Though one would expect the aerospace and defense sector to do well in the fourth quarter of 2015, backed by the budget deal and escalating political disturbances, the estimate picture shows a somewhat contrasting tale ahead of the major earnings releases starting off from the next week. 

The U.S. economy is expected to have suffered in the fourth quarter of the year as the Atlanta Fed’s real-time Q4 GDP growth estimate is currently tracking at +0.6%, down from the earlier projection of +0.8% on Jan 8. This is a reminder that the country’s economic growth had started to cool off by the end 2015 given the weak readings on the nation’s manufacturing and construction activity, two key drivers of economic growth.
 
A strong dollar, weak energy prices, low global commodities prices and slowdown in overseas economies further added to the woes. Overall, the aerospace sector’s earnings are expected to decline 10.9% in the fourth quarter, as against the 2.4% earnings growth notched up in the third. Revenues too are expected to decline 2.8% overall (4.1% growth in Q3) while margins are expected at -0.63% (-0.13% in Q3).
  
Geo-Political Uncertainties: a Defense Tailwind
 
Despite a multitude of challenges, the long-term outlook for the defense industry has held up pretty well. The terror spawned by the Islamic State of Iraq and Syria (ISIS) sparked renewed anger around the world. The increased threat of global terrorism means more spending on defense and intelligence services. This has drawn market watchers to closely track defense stocks and the sector overall.
 
We have already seen how defense players performed well in the preceding quarter despite the familiar challenges of weak global economic growth, strong dollar and falling energy prices. Top defense contractors put up healthy performances on the back of mounting geopolitical risk and strong commercial sales.

Moreover, near the end of 2015, President Barack Obama signed a $1.1 trillion budget that included extra funding and tax breaks for fiscal 2016. The new budget deal will avert unseemly situations like a government shutdown and the need to fall back on stop-gap spending measures through fiscal 2016. The budget increases defense spending, a logical step in light of increasing unrest in the Middle East and other regions.
 
In spite of economic woes, the case for investing in defense stocks looks good. So, it is a profitable strategy to zero in on a handful of defense names that are poised to beat earnings estimates this quarter. An earnings beat would also pave the way for stock price appreciation.
 
How to Pick?

Picking the right stock for your portfolio could appear to be a daunting task given the wide range of companies in the aerospace and defense space. One way to confine the list of choices during this earnings season is by looking at stocks that have a solid Zacks Rank accompanied by a favorable Earnings ESP. The combination of a favorable Zacks Rank – Zacks Rank #1 (Strong Buy), #2 (Buy) or #3 (Hold) – and a positive Earnings ESP is usually an indication of an earnings beat.

Earnings ESP is our proprietary methodology for determining which stocks have the best chance to pull a surprise in their next earnings announcement. It shows the percentage difference between the Most Accurate estimate and the Zacks Consensus Estimate.

Our research shows that for stocks with this combination, the chance of a positive earnings surprise is as high as 70%.

For investors seeking to apply this strategy to their portfolio, we have highlighted five defense stocks that may stand out this season. 
 
Textron Inc. (TXT - Analyst Report)
 
Textron’s geographically diverse network of aircraft, defense & intelligence, industrial and finance businesses negates any specific business risk. The company is known globally for its most recognizable and valuable brand names, such as, Bell Helicopter, Cessna Aircraft Company, Jacobsen, Kautex, E-Z-GO and Greenlee. Its systematic inorganic growth strategy along with its focus on strengthening international presence will improve the growth trajectory.
 
The company has a long-term earnings growth expectation of 11.45% and a forward P/E of 13.1. It has a decent earnings beat history. Textron has reported better-than-expected results in three out of the last four quarters with an average positive surprise of 1.83%.
 
Textron has a Zacks Rank #2 (Buy) along with an earnings ESP +7.32%. The company is expected to report fourth-quarter 2015 results on Jan 27 before the opening bell.
 
