After decades of working with defense technology companies, I know the ebb and flow of military spending all too well.
I remember that when the Cold War came to an end, the nation's political leaders were talking enthusiastically about the so-called "peace dividend."
That's Washington-speak for Pentagon budget cuts that always seem to come after a major conflict has ended.
Many investors believe that with our presence in Iraq largely gone, defense firms will offer mediocre returns at best.
I'm not buying into it. I think massive profit opportunities are there. And the market and the government are lining up behind them...
Not Just a Bull, a National Imperative
Fact is, earlier this decade, several key defense contractors saw there were tough times ahead and revamped operations to do well with lean budgets.
More to the point, as current dramatic news makes all too clear, the U.S. needs a strong global military presence with an army, navy, air force, and Marine Corps second to none.
The escalating conflict in Ukraine is a great example of why the U.S. must maintain a strong defense structure. It includes the ability to support NATO allies against incursions into Europe.
But that's not the only global threat we face...
Look at how aggressive China has become in its demand to control the South China Sea. Not only that, but North Korea's unstable regime remains a looming threat.
So, while many investors are looking at other sectors because of the ongoing Washington budget battles, defense stocks as a group have greatly outperformed the overall market.
Here's the thing. I grew up in a military household and have followed defense technology my entire career as an analyst.
In fact, I was in the tech trenches during the 1980s when President Reagan broke new ground with his tech-centric Strategic Defense Initiative, more commonly known as his "Star Wars" program.
So, I have seen first-hand the Pentagon and its prime contractors adapt to budget cuts and come back stronger every time. And they are brimming with advanced technology that gives America defense superiority.
Back U.S. Defense and Reap Huge Gains
What we want to do is take advantage of the all the opportunities to profit from tech breakthroughs and weapons programs that will permeate the entire sector.
That's why I think investors would do well to take a good look at PowerShares Aerospace & Defense (NYSE: PPA). This is a cost-effective ETF made up of 80% defense and aerospace stocks from companies who are proven leaders.
The fund has a solid mix of companies, including cutting-edge small caps like FLIR Systems Inc. (Nasdaq: FLIR), the world's predominant maker of commercial thermal-imaging cameras.
There's also the advanced materials firm Hexcel Corp. (NYSE: HXL), which supplies honeycomb composites to some of the biggest names in the aerospace industry.
But the heart of this ETF play is found in its top 10 holdings.
They include many well-capitalized companies that have succeeded for decades regardless of Washington's defense budget battles.
Raytheon Company (NYSE: RTN) is a full-spectrum company that provides the Pentagon with systems for electronic warfare, laser rangefinders, military training, and advanced radar.
Plus, the company's intercept vehicles, radars, and space sensors work together to protect the U.S. and its allies against ballistic missiles, cruise missiles, aircraft, and other threats.
Raytheon was recently awarded an $8.5 million contract by the Office of Naval Research to develop a digital radar system that is thought to be the world's most advanced.
In this year's first quarter, earnings per share increased 3% from the year ago quarter to $1.57. New bookings grew 19% to $4.3 billion. Trading at $97 a share, Raytheon has a $30 billion market cap.
For its part, Lockheed Martin Corp. (NYSE: LMT) is well-known for making military aircraft. But the firm also supplies combat ships and ground vehicles as well as advanced radar and tactical communications.
Indeed, this is a company that illustrates what I've been talking about in terms of realigning to take advantages of the sector's broad changes. The company's history dates back more than 100 years, but the modern firm came together in a 1995 merger.
Lockheed Martin's reach also includes space exploration, satellite systems, and climate monitoring. Moreover, the company has deep expertise in biometrics, cyber security, and the booming field of cloud computing.
The company recently secured two contracts from the U.S. Navy and Royal Canadian Air Force, combining for $34 million to develop laser-guided bombs.
In this year's first quarter, sales fell 4% to $10.7 billion, but profits rose 23% to $933 million. The company forecasts higher sales, operating margins, and cash flow for the full year. Trading at $162 a share, Lockheed Martin has a $51 billion market cap.
And Northrop Grumman Corp. (NYSE: NOC) has a wide spectrum of operations that cover everything from advanced sensors to missile defense to cyber security.
The company makes manned and unmanned aircraft for defense applications. But it's also collaborating with Yamaha to develop an autonomous helicopter with onboard intelligence gathering equipment for such civilian uses as search and rescue and forest fire observations.
Northrop Grumman also provides the military with electronic warfare and infrared countermeasures. In addition, the firm gives us a strong play on sensor technologies, advanced materials, and laser weapons systems.
For the first quarter of 2014, sales fell 5% from the year-ago period to $5.8 billion, but earnings per share rose 23% to $2.63. Trading at $120 a share, Northrop Grumman has a $26 billion market cap.
Thus, for tech investors PPA offers us access to some of the best and most advanced systems on earth - everything from robotics to sensors and space exploration.
It sells for just a fraction of some of its big-cap members. PPA trades at just $32, less than one-third the price of even the cheapest of the three big-cap defense firms we talked about today.
And it offers us superior returns. Over the past two years, PPA has gained some 74%. That's more than two-thirds better than the S&P 500's return over the period of 44%.
Setting Up Perfectly for the Short Term (and Long)
This also is a great long-term play. See, no matter what happens in Washington over the next several years, America's role as the world's only real superpower means we have little choice but to fund a strong defense system.
Plus, the U.S. will continue to push the boundaries of tech-centric warfare. No matter which party is in power after 2016, advanced technology will continue to get strong fiscal support.
All of which means both the big-cap contractors and the small-cap cutting edge firms stand to gain, which will only provide more support and price appreciation for PPA.