together with duct tape. Any large-scale global conflict where the U.S. is an actual participant could put the industry in severe distress.
As a result, if you own individual defense stocks, here are three reasons you might want to sell your holdings right now.
There’s Only So Much Growth Available
In fiscal 2023, the Department of Defense (DOD) will account for 17% of the U.S. federal budget. Of the $1.9 trillion allocated to the DOD, approximately $405 billion has been committed and paid out by the federal government, with the remaining $1.5 trillion in the form of contracts, grants, and awards to be paid out at some point in the future.
So, as you can see, it’s a fast-moving target that changes by the day. For example, the budgetary resources for the DOD have risen by 52% over the past five years, from $1.25 trillion in fiscal 2019 to $1.90 trillion in 2023.
According to USASpending.gov, the DOD has $100 billion in commitments left from 2019, $150 billion in 2020, $360 billion in 2021, $450 billion in 2022, and $1.5 trillion in 2023. That’s a total of $2.56 trillion yet to be paid out.
Of course, this isn’t all for weapons, but there are still a bunch of commitments to the five companies mentioned in the intro and the other sub-contractors doing work for the prime contractors.
While this monopoly seems like a good deal for the five companies, it hinders the speed and efficiency of significant projects.
“A 2021 Hudson Institute study argued that the time it takes for the Defense Department to go from identifying a need to awarding a contract has increased from about one year in 1950 to seven years today. For innovative systems, such as the F-35, it can take another 21 years to become operational,” Bloomberg stated.
So, while the stability of having long-term contracts in place is a good thing, the combination of the federal government’s perilous finances, with an artificial ceiling put in place by these multi-year contracts, means the five prime contractors can only grow so fast.
The Prime Contractors Are All Public Companies
Together, they generated $78 billion in revenue in 2022, with more than $10 billion in earnings before interest, taxes, depreciation, and amortization (EBITDA). That’s a 13.4% EBITDA margin. While that’s good, it can’t compare to 31% for Apple (NASDAQ:AAPL), for example.
As I wrote in the previous section, there’s an argument to be made that the consolidation of prime contractors (70 in 1980, down to 5 since the 2000s) has severely curtailed competition and innovation in the defense and aerospace industry.
Having five prime contractors, all public companies, and all accountable to short-termism, also stifles innovation and research. After all, why spend billions on R&D when you can shower shareholders with dividends and share repurchases?
Consider this: Over the past five years, only Lockheed Martin’s stock performed anywhere close to the S&P 500. The index’s five-year cumulative return is 42.88%, 240 basis points higher than LMT. The next highest return was Northrop Grumman, up 33.93%, while the other three averaged -7.62%.
So, despite all the talk about how wars are good business, these five companies rarely seem to be leading the markets.
This ETF Gives You Defense Exposure and Is a Smarter Bet
Look, I’ve recommended individual defense stocks from time to time. For example, in July 2018, I suggested investors buy LMT stock on the dip. It’s up 60% since, 16 percentage points better than the index over the same period.
There’s a time and a place.
However, if you’re brilliant, you’ll use ETFs to get your exposure to defense stocks without opening yourself up to long periods of poor performance.
The iShares U.S. Aerospace & Defense ETF (BATS:ITA) invests 51.14% of its $5.7 billion in net assets in the stocks of the five prime contractors. Its performance isn’t that good, which isn’t surprising given over half the portfolio is in the five defense stocks. You might as well buy the five individually.
A better alternative is to buy the Fidelity MSCI Industrials ETF (NYSEARCA:FIDU), which tracks the performance of the MSCI USA IMI Industrials Index, a collection of stocks representing the U.S. industrial sector.
The five defense stocks in FIDU account for slightly less than 13% of the $728 million in net assets. Its performance is much better than ITA (Morningstar.com gives it a four-star rating), and it only charges a fee of 0.08%, keeping it cheap and cheerful.
There are better ways to invest your money. I’d be cautious when it comes to buying defense stocks.
On the date of publication, Will Ashworth did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.