Are Gun Stocks Bulletproof?


It looks like high noon for gun stocks.

While much of the country is up in arms about the rash of mass gun violence in 2012 and demanding stricter gun control, gun makers have been reaping a huge payday. The short explanation seems to be that fears that new legislation will ban certain weapons have led to a run on guns, but stocks of publicly traded companies Smith & Wesson and Sturm, Ruger do not seem to reflect the recent boom.

Let's look at the recent statistics:

  • In December, the FBI processed more background checks (2.78 million) in a single month than it ever had in its 14-year history.

  • In 2012, background checks increased by 19%, and in December by 39%.

  • Many Wal-Mart locations and other gun sellers sold out of guns, and the price of some guns on auction sites such as eBay was bid up two or three times in value compared to prices before the Newtown shooting.

From an economic standpoint, the response seems rational. If a product is soon to be banned, you would expect a run on it. Scarcity tends to drive up demand, even though we only have a perceived regulatory scarcity in the gun market right now. President Obama has declared his desire for more effective gun control, and has appointed Vice President Joe Biden to head up a task force to investigate the matter. Among the team's potential proposals are a new assault weapons ban, universal background checks, and a national gun registry database. In a year's time, it may be somewhat more difficult to purchase a gun, but the U.S already had an assault weapons ban for 10 years, and gun sales hardly disappeared.

As you can see from the charts below, gun sales spiked in the run-up to the 1994 assault weapons ban, but then essentially returned to levels experienced before the ban was passed. The spike in 2008-2009 comes from fears of an Obama administration passing new gun control legislation.

Source: ATF.

Source: ATF.

Based on the manufacturing and import statistics, it's unlikely that gun sales will crash even if new legislation is passed.

The taboo effect
Cerberus Capital Management made headlines when it said last month it would sell its stake in the Freedom Group, the maker of the Bushmaster rifle used in the Newtown shooting. Other public entities have signaled similar wishes, including the California State Teachers' Retirement System, but while those divestments might create a sense of shame around gun makers, they do little to affect the companies financially. After all, it's a bit contradictory to see customers rushing in for a product while investors are fleeing for the doors.

Just ask Philip Morris or its former parent Altria how the negative effects of cigarettes have affected their bottom line. Hardly at all, of course. Those stocks have given investors returns of over 1,000%, and pay healthy dividends to boot. In fiscal 2011, Philip Morris netted more than $8.5 billion in profits.

The problem with selling a stock out of protest is that the more socially conscious divestment there is from a stock, the greater its returns will be to the investors who stick around, since the stock is likely to be undervalued.

Foolish takeaway
Despite the recent spike in sales, Smith & Wesson is still trading below its early December price, while Sturm, Ruger is just a few points higher. Analysts have raised earnings estimates, and the high demand for guns is likely to stick around as long as the gun control issue is being debated in Washington and in the media and the threat of new legislation hovers. I've placed a bullish CAPScall on both of these companies as I think there's plenty of reason to expect these stocks to continue to build toward their next earnings report, which could easily yield an earnings beat. In the long run, new legislation may dampen some of the recent sales growth, but it certainly won't kill these stocks, based on what we saw with the last ban.

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Jeremy Bowman has no position in any stocks mentioned. The Motley Fool recommends eBay. The Motley Fool owns shares of Sturm, Ruger & Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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