Kiss These Dividends Goodbye!

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With dividend investing currently back in vogue, investors are clamoring for income-producing investments. And while we here at The Motley Fool certainly support finding a healthy stream of investment income, we recognize not all dividends are created equal. Like all investments, you need to understand both the potential risks and the possible rewards before investing any of your hard-earned capital. In that vein, I want to highlight for you today a sector riddled with dividend stocks -- not to buy, but to avoid like the plague.

Those were the days
The 2000s proved a boom for defense investors. The realities of the post-9/11 world bolstered our need to spend more money to maintain our national safety -- and by a pretty wide margin. For instance, the Department of Defense requested funding of $291.1 billion for the fiscal year 2001. In 2011, the DoD sought $708 billion in funding, equating to a 9.3% annual growth rate over the last decade. And, perhaps unsurprisingly the defense industry as a whole benefited mightily from the uptick in activity, as you can see below.

Company

10-Year Share Price CAGR

Dividend Per Share 10-Year Growth Rate

Current Dividend Yield

Lockheed Martin (NYS: LMT)

8.2%

20.7%

4.3%

Northrop Grumman (NYS: NOC)

6.0%

16.9%

3.8%

United Technologies (NYS: UTX)

9.3%

14.9%

2.6%

General Dynamics (NYS: GD)

6.1%

12.7%

3.0%

Boeing (NYS: BA)

3.6%

10.0%

2.7%

Raytheon (NYS: RTN)

6.5%

7.2%

4.2%

ITT (NYS: ITT)

8.8%

10%

2.1%

S&P 500

2.1%

N/A

1.8%

Source: Capital IQ, a Standard & Poor's company. N/A = not applicable.

If you'd just held a basket of the larger defense contractors over the past decade, you'd have absolutely smashed the market's returns. Investors loved this sector -- and for good reason. Beyond the juicy returns shown above, the defense industry also derives a substantial amount of its revenue from governments (the U.S. federal government, especially), giving investors a greater degree protection from the economic cycle than most stocks. This powerful combination helped make defense an attractive option, allowing investors to both outperform the market and diversify risk away from consumer spending.

The end of an era
Unfortunately for current defense investors, that spending boom also helped drive the federal deficit into the stratosphere as, adding $1.2 trillion to our financial shortfall by themselves, according to some estimates. In this year's budget, the DoD intended to allocate $159 billion of the requested $708 billion for its overseas conflicts, which it seems safe to say will end at some point. This means that entire $159 billion should vanish from the revenue streams of these now-titans. This brings the possible range of cuts into the ballpark of $194 billion annually, or roughly 28% off all defense spending this year, between these two issues alone.

In order to further combat our burgeoning budgetary woes, Congress supported $350 billion in defense-related spending cuts over the next 10 years as part of its recent deficit-reduction plan. Worse yet, if the congressional supercommittee appointed by Congress fails to negotiate that pre-specified $350 billion in cuts, the mandated cuts then increase to a required $500 billion.

This will undoubtedly impact the future performance of these contractors for the worse. During the last defense drawdown, which took place from 1985 to 1997, defense stocks underperformed the stock market by 33%. A similar scenario this time around seems more than plausible to me.

Foolish bottom line
What would you expect if your main revenue stream faced an impending 28% reduction? Nothing good. The companies involved see less business come through the door, compete more vigorously with one another, all hell breaks loose, and those dividends so near and dear to your heart get crushed.

I argued in the past for the contrarian play with defense stocks. That's no longer the case. Better to avoid that massive looming risk than see your portfolio get nuked. The market has plenty of great dividend stocks out there. Research proves those little checks help investors beat the market and retire in style. The Motley Fool compiled a report for you highlighting some of best dividend opportunities on the market in a report for you. Click here to get your free copy today.

At the time this article was published Andrew Tonner holds no positions in any of the companies mentioned in this article. The Motley Fool owns shares of Raytheon, General Dynamics, Lockheed Martin, and Northrop Grumman. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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