by Chris Lay, LEONID Co-Founder
As an investment firm specializing in identifying and financing mispriced assets within the US National Security contracting realm, the Leonid Capital Management team has spent considerable time studying both the public equity markets and US Defense contracting ecosystem. When investors allocate capital to the defense sector, they invest in an asset typically not sensitive to economic cycles. This means that the performance of the defense sector is not affected by the same market forces as traditional stocks and bonds. Instead, they are diversifying their portfolio into regions that, ideally, do not impact one another. They are spreading their bets.
One of the ways in which investment professionals can measure the degree to which they are effectively diversifying is to measure the correlation between movements in one asset class (i.e., the stock market) and another (i.e., defense). In this study, we compared the annual closing price movements of the S&P500 to the changes in the annual US Defense budget, dating back to 1947 (post-WWII) up into the present (FYE2022), and confirmed our hypothesis that no such correlation exist.
Across the time period studied, we observed a non-significant, near-zero correlation coefficient (Pearson’s r(73)= -0.17, p = 0.16) between the S&P500 and US Defense. This finding is, perhaps, unsurprising given that we have previously noted that US Defense spending tends to increase by ~18.0% year over year during periods of economic recession. Politics aside, our theory here would be that the Federal Government often tries to spend its way out of a recession. Further quantitative analysis of these recessionary trends, specifically, is certainly warranted.
Untapped Opportunity Amongst Small & Medium-Sized Companies
Despite the evident benefits of diversifying into the US Federal space, many capital allocators lack exposure to the US Government space. One of the reasons for this is the perception that the defense sector is complicated and challenging to understand. For example, the defense sector is highly regulated, with complex contracting processes and a vast array of companies involved in the supply chain. This complexity can make it challenging for investors to identify which companies are likely to benefit from an increase in defense spending.
Additionally, large defense contractors such as Lockheed Martin and Boeing have historically dominated the defense sector. As a result, these companies have dominated the market, making it difficult for smaller, specialized companies to gain traction. However, in recent years, there has been a shift towards more specialized, innovative companies that focus on specific areas of defense, such as cybersecurity, artificial intelligence, and unmanned aerial vehicles. These specialized companies may provide attractive investment opportunities for capital allocators who are willing to do the research and understand the market.
Leonid Capital Management
Leonid Capital Management is committed to identifying underpriced assets within these growth areas and providing our investors with unique investment opportunities within the US National Security, Intelligence, and Space ecosystems. By investing in this space, investors can diversify their portfolios, achieve higher risk-adjusted returns, and support the critical work that is being done to maintain global security and stability.