Tiny Defense Stocks Are An Exciting And Profitable Investment Niche

By: Dick Sterling | Mon, Apr 21, 2014
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On the whole, defense stocks have crushed the S&P500 by a considerable margin in the past year. If you were long, you did well. It was a surprise to the pundits who were predicting weak sector performance due to defense spending cuts and a dormant economy. But strong international sales and a surprisingly robust commercial aerospace market resulted in big gains for contrarian investors in 2013. But now that the biggest gains have been made, big defense stocks are performing about the same as the broad market. So are there any contrarian opportunities still waiting to be exploited?

I'll answer that question in a moment, but first let's recap:

The SPADE Defense Index (NYSE: DXS) pummeled the S&P500 in 2013, as did the ETF's "iShares US Aerospace & Defense (ITA)" and "PowerShares Aerospace & Defense (PPA)." By January of 2013 each of these had gained nearly 200% more than the broad market for the year.

This amazing showing for defense/military stocks took many by surprise since defense stocks were predicted to underperform in 2013 in light of forecasted military spending cuts. Today, analysts are predicting the sector will mirror the broad market for the balance of 2014, and to my mind they're probably correct.

Still, I'm bullish on a specific niche within the sector, and have singled out a handful of small companies which I believe are underfollowed and favorably priced. A few months ago I told my readers about: Mercury Systems (MRCY), which has hit $14, up from $10 when I wrote about it 4 months ago; Kratos Defense (KTOS), which is up by 10 percent during the same period; and API Technologies (ATNY), which has tanked in the previous two months but has recently been gaining strength.

Regarding Mercury Systems' (MRCY) hot streak, it comes as no surprise. As I wrote about the stock, insiders were buying. The company makes image and digital signal processing systems. It turns out the company is being groomed for acquisition, and Reuters ran a story indicating that Boeing might purchase the company for up to $500 million - a premium to the current market cap.

The shares of API Technologies (ATNY) on the other hand have not done so well. It produces secure communications and radio frequency products. These products are used by commercial, defense, and industrial customers. Applications comprise unmanned systems, satellites, missile defense, aerospace, electronic warfare, wireless communications, and more. Among its main customers are Boeing, Harris, Raytheon, Lockheed, BAE Systems, and General Dynamics. I see it as an intriguing company, mostly because no one follows the stock, it's cheap, and it's in the defense sector, which I'm usually bullish on. As of right now, the company is trading at about $2.40 with a market cap over $130 and is cash flow positive. I intend to discuss it more in a forthcoming article.

Concerning Kratos Defense (KTOS), it deals in products and IT services, which includes systems integration --- principally to US security/defense agencies. It trades above $7 with a market cap over $400 million. When I mentioned it in December, a number of its executives were buying. As with a lot of small companies, Kratos finds it difficult to get sufficient coverage. Because of this, retail investors largely disregard the company or just don't know it's there.

Small defense stocks like these can be volatile, and are highly speculative. Even so, they have solid prospects, significant upside, and established revenues. I like small defense stocks for several reasons.

Number one, digital equipment represents a great percentage of modern military weaponry. In almost all military equipment, from aircraft carriers to fighter aircrafts to armored tanks, electronic circuits and silicon are critical components. This reflects what has occurred in industries worldwide - they've become more digitally-driven. The military sector isn't any different. It's a continuing trend, and smaller companies with new breakthroughs can establish niches inside the defense sector and reasonably expect to eventually be acquired.

Number two, battlefield communications have gone wireless but with exceedingly particular needs; this makes military communications completely different from civilian applications. They have specialized concerns relating to bandwidth, security, and unique strength/signal range. Small suppliers are often the quickest to address these needs, and sometimes even bring in niche technologies which put them squarely in the acquisition-bullseye.

And number three, the reality of cyber warfare has proven itself to be a profitable niche for smaller military suppliers. Dozens of applications are being developed within the space, and Silicon Valley startups are rushing to provide solutions.

These points all relate to the growing extent to which new technologies are altering military equipment and leading to the development of new supply niches. Comparatively tiny players are supplying Raytheon, Lockheed Martin, and Northrop Grumman. I penned a piece about how the CIA, through its venture capital branch, invests in technology startups directly. Despite how alarming this is, it's an indication of the extent to which the country's security agencies are turning to technology companies to supply their security/military solutions.

Finally, you need to remember one thing as a retail investor: You hold a number of competitive benefits in small stocks such as these. Large institutions are often prevented from getting involved in tiny defense companies due to their small market capitalizations and limited liquidity. Plus, institutions often need to follow industry-specific rules which stop them from buying stocks below a certain price. And lastly, most tiny stocks get limited (if any) research coverage from Wall Street, making it challenging for fund managers to evaluate or even follow them to begin with. And besides all this, fund managers don't tend to think outside the box - they generally look to the herd and "play it safe."

And one more thing --- I prefer defense stocks due to my outlook on geopolitics. I believe military clashes are inevitable and part of the fabric of the system. There are very few things in life which are as dependable as war. Even throughout periods of general peace, there's still war - at least somewhere on the globe. And classically the US is part of it, either indirectly or directly. Niche defense stocks give investors a unique way to profit from it. I cover them in my Sterling Intelligence email letter.



Dick Sterling

Author: Dick Sterling

Dick Sterling
Editor, Dick Sterling Publishing

Dick Sterling

As an economist and investment pro, Dick has been actively and unceasingly involved in the stock market for the past two decades. He is known for his contrarian, outside-the-box approach to investing, and his unique insights are always the opposite of mainstream groupthink. His ground-breaking proprietary investment tools include The Profit Machine, Mastering the Bubble, The Small Stock Formula, and Keys to the Investing Universe. Dick's commentary and publications can be found at his website: www.DickSterling.com

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