ABSTRACT: During the period 1970-1989 the profit rates of the top 50 defense contractors substantially exceeded those of comparable nondefense companies. This conclusion holds regardless of whether profits are measured by the firms accounting rate of return on investment or assets or by the stock-market payoff to shareholders in the form of dividends and capital gains. Investing in defense contractors was not significantly riskier than investing in comparable nondefense companies. In the cross section the relation between stock-market returns to investors and the defense-intensiveness of the contractors was a polynomial of second degree.
Do big defense contractors earn greater returns than other companies? The question has long been controversial, and despite numerous studies the issue remains unsettled (Gansler, 1989, pp. 253-254; Rogerson, 1989, pp. 1290-1291). Most of the studies have been made by interested partiesthe armed services or the Department of Defense. Some of the studies fail to meet professional standards; others are patently tendentious. (For devastating criticism of the major study by the Department of Defense, see U.S. General Accounting Office, 1986). But even the studies published in professional journals disagree widely. (See Kaun [1988, pp. 2-7] for a recent survey of the literature.)
The disagreement is hardly surprising, because the various studies are not comparable. They have considered different groups of firms and different time periods, and they have employed different measures of profitability.
There are two basic types of profitability measure: accounting rate of return and stock-market rate of return. Most previous studies have examined some variant of the accounting rate of return. In this case one calculates net income (annual revenues minus annual costs) as a percentage of a book value of capital invested. Return on investment (ROI) and return on assets (ROA), which we shall define below, are the most common measures of this type, although reports of return on equity or some other accounting measure are not uncommon.
Unfortunately, various problems associated with accounting data, such as differences between book values and market values, render accounting measures of profitability highly suspect. In the view of some analysts (Fisher and McGowan, 1983), accounting rates of return are virtually worthless as indexes of economic profitability in any event. Studies comparing returns for the defense business and the commercial business within firms have had to contend with additional intractable accounting problems: attribution of common costs to the different portions of a firms operations, as noted by Willis Greer and Shu Liao (1986, p. 1261), and certain [intrafirm] externalities of defense business, as noted by Douglas Bohi (1973, pp. 722-723).
One study, by George Stigler and Claire Friedland (1971), side-stepped these accounting complications and considered a large group of leading defense contractors over an extended period. Stigler and Friedlands approach was to compute the total market rate of return (MRET) to investors owning stock in the firms (that is, annual dividends paid to shareholders plus stock price appreciation, the sum being divided by the initial value of the stock and the quotient expressed as a percentage). Note that whereas accounting rates of return such as ROI and ROA are measures of the profitability of the firm, MRET is a measure of profitability to the shareholder of the firm. There is no necessary relation between the accounting returns and the market returns in a particular year. Consider, for example, a firm that had an extraordinarily large ROI in 1980. If investors in 1979 had expected that impending profitability, they would have bid up the price of the stock in anticipation, and as a result the MRET of shareholders would have increased for 1979 but not for 1980.
Stigler and Friedland calculated shareholders MRET for a set of top defense contracting companies and compared this return over two periods, 1948-61 and 1958-68, with the comparable return to investors in all companies listed on the New York Stock Exchange. They found that during the first period the defense firms outperformed the market by a large margin, and during the second period the difference was negative or positive depending on whether the investor held the defense firms ranked high in defense contracting as of the beginning of the period or the defense firms ranked high in defense contracting as of the end of the period.
During the past twenty years, controversy over the profitability of defense contractors has continued to flare from time to time, but no one has updated the Stigler-Friedland study for the 1970s and 1980s. To do so is a principal objective of the present paper. For completeness, we also present findings for two accounting measures of firm profitability, ROI and ROA, that are often discussed, notwithstanding their potential flaws, in the literature of business and defense economics. Like Stigler and Friedland, however, we focus our analysis on the stock-market rates of return. We also evaluate whether relatively greater firm dependence on defense was associated with greater stock-market returns to investors and whether the risks borne by defense investors differed from those borne by investors in other companies. Finally, we compute the cumulative market return to investors in leading defense firms over a long period and compare it with the cumulative return to investors in the overall stock market.
