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World politics, health and defence spending key indicators on US stock

IN many US industries, investors need to weigh how much of the budget-cutting news coming from the White House and the Senate is already reflected in the price of a particular stock.

The higher the share price relative to earnings, the more vulnerable it is. Some companies threatened by budget cuts are already so cheap their shares may be worth buying.

In my opinion, that's the case with defence stocks. Raytheon and Lockheed Martin sell for about nine times earnings, General Dynamics and Northrop Grumman for about 11 times earnings.

General Dynamics, for example, showed earnings growth of 10pc or more in seven of the past eight years. Yet analysts foresee only 5pc growth in 2011.

I believe lawmakers will decrease defence spending; but given the conflicts simmering around the world, I expect mild reductions. Consider some developments in the Middle East in the past few months:

  • The people of Egypt rose up against Hosni Mubarak's regime.
  • Iran continued developing nuclear weapons, and boasted that it has "complete domination" over the entrance to the Persian Gulf.
  • US forces are struggling in Afghanistan, and the people of that country seem to have no faith in the central government.
  • Sectarian fights rage in Iraq, which wants the US out but has no compelling plan for stability.

I haven't even mentioned Pakistan or Israel yet. I think the point is obvious: the need for US military force may be heightened in the next few years, even if it's inconvenient from a budgetary standpoint.

If Congress can't revamp the defence budget too much, it may have to cut health-care spending more than it otherwise would. That could mean lowering reimbursement rates for the US health-care system called Medicare and Medicaid, or restricting permissible expenses, or both.

Health maintenance organisations that get a large slice of their revenue from Medicare seem vulnerable. That includes companies such as Molina Healthcare and Healthspring. At 27 times earnings, Molina seems more at risk than Healthspring at 10.

Long-term care facilities, also known as rehab hospitals, could find the federal government stingier than before. National Healthcare looks vulnerable. The company gets 70pc of its revenue from the federal government, according to Barclays Capital. The stock isn't cheap, at 17 times earnings.

Also at some risk are health-care companies whose treatments are expensive, especially if there are some cheaper therapies available. Zimmer Holdings dominates the orthopaedic implants business, but may find doctors more reluctant to use top-of-the-line implants that carry high profit margins.

Similarly, Boston Scientific which makes stents in Galway to keep blood vessels open, could face competition from cheaper stents or drug treatments.

Besides defence and health care, selected stocks in other industries may also be vulnerable. For-profit colleges, for example, depend on the federal government to guarantee the student loans that pay for their students to attend. Without loans, most students couldn't go; and without federal guarantees, few lenders would issue student loans.

Also dependent on federal money is Corrections Corporation of America, a builder and operator of for-profit prisons. The Nashville, Tennessee, company has a consistent history of profits, but growth slowed to single digits last year.

I hope that Congress does not choose to cut spending on cyber-security. If it does, though, Keyw Holding would be in some trouble. A leader in that field, the Hanover, Maryland, company sells for 25 times earnings.

Indo Business