Highlights:
We reiterate our preference for defense-related shares to technology related shares. Our short-term preference is based on the combination of the on-set of war and attractive valuations. Our longer-term story is based on our long-standing theme of "returning to a cold-war mentality regarding technological innovation". We continue to believe that investors are defining geopolitics too narrowly by focusing only on Iraq. It appears to us that we are entering a significantly different "new era" of geopolitics that might last 10 or 15 years.
Although war has begun, investors still seem unenthusiastic about the defense stocks. We think investors should continue to overweight the sector despite its recent underperformance relative to the overall market. The combination of war, attractive valuation, an interesting secular theme, and a potentially new era of geopolitics are factors to which we think investors should be paying more attention.
We continue to suggest overweighting the defense sector. Although most investors have thought of defense stocks only in the context of the Iraq war, we have thought for some time that several powerful secular themes support the stocks' overweight as well. This comment first discusses our near-term outlook for the industry, and then expands on our secular themes.
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Our long-standing theory is that most technology analysts do not appreciate that the 1990s was an atypical decade in the United States' post-war era. It was atypical in that the Pentagon actually encouraged the use of innovative technologies for commercial purposes. The end of the Cold War meant an end to the "Evil Empire", and one of the post-Cold War "peace dividends" was the Pentagon relaxing restrictions on innovative technologies.
However, even before September 11, the Pentagon appeared to have become increasingly paranoid that perhaps too much innovation had been allowed into the public domain (some might remember the issues surrounding encryption technologies). After September 11, the Pentagon established several new agencies specifically for the purpose of restricting innovative technologies. For better or for worse, it seems to us that we have returned to a "Cold War" mentality regarding technological innovation.
Several relevant examples might help to explain:
1. Homeland Security's much advertised initial venture is to coordinate the data between the FBI, CIA, INS, etc. As Byron Callan (Merrill Lynch's Defense Analyst) likes to rhetorically ask, do you think the programming needed for that coordination to take place will be "outsourced" to a firm in Bangalore? Of course not. In fact, many software companies in the United States have programming staffs who are in the United States on visas and do not have security clearances. What companies have secure programmers? The defense contractors.
2. According to one outside research firm, the number one IT consulting and systems integration firm in the United States is now a defense company.
3. An article in the Financial Times last year pointed out that the military is using only about 60-70% of the capabilities of the unmanned drones that were made famous in Afghanistan, and that the reason why they were not able to use 100% was a typical problem. There is not adequate bandwidth between the drone and the satellite. It is probably not unreasonable to suspect that the Pentagon is undertaking research on wireless bandwidth. In the 1990s, such research would have been done in the private sector, and you and I would end up watching movies on our mobile phones. Today, such research is conducted in the public sector, and the benefits of that research go to the drones in Afghanistan.
4. A major networking company recently had a spat with a Chinese company that had evidently reverse engineered the US company's products. It turns out that the Chinese company has links to the Chinese military. We strongly doubt the Pentagon feels comfortable with this situation.
There are many other examples we could mention. However, the main point is that the 1990s was the decade of privately funded research and development (i.e., venture capitalists and the markets), and of private sector capital spending, (i.e., enterprise hardware, enterprise software, and the importance of the capital spending cycle). We feel the next decade will be about publicly funded R&D (i.e., the Pentagon), and about public sector capital investment (i.e., spending on defense, intelligence, and security).
Geopolitics More than Iraq
Last summer, we argued that investors were not paying enough attention to geopolitics. In January, we suggested that investors were defining geopolitics too narrowly. We still believe that it's true because most investors seem to be defining geopolitics solely in terms of Iraq. It seems to us that we are beginning a 10 or 15 year period of significant geopolitical change, which may be on the order of magnitude of the fall of the Berlin Wall or the demise of the former Soviet Union. However, this time the United States is embroiled in the situation. Last week, Russian President Vladimir Putin said that state sovereignty was being threatened by allowing "international law to be replaced by the rule of the fist". Although many might find such a comment rather ironic coming from a Russian President, the question remains as to whether some will try to paint the United States as the next "evil empire". We strongly doubt that investors are considering this possibility, and its ramifications. We think that the combination of an uncertain geopolitical environment, our long-term theme regarding a "Cold War" mentality regarding technological innovation, and attractive current valuations warrant a significant overweight of the Aerospace/Defense sector.