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BARRON'S ONLINE: A Tug Of War In The Year Ahead
By Dimitra DeFotis
Weekday Trader
(This item was originally
published late Tuesday).
Editor's note: Today Barron's Online concludes our survey of the year
ahead
with a look at how defense and energy stocks may do in 2003.
As a new year begins, it looks like deja vu all over again, except for
one
thing: We may have a real war in 2003.
Given the current military buildup in the Persian Gulf, a U.S.-led war
against
Iraq looks likely. And domestic terrorism still remains a front-and-center
issue
16 months after the September 11, 2001 terrorist attacks.
"I predicted a war against Iraq in 2002. But the president is out
on a totally
different limb now," says Marvin Zonis, a political risk consultant
and
professor at the University of Chicago.
"We are building to a logical military conclusion. The logical
timing is the
end of February."
The Bush Administration
wants a quick, decisive victory, with few casualties,
that results in "regime change" in Baghdad. Zonis and others
say if Iraqi
President Saddam Hussein draws U.S. troops into urban guerilla warfare,
or uses
weapons of mass destruction, the conflict could be longer and bloodier.
During the Persian Gulf War, defense stocks fell after it became clear
that
the U.S.-led coalition would be victorious. This time, even if the initial
conflict ends quickly, the increase in U.S. defense spending in a post-9/11
world should continue to benefit defense stocks.
The federal defense budget for fiscal 2004 (beginning in October) should
be up
more than 5% over fiscal 2003, according to Peter Arment, a defense
analyst at
JSA Research in Newport, RI. Increased tensions throughout the world-such
as the
showdown with North Korea-should help defense spending rise by a 7%
compound
annual rate over the next five years (including outlays for homeland
security),
JSA projects.
Energy prices may
not follow the same path they took after the first Persian
Gulf War, when they sank quickly. The world oil supply is tighter now,
population growth means increased demand and oil companies still have
to drill
for oil.
But energy investors still should see oil and natural gas prices above
historic averages when the dust settles in the Middle East and Venezuela,
where
political turmoil has virtually frozen oil output.
In the short term, crude could go to $40 per barrel when the shootout
starts,
but it should fall back to between $22 and $25 a barrel if the war ends
successfully. Natural gas, meanwhile, should hover nearer $4 per million
British
Thermal Units. Those prices still should be profitable for oil and gas
services
companies, says Mark Baskir, manager of the Strong Energy Fund.
"Most analysts think stocks reflect $20 [a barrel] oil," says
Baskir. "I can
see attractiveness in each of my energy sectors."
Baskir thinks that energy stocks, given their dividends, can perform
as well
as or better than stocks in the Standard & Poor's 500, even as oil
prices fall
after a successful war against Saddam.
"I think we are in a constricted oil supply environment. If there
were no
trouble in Iraq or Venezuela, I think oil prices would be $22 to $25,
economies
would be OK, and there would be two million barrels a day of excess
oil in Saudi
Arabia," Baskir says.
Meanwhile, energy
stocks in the S&P have lost about 14% of their value since
9/11, including a nasty 23% drop in July alone, according to Baseline.
Baskir has roughly 30% of his fund in oil services. One favorite: integrated
oil and gas services company Murphy Oil (see Weekday Trader, "Venezuela
Crisis
May Fuel Oil Firestorm," December 12, 2002). Analysts and investors
look for
drilling projects in Southeast Asia to double the company's size by
2007.
He also likes select integrated oil companies, including ChevronTexaco.
The
stock has underperformed its peers in part because of ChevronTexaco's
investment
in Dynegy, whose stock collapsed (and credit rating fell to junk status)
following the demise of its energy-trading business.
But Baskir thinks Chevron can erase 2002 production problems with synergies
from its acquisition of Texaco, including good production potential
off the
coast of West Africa and in Azerbaijan.
ChevronTexaco is selling
below its historical median price-to-earn ings
multiple of 18x forward earnings, and is trading at twice its historic
7%
discount to its peers, according to Baseline.
John Segner, manager of the Invesco Energy Fund, likes Baker Hughes,
a
pure-play oil services company that has outperformed peers like Halliburton
and
Schlumberger Ltd.
Baker Hughes is trading
in line with its peers, but slightly below its
historic median P/E of 29.4x, according to Baseline. It fetches a premium,
however, to its projected long-term annual earnings growth rate of 15%.
As one of the world's largest oilfield services companies, its
"product/geographic diversification provides a safe haven to investors
during
uncertain times," S&P recently wrote.
Defense spending should rise, too, as we noted, for both equipment purchases
and research. Much of that money will go for missile defense; new planes,
including the Joint Strike Fighter, and upgrading communications and
networking
ability.
The projected defense budget of $400 billion in fiscal 2004 (including
homeland security) will be some 35% higher than the $296 billion the
U.S. spent
in fiscal 2000, according to Paul Nisbet, defense analyst and founder
of JSA.
"We see fundamental changes in defense spending after a decade
of declining
budgets," Arment says. "The catalyst events are Iraq and the
continuing war on
terrorism."
Aerospace and defense
companies in the S&P 500 do reflect some of the spending
gains, having appreciated 18% since the market reopened after last year's
terrorist attacks. But their shares have fallen 19% since the market
selloff
last July, way underperforming the 6% loss in the S&P during the
same period,
according to Thomson Financial/Baseline.
Some of the decline may have been linked to speculation that growth
of the
defense budget won't be as healthy as was previously predicted, says
Arment. He
thinks aerospace and defense stocks look attractive, offering 15% to
20% returns
in the next year.
One of his favorites is Alliant Techsystems, the Pentagon's largest
ammunition
supplier and the world's largest maker of solid-fuel rocket engines.
(Customers
include Boeing, Lockheed Martin and Raytheon.)
With the likely need to replenish munitions during and after a war,
"the stock
has good prospects in the next two to three years," Arment says.
He thinks the
shares could appreciate more than 18% to his 12-month target of 78,
which they
reached in 2002.
Alliant is trading at a slight premium to its median multiple of 14.2x
forward
earnings over the last five years, but it's changing hands at only half
its
typical 20% premium to its peers, according to Baseline.
Sooner or later, the crisis with Iraq will be resolved, and that could
help
jump-start the economy. That in turn could prompt investors to put their
money
into faster-growing, economically cyclical sectors rather than energy
or
defense.
But we live in a new
Age of Anxiety that won't dissipate even if Saddam leaves
the stage. And with the carefree days of the 1990s over, people may
always want
to hedge at least some of their bets by investing in energy and defense.
That's why some names in those areas could do well in 2003, which Zonis
dubs
"the year of war."
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