War portfolios: Casting a wider net
Few people want a war if it can be avoided, but you should be prepared to protect your portfolio in case of one.
By Larry Dignan
Oct. 8, 2002
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With a telegraphed war against Iraq looming and persistent worries about terrorism, some investors and academics are pondering an "Armageddon" portfolio, designed to find stocks that are likely to benefit from war and the potential retaliation. To be sure, the war scenario is one no one wants to see happen, but that hasn't stopped investors from looking for companies that will benefit from turmoil in the Mideast. The catch is finding the next big thing before everyone else does.
In a recent research report on defense contractor General Dynamics, Stephens analyst Eric Hugel summed up the prevailing view on Wall Street since Sept. 11. "We see investment in General Dynamics and in defense stocks in general as portfolio protection for investors due to the global instability and possible future acts of terrorism," he said.
But a lot of folks think that way, so gains have already been priced into many big-name defense stocks. According to Scott Larson, an assistant professor at National Louis University, the one-year return ending Sept. 17 for traditional defense companies such as Boeing, General Dynamics, Lockheed Martin, Northrop Grumman and Raytheon among others was a loss of 5.12 percent -- better than benchmarks such as the S&P 500, but still in negative territory. It should be noted that those defense companies have been hamstrung by a weak aerospace business.
The solution? Cast a wider net and include smaller players. In fact, one portfolio constructed by Larson managed to squeak out a gain of nearly 6 percent for the year ending Sept. 17. Larson, who owns some of the stocks in his portfolio, splits stocks into eight sectors: biological threats, communications, security and threat prevention, direct response/support, biometrics, data security, traditional defense and portable power.
"It's a new world and a whole new infrastructure is being built up," said said David Sauer, associate professor of finance at the University of Dayton. "In the next war, looking at biological stocks may make sense."
Larson said it will pay to focus not on an attack on Iraq, but the potential retaliation and terrorism threat. That means companies that are working to detect and prevent wrongdoers. Among his sectors, companies that directly target terrorism had the best stock surges in the last year. Companies like Cepheid, which is working on biohazard detection equipment; Invision, which makes explosive detection systems; and Acambis, which makes vaccines, have fared the best.
"I'm looking for long-term trends, and detection is where you ultimately wind up," said Larson, who noted he sticks to leaders in any particular sector. "The systems are not very good, but getting there. If you're really worried about Iraq and forced to look for stocks, it's better to look at niche players."
That strategy can be risky -- 21 of the 39 stocks in Larson's model war portfolio actually declined in the year following the Sept. 11 attacks.
Several stocks in Larson's portfolio are small-cap issues, which can often be illiquid and thus subject to sudden, dramatic shifts in price. A few of the companies in Larson's portfolio haven't turned a profit yet, and many live and die on contract announcements. For example, investors had been anticipating that Cepheid would win a contract from the U.S. Postal Service for a anthrax detection system. When that deal didn't come through when expected, worries increased about the money-losing Cepheid, although the company says it's making progress on the deal. "We believe that uncertainty regarding the timing of the contract award has increased, although we still believe that Cepheid should win the award by year-end," William Blair analyst Winton Gibbons said.
Timing can be everything when picking war stocks, a point that Larson concedes.
Biometric companies such as Viisage and Indentix surged when the markets opened after Sept. 11, but quickly fell. The returns for Viisage tell the tale. For the month ending Sept. 17, 2001, Viisage shares were up 160 percent. For the year ending Sept. 17, 2002 Viisage was down 10 percent. Simply put, investors that hopped on the bandwagon weeks after Sept. 11 were burned.
Larson outlines the following strategy for his portfolio:
When an attack on Iraq commences, sell traditional defense players and direct response players such as Armor Holdings, which provides security products, vehicle armor systems and security risk management services.
Keep companies that detect security threats such as Invision and American Science and Engineering, which screens cargo and sea containers for radiation. Investors will become increasingly interested in these stocks in anticipation of retaliation. If there is a terrorism attack of some sort -- a scenario Larson emphasizes he doesn't relish -- it will pay to sell these stocks.
As for biometrics, biohazard detection companies and security stocks, take some off the table on gains, but also look to strategically add to positions. "There are quite a lot of long term trends here," he said.
Watching how the trading plays out will be interesting. Many analysts are expecting short-term returns similar to what was seen immediately after last year's attacks on the World Trade Center and Pentagon. "Although the market's reaction to future terrorist events is inherently unpredictable, we believe the events of Sept. 11 can serve as a reasonable expectations basis," said Hugel.
Based on data from the Persian Gulf War in 1991, research and investment advisor firm Riskmetrics Group has calculated that among widely-held stocks, the least risky companies for a regional war are conglomerate General Electric, health care manufacter Johnson & Johnson, and drug companies Merck and Pfizer. "Those are the stocks that have been doing well in shock scenarios, like the one people are anticipating now, the Iraqi invasion," Riskmetrics market strategist Michael Thompson said, on the Oct. 4 broadcast of Wall $treet Week with FORTUNE.
The big question: If everyone is expecting a run-up in war-related stocks, will there be one?
Although groups such as Riskmetrics have looked at certain widely-held stocks, academics note that there aren't any studies showing for certain which stocks respond well to war. "I'm not aware of any study that's definitive," said Sarkis Joseph Khoury, professor of finance and international finance at the University of California, Riverside.
Sauer, whose students get to manage a $2 million chunk of the University of Dayton's endowment, said you have to look at defense given the possibility of war but notes some of the valuations may be out of whack. "The market has priced in a lot of the war potential in the securities," said Sauer. "It may be hard to find good values."
Khoury, who has written books tracking markets through history, said some defense stocks did well in Vietnam, but it wasn't uniform. "There are no consistent rules," Khoury said. "You still have to pick well."
In Khoury's view, a better strategy would be to short -- or bet that stocks will fall -- sectors that historically have been roiled by war. Airlines, for instance, would suffer from a further decline in travel. Energy and broader transportation stocks would also be affected. "If one wants to make money you could short on the presumption that certain sectors would suffer," he said.
However, it may not pay in the long run to totally focus on war stocks, Khoury said. After all, war is just one risk to the market. Corporate misdeeds and poor financials can have just as big of an effect as terrorism when it comes to market machinations. "Overall, there's an umbrella of bad news," he said.
Nevertheless, you can protect your portfolio amid the turmoil, Khoury said. "I tell my students that there's no such thing as a bad sector -- just a bad position in a
sector."
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