Defense: Buy Defense After the Election
(Source: Morgan Stanley; issued Nov. 02, 2020)
Defense is trading at a 35%+ discount to NTM S&P 500 P/E, providing a positive skew to the upside. US military superiority is no longer guaranteed. We expect high perceived threat to drive higher defense spending under a Democrat or Republican sweep. Top stock pick is Northrop Grumman (ticker: NOC).

Attractive buying opportunity for Defense stocks

Defense stocks have pulled back in recent months on uncertainty linked to the upcoming U.S. presidential election. Stocks are off ~6% on average since September and ~12% since August, creating what we see as an attractive buying opportunity. In our view, investors are largely staying on the sidelines until after the elections. However, the broader global security landscape suggests that a Democrat or Republican win requires higher U.S. modernization spending. Our top defense pick is Northrop Grumman (ticker: NOC).

Broader national security concerns

U.S. military superiority is no longer guaranteed according to the Department of Defense. Hence, we expect Defense Investment Accounts to grow regardless of political control. Adjusting for purchasing power parity and U.S. involvement in the Middle East, China spends more money on Defense than the U.S. We believe this dynamic is largely underappreciated by the market and can provide downside protection for Defense primes' top line in the next few years as the U.S. keeps pace to remain competitive. Going into the elections, the two likely scenarios we expect are Scenario 1 (base case) Keeping Up with the Neighbors and Scenario 2 (bull case) Speak Loudly and Carry a Big Stick. Both scenarios provide more upside than downside risk for NOC, LMT, and LHX at current prices.

Stocks are pricing in a change in political control

At current levels, investors appear to be pricing in a likelihood of the November 2020 election shifting political control in the White House, and potentially Senate, to the Democratic Party. Under this scenario and based on history we believe multiples could trade as low as a ~55% discount but expect the median to be closer to a ~25% discount over the coming two years.

Republican win could provide a 15% premium to the S&P 500

Conversely, if the Republican Party were to retain control of the White House and Senate, we believe multiples could trade as high as a ~30% premium but expect a level closer to a ~15% premium. A 15% premium considers the sequential decrease from first term to second term observed during the Bush administration. This implies a ~23x P/E multiple for Defense. A change in political control generally creates volatility in Defense multiples; however, when Presidents see second terms, Defense multiples typically see lower highs and higher lows, a trend we expect to hold if President Trump is re-elected.

50%+ upside for Defense stocks under Democrat scenario

With the current discount of 35%+ and an expected ~25% discount under the Democrat scenario and ~15% under the Republican scenario we see a favorable risk-reward skew. Average upside for our Overweight-rated Defense stocks currently stands at ~54%.

Biden may be less negative on Defense than Obama

Compared to the previous presidential election, there are a few things that are different this time that could change the trough in multiples for Defense. President Barack Obama campaigned in 2008 on cutting the Defense budget during peak U.S. troop deployment in the Middle East and in a period in which U.S. military technology was unmatched by peers and near-peers. Meanwhile, presidential candidate Joe Biden has not been as vocal on cutting the Defense budget so far.

Northrop Grumman's portfolio and recent result make it our top pick

As we compare the portfolio exposure of the defense primes versus the priorities outlined in the National Defense Strategy, we view Northrop's portfolio as one of the strongest among peers. Northrop is aligned to priority capabilities like autonomy, directed energy, and hypersonics. The company has the strongest portfolio to modernize the nuclear triad and has end to end solutions in space after its acquisition of Orbital ATK in 2018.

Given recent results and our view of Northrop Grumman's portfolio positioning, we see it as the company with the most growth potential over the near- to medium term. With a notable discount to the market and room for improvement relative to peers, we see upside potential for the multiple, especially if the Republicans maintain control of the White House. NOC is our top pick in Defense with ~62% potential upside to our PT of $470.

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