COMPANIES ANALYZED AND DATA
For each fiscal year, the Department of Defense publishes a list of the 100 companies receiving the largest dollar volume of prime contract awards. Our procedure for selecting the top defense contractors is to accept the rankings on this list. It should be noted that prime contract awards are not the same as income from defense sales in the same year. Prime contract awards often give rise to sales revenues stretching over a period of years. Also, many prime defense contractors receive defense dollars indirectly by acting as subcontractors, and some defense sales are concealed in a secret black budget. Despite these qualifications, it is not unreasonable to use the published list of prime contractors to identify the firms that tend to do the most business with the Department of Defense. Stigler and Friedland, as well as many other investigators, used this approach. Besides, no alternative ranking exists, as many companies do not ordinarily report their defense and nondefense sales separately.
To gauge the financial performance of the leading defense contractors, we employ data provided to us by Standard & Poors Computstat for the period 1970-1989. We have adjusted the data so that each companys performance is shown on a calendar-year basis even though its fiscal year may be different. The Compustat data have some gaps, usually because firms disappeared in mergers. If gaps exist in the data for a period we are analyzing, we report the arithmetic average performance for the firms that remain in the specified group. Also, our analysis includes only publicly traded U.S. corporations. The few top contractors that are foreign, not publicly traded, or not-for-profit institutions are excluded.
FINDINGS ON FINANCIAL PERFORMACE
To assess the average financial performance of the top defense companies, we present in Table 1 our findings for companies ranked among the top 50 and the top 10 prime contractors. The figures are arithmetic averages of annual values for the periods indicated. Findings for the 1970s, the 1980s, and the two decades combined are given separately. Findings are presented for three different measures of financial performance: return on investment (ROI), return on assets (ROA), and total market return (MRET). Return on investment is defined as net after-tax income as a percentage of the sum of long-term debt, preferred and common stock, and minority interest, all as evaluated by the accountants. Return on assets is defined as net after-tax income as a percentage of total assets, again as evaluated by the accountants. Note that, by accounting conventions, assets are valued at book rather than market values, and any government-owned equipment or buildings used by the firm (not uncommon in the defense industry) are not counted among the firms assets. Total market return is defined as the sum of the years capital gain or loss (December closing price of a companys shares minus the previous years December closing price) and the years dividends per share divided by the previous years December closing price of the shares, the quotient being multiplied by 100 to express a percentage rate of return. MRET is the annual percentage increase of the wealth of a shareholder who holds the stock for the duration of the year. We use the Standard & Poors 500 stocks as our comparative standard, which we call the overall market or simply the market.
Like Stigler and Friedland, we present two sets of findings for each decade. Thus, one can see whether an investor knowing only which companies rank high in defense business at the beginning of the decade would have done better or worse than an investor with the foresight to predict which companies would rank high in defense business at the end of the decade.
In the bottom third of the table we present comparisons for the entire period 1970-1989 between the 1979 top 50 contractors as a whole and the top 50 minus the firms for which prime defense contracts (1981-83 average) equalled less than 5 percent of total sales in 1983. The dates used for this division of the firms reflect the availability of data compiled for these dates by Linda Shaw, Jeffrey Knopf, and Kenneth Bertsch (1985, pp. 198-99), but the partition would surely be similar for other dates near the middle of the period, because the relative dependence of the top contractors on defense business normally changes little from year to year.
For the 1970s, the top defense contractors performed about the same as the market in terms of ROI, somewhat better than the market in terms of ROA, and much better than the market in term of MRET. On the last measure, the poorest performing contractor group in the table had 1.71 times the average annual MRET of the market, and the best performing group had 2.62 times the average annual MRET of the market. The top 10 firms showed mixed results relative to the top 50 on ROI and ROA but performed substantially better in terms of MRET, the difference being about 31-32 percent.
