Introducing The Inner Circle Defense Sector Model Portfolio

Constituent stocks and the portfolio logic follows below.

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If This Beats The Market We Likely Have Other Problems

by Alex King, with thanks to Abhishek Singh for the idea.

This week we introduce the Inner Circle Defense Portfolio. Like the other model portfolios here - Core, High Beta and Financials - this is a model portfolio not a real-money one. As you know Cestrian is an investment research firm not a money manager - Cestrian doesn’t run its own money nor that of third parties. We always disclose holdings and trades in covered stocks in Cestrian staff personal accounts; stocks in this Defense portfolio will be the same.

Why Defense, Why Now?

Primarily because a number of large-cap, liquid defense primes are showing signs of institutional accumulation - sideways price action at local lows, at high volumes. Very often, you can observe institutional capital rotating into sectors this way. It happened in the energy sector during 2021, particularly towards the end of the year - energy broke to the upside in 2022, as you know. It happened in tech in late 2022; tech broke to the upside in 2023, as you know. This doesn’t mean that defense will break to the upside anytime soon or at all, but it might do.

Secondly because these stocks tend to be very stable and don’t get blown around by the wind too much, owning them can provide a good degree of ballast in an overall portfolio. If you hold high-beta names during a downturn, as I did in 2022, it can be gratifying to see some solid-as-a-rock names holding fast, maybe even moving up whilst markets are committing grievous acts of self-harm.

Thirdly, because it is possible that the reason for those accumulation patterns on the stock charts is because market bigs see the world becoming more atavistic, more nationalistic, less interdependent, and believe that this will lead to increased total defense spending. In the West there are relatively few large scale defense companies that nations can buy the heavy hardware from. So if, as seems likely to this author, the EU has to up its defense budget in the face of increasing Russian aggression and decreasing appetite for the US to fund third-country defense needs, much of the new spending will flow to US vendors, not only to Airbus or BAE or Cobham or the other European vendors. Bigs in 2021 knew that the Russian invasion of Ukraine was (1) likely to happen - it wasn’t just a wargame as many speculated in 2021 - and (2) if it happened would likely spike energy prices. Remember that the job of the Big of Bigs - the individual with the good corner office at each and every one of the Big Money, LLC firms - is to make nice in DC to find out what may be happening in the world that isn’t surfacing on the evening news or the Wall Street Journal. Bigs can then plan - accumulate and distribute that is - accordingly.

So, we opened our defense portfolio this week and will start tracking its performance. For good measure we’ll show it vs. the four major indices (S&P500, Nasdaq-100, Dow Jones 30, Russell 2000) but for clarity - we are not looking to this portfolio to beat the indices. It is meant to be a low beta place to park capital, with the chance of meatballs.

What Does Good Look Like In Defense?

In defense companies, from a fundamental perspective, what good looks like is:

  • The US government in its various forms as the dominant customer
  • Relatively diversified revenue streams within US government departments and agencies ie. not all concentrated in, eg, the USAF or the Army
  • Large and growing order backlog - this is the no.1 metric to watch
  • Cashflow margins which are good but not too good (else the G-men will take a knife to the contract terms) - call it 5-15%.
  • A dividend of some kind
  • Leverage which isn’t excessive - call it 4x TTM EBITDA or below
  • Sustained high-single-digit revenue growth.

As regards their stock charts, a stock chart is a stock chart and what good looks like on a stock chart is common across all stocks as you know.

Which Stocks Are Included And Why