Profit From Military Myopia

“Armies always prepare to fight the last war.”—- Anonymous

“Most investors tend to project near-term trends … indefinitely into the future.”— Baupost Group portfolio manager and noted value investor Seth Klarman

In this one respect, at least, soldiers and civilians think alike. We’re forever focusing on what we know now, guessing the future will look similar — and presuming we’re right. We take out option-ARM mortgages to buy “too much house” because housing is going nowhere but up. We buy stocks based on momentum for much the same reason.

Over at the Pentagon, projecting the recent past into the future mandates building fighter jets based on 1980s technology, better suited to battling Brezhnev than bin Laden. It has us building high-tech warships to blockade the Red Army, while vagabonds in rowboats nibble on our flanks, and China opens a new front in cyberspace.

Make money on myopia
But it’s not all bad news. Recognizing that others bear the same faults as plague us, we can profit from guessing at the mistakes they’ll make. Perhaps nowhere is this truer than in the defense industry, where the very nature of “current events” ensures they’ll grab headlines and lead off the evening news. Simply put, you cannot fail to notice what recent trends the Pentagon is seeing. And so knowing, you can invest in them.

What are the “last wars” we can expect the Pentagon to spend big on preparing to fight in the future? Three come to mind:

Iraq
Clearly, this is the biggie. In Iraq, the U.S. military faced its biggest insurgency threat since Vietnam, and just like that conflict, developed solutions to overcome the threat. Unmanned aerial vehicles (UAVs) to silently observe, track, and kill bad guys. Mine-resistant, ambush-protected armored vehicles capable of surviving a full-on hit from an improvised explosive device. Ceramic body armor to protect soldiers individually.

Expect each of these threats to reappear as the Obama administration expands its surge into Afghanistan (because insurgents suffer from “last-war syndrome,” too.) And expect the Pentagon to reuse, and further validate the responses it developed in Iraq in the Afghanistan/Pakistan theater of operations — reinforcing its commitment to further funding these weapons systems.

Key beneficiaries: General Atomics, Northrop Grumman (NYSE: NOC), AeroVironment — three leading lights in UAV technology. Also Ceradyne (Nasdaq: CRDN) in body armor, and General Dynamics (NYSE: GD) in armored vehicles.

Somalia
Or rather, the deep water just offshore Somalia, which for months has become a pirate’s playground. Every week we read of more incidents in which waterborne highway robbers in rowboats board multimillion-dollar supertankers and hold their crews for ransom. The occasional hoo-rah news of SEAL team snipers giving the pirates what-for notwithstanding, the piracy problem has become a major headache for international shipping firms — and you can bet they’re making their complaints heard at the White House.

As many as three dozen U.S., NATO, and allied vessels have been tasked with prowling the sea lanes off Somalia. So far, they haven’t had much luck solving the pirate problem. But I’m guessing a lot of smart minds are hard at work figuring out ways to stave off the hijackers — and profit from so doing.

Key beneficiaries: Hard to say, since nothing seems to be working so far. But judging from comments by Defense Secretary Robert Gates, the piracy issue seems to be benefiting at least two firms involved in high-profile naval projects, Lockheed Martin (NYSE: LMT) and General Dynamics. I suspect a second side effect of the pirates’ escapades will be to ensure that funds keep flowing to the nation’s other key warship-builder, Northrop Grumman.

Cyberspace
The raft of headline-grabbing cyberattacks on U.S. information technology infrastructure is going to inspire — nay, demand — a response by the government. In fact, the Obama administration announced last week that it is setting up a “cyber command” to coordinate military responses to attacks on Pentagon IT.

This, incidentally, is probably the single “current events” trend with the most room to run. Cyber warfare has only really been around — and in rudimentary form — for about five years now, and it’s taken us this long just to recognize the threat. This, Fools, is truly the wave of the future.

Key beneficiaries: Lockheed and Boeing (NYSE: BA), both of which have significant cyber security divisions; also civilian contractors Cisco Systems (Nasdaq: CSCO) and Juniper Networks (Nasdaq: JNPR), which specialize in this stuff.

Foolish final thought
“Rein in your caveman brain.” — The Motley Fool. Each of the above companies is poised to profit from military myopia, and from our instinct to project recent events into the distant future — but this fact alone does not make the stocks “buys.” Whether a stock is worthy of investment depends not solely on its prospects, but on the price you’re asked to pay for them.

But don’t fear. We’ll address the question of these companies’ valuation later this week, so stay tuned: Different Fool time, same Fool channel. Fool contributor Rich Smith owns shares of Boeing, AeroVironment, and Ceradyne — the last two also being Motley Fool Rule Breakers recommendations. The Motley Fool’s disclosure policy is bulletproof.

By Rich Smith (TMF Ditty) April 28, 2009 at.