Table 1. Average financial performance of top defense contracting companies, 1970-1989
|Performance Period and
|Performance Measure (% per year)|
|1969: top 50 contractors||7.71||4.99||12.56|
|1969: top 10 contractors||8.27||4.72||16.42|
|1979: top 50 contractors||8.50||5.43||14.55|
|1979: top 10 contractors||7.49||3.97||19.24|
|Standard & Poors 500||8.23||3.93||7.33|
|1979: top 50 contractors||9.19||4.93||17.94|
|1979: top 10 contractors||12.13||5.85||15.97|
|1989: to 50 contractors||10.20||5.45||16.27|
|1989: top 10 contractors||12.88||6.18||16.33|
|Standard & Poors 500||7.68||3.19||17.69|
|1979: top 50 contractors||8.85||5.18||16.24|
|1979: top 50 (D/S > 5%)a||9.51||5.33||16.72|
|1979: top 10 contractors||9.81||4.91||17.60|
|1979: top 10 (D/S > 5%)a||10.14||5.07||17.46|
|Standard & Poors 500||7.96||3.56||12.51|
Source: Computed from basic financial data supplied by Standard & Poors Compustat, Inc.
Note: ROI is the firms average return on investment; ROA is the firms average return on assets; MRET is average stock-market return to stockholders of the firms. For full accounting descriptions of how these rates of return are measured, see text.
a (D/S > 5%) denotes firms for which prime defense contract awards (average for 1981-1983) divided by sales in 1983 exceeds 5%.
For the 1980s, the top defense contractors performed substantially better than the market in terms of ROI and ROA and about equal to the market in terms of MRET. The top 10 firms consistently outperformed the top 50 on ROI and ROA, although the differences were not great, while the two groups differed little in terms of MRET.
As the bottom third of Table 1 shows, for the two decades combined the top defense contractors outperformed the market substantially by all three measures. The 1979 top 50 firms surpassed the Standard & Poors 500 by 11 percent on ROI, 46 percent on ROA, and 30 percent on MRET. For the whole period 1970-1989 the top 10 did slightly better than the top 50 on ROI and MRET and slightly worse on ROA, but in no case was the difference greater than 11 percent. Firms with a relatively high reliance on defense business performed slightly better than the others on five of the six comparisons and slightly worse on the remaining comparison.
Stigler and Friedland reported a significant correlation (r2 = 0.295) between MRET and the ratio of defense to total sales for top contractors in the 1950s, but no such correlation for the 1960s (r2 = 0.00008). Our comparisons from the table for the top 50 contractors show little difference between the relatively high-defense groups average annual MRET (16.72) and the entire groups average annual MRET (16.24) during the period 1970-1989.
As a further and more exacting test of this relation, we regressed the average annual MRET (1970-1989) on the ratio of defense awards (1981-83 average) to total sales (1983) for the cross section of the 1979 top 50 contractors. Gaps in the Compustat data reduce the set of companies in this test to 40. The slope coefficient of the regression is 4.08 with a t statistic of 0.82. Thus the data display a positive relation but one having virtually no statistical significance (r2 = 0.018).
Inspection of the data shows, however, that a single firm Ling-Temco-Vought (LTV) was an extreme outlier from the estimated relation and that the empirical relation was nonlinear. If LTV is deleted from the data set and a second degree polynomial is fitted, the result is
MRET = 13.04 + 34.63 D/S - 40.65 (D/S)2 (11.79) (14.78) R2 = 0.19, S.E.E. = 5.40, N = 39
where D/S denotes the ratio of defense awards to sales, and the standard errors are shown in parentheses. The equation shows that there was a statistically significant nonlinear relation between the top firms relative dependence on defense business and their total market return during the period 1970-1989.
Setting the first derivative of the regression equation equal to zero and solving for D/S, one finds a maximum at 0.426. Only seven firms had values of D/S greater than 0.426, namely, Grumman (0.873), General Dynamics (0.816), Todd Shipyards (0.676), McDonnell Douglas (0.665), Lockheed (0.522), Martin Marietta (0.476), and Sanders Associates (0.471). For the shareholders of these firms, the firms heavy specialization in the defense sector seems to have been too much of a good thing.