Spirit AeroSystems Holdings, Inc. (SPR - Snapshot Report)
 
Based in Wichita, KS, Spirit AeroSystems is a manufacturer and supplier of large aircraft structures. Commercial aircraft manufacturer Boeing Co. (BA) has to depend on Spirit AeroSystems for bare fuselages of its popular 737 and 787 airplanes. 737 is currently the best-selling single-aisle airplane with demand increasing each passing day. Moreover, Boeing’s decision to ramp up the 737 Next Generation production rate in response to strong market demand will prove beneficial for Spirit AeroSystems.
 
And it’s not just Boeing that contributes to Spirit AeroSystems’ business. There are other commercial and aerospace programs of which the company is a part. Spirit AeroSystems’ involvement in the A350 XWB Program could further strengthen its top line. Encouraging performance in the first nine months of 2015 has encouraged the company to raise its 2015 earnings guidance.
 
The company has a long-term earnings growth expectation of 10.07% and a discounted forward P/E of 10.78. The company reported positive earnings surprises in three out of the last four quarters with an average beat of 7.19%.

For the upcoming release, Spirit AeroSystems has an earnings ESP of +1.03% and a Zacks Rank #1 (Strong Buy). The company is expected to report fourth quarter results on Feb 2.
 
Orbital ATK Inc. (OA - Analyst Report)
 
Dulles, VA-based Orbital ATK is a premier aerospace and defense company. It presently has operations in the U.S. and overseas. Orbital ATK designs, manufactures and delivers launch vehicles and associated propulsion systems, satellites and related components and services, and composite aerospace structures. It also supplies ammunitions and related accessories to the U.S. government agencies.
 
Orbital ATK delivered an average positive earnings surprise of nearly 14.66% over the trailing four quarters. The company’s consistent expansion in the Middle East and association with the U.S. government and international defense establishments as well as the NASA position it favorably. In the Sep-Oct 2015 period, the company’s share price had jumped approximately 25%.
 
Orbital ATK has a Zacks Rank #3 (Hold) along with an earnings ESP +2.80%. The company is expected to report fourth-quarter 2015 results on Jan 27.

General Dynamics Corp. (GD - Analyst Report)

General Dynamics’ revenues are derived from a broad portfolio of products and services that help to keep the overall growth momentum steady. General Dynamics − the maker of Gulfstream jets, tanks as well as war ships − is one of the only two contractors in the world equipped to build nuclear-powered submarines.

For the upcoming release, General Dynamics has an earnings ESP of +2.99% and a Zacks Rank #3. The company is set to report fourth-quarter results on Jan 27 before the opening bell. The company has a long-term earnings growth expectation of 8.34% and a forward P/E of 13.51.
 
Northrop Grumman Corp. (NOC - Analyst Report)

With rising security threats, the defense industry’s increasing emphasis on high-tech intelligence equipment can be well traced to Northrop Grumman’s timely focus on intelligence, surveillance and reconnaissance (“ISR”) systems, advanced electronics and software development technologies. It is the proud owner of the popular Global Hawk, an unmanned system with the ability to transform itself into an operational weapons system. Northrop also boasts products like the E-2D Advanced Hawkeye, which provides 360-degree surveillance at all times.

This $33.84-billion market-cap, defense Zacks Ranked #3 company posted an average earnings surprise of 3.64% in the trailing four quarters. The company has a long-term earnings growth expectation of 7.49%.
 
The company has a P/E (F1) of 17.76 along with an earnings ESP of +2.58%. The company is expected to report fourth-quarter 2015 results before the opening bell on Jan 28.
 
Bottom Line
 
Although a stronger dollar and budget austerity played spoilsport in the fourth quarter, we believe these five stocks are good picks for this earnings season considering their cost-cutting measures, stock buybacks and earnings gains from overseas businesses. The fiscal 2016 defense budget is also a major harbinger of hope.