Before the outbreak of the conflict with Iran in February this year, the valuation of major US defense stocks relative to the S&P 500 reached a premium of about 15%, which Bernstein believes already included the anticipated $1.5 trillion defense budget. Since then, the sector has continued to decline and is currently trading at a discount of about 12%.
Historically, sustained outperformance of defense stocks typically requires one of two conditions: a significant increase in defense investment budgets, or a free cash flow yield that is at least 3 percentage points higher than the S&P 500.
Currently, the S&P 500's free cash flow yield is about 2.5%. Among the major defense companies covered in the report, only L3 Harris meets the requirement of a yield difference of more than 3 percentage points. Therefore, Bernstein still believes that whether the budget growth can be realized is a crucial condition for the valuation recovery of the entire sector.