FINDINGS ON RELATIVE RISK
The finding that over a period of twenty years investors in the top defense contractors received a far better total market return than investors in the overall market raises the suspicion that the market returns of the defense firms might have been riskier. Stigler and Friedland assessed the riskiness of the defense contractors in their study by correlating the variability of total sales over time and the defense share of sales. Finding coefficients of determination of 0.337 for 1950-1957 and 0.245 for 1958-1963, they concluded tentatively that investment in defense contracting companies was riskier. Stigler and Friedland did not compare the riskiness of the contractors as a group with a set of comparable nondefense firms.
To access the relative riskiness of investment in the defense contractors, we follow the now-standard approach of computing the beta coefficients of the Capital Asset Pricing Model. In this model, ß, which is a measure of systematic risk (i.e., risk that cannot be diminished by diversification), is defined as the slope coefficient in a time-series regression of a firms rate of return on the market rate of return. If a firms returns are more (less) variable than market returns, ß is greater (less) than one.
We have computed the betas of MRET for the period 1970-1989. For the 1979 top 50 contractors, beta is 1.25; for the 1979 top 50 with relatively high dependence on defense business it is 1.27; for the 1979 top 10 contractors, it is 1.22. Although the betas all exceed unity, which may have some importance on the eyes of investors, none differs significantly from unity (the market beta, by definition) at any conventional test level: no estimate of beta differs from unity by more than 1.314 times the standard error of estimate. Hence, we conclude that investors in the group of defense contractors analyzed here were not subject to significantly greater risk than investors in the overall market. No risk adjustment is necessary or justifiable in making the comparisons of MRET we have made above.
DIFFERENCES IN CUMULATIVE RETURNS
For total market return the difference between defense investments and the overall market after 1970 arose entirely from the difference during the 1970s; there was virtually no difference during the 1980s alone. From 1970 to 1989, however, an investor who maintained a portfolio of the 1979 top 50 defense firms would have increased the value of his holdings by a multiple of 14.78, versus a market multiple of 8.19 for the Standard & Poors 500. By holding only the 1979 top 50 firms with a relatively high dependence on defense business, the investor would have done even better (16.18), and by holding only the 1979 top 10 contractors with a relatively high dependence on defense business better still (19.22). (Performance of the 1989 top firms over the same long period, not reported here, was virtually identical; that of the 1969 top firms was somewhat poorer but still much better than the overall market.)
By linking the two periods studied by Stigler and Friedland, one can determine the cumulative market return to stockholders of the top defense companies over the period 1948-1969. (We extended Stigler and Friedlands results one year beyond the terminal year of their study, 1968.) We linked the cumulative MRET for their 1950-1957 top 54 defense contractors over the period 1961-69 (1.981-fold). For the whole period 1948-1969 the cumulative MRET equals 24.9 times the original investment for the defense investors, as against 16.1 times the original investment for investors in the overall market as proxied (following Stigler and Friedland) by the New York Stock Exchange.
Linking the cumulative returns for Stigler and Friedlands top contractors during the period 1948-1969 with the cumulative returns we have computed for the period 1970-1989, one arrives at an overall cumulative multiple of defense MRET for the period 1948-1989 of about 331, as against a cumulative multiple for the overall market, which we proxy by linking the S&P 500, of about 137. Thus, an investor who stubbornly insisted on holding a portfolio of top defense firms over this period of more than four decades would have had at the end a sum about 2.4 times larger than that of an investor of an equal initial amount who held a diversified market portfolio.
For the period 1970-1989 as a whole, by every measure, the top defense firms outperformed the market by a huge margin. On the average the difference ranged from 11 to 27 percent for ROI, from 38 to 50 percent for ROA, and from 30 to 41 percent for MRET, depending on the specific contractor group considered. Given the potential frailties of the accounting rates of return, we have elected not to inquire deeply into the reasons for their apparent excessiveness, although the defense firms subsidized use of government-owned capital is an obvious possible explanation, especially for the defense firms extraordinarily high ROA (Gansler, 1980, pp. 88-89; Weida and Gertcher, 1987, pp. 140-142). The elevated MRET of defense investors, however, cannot be denied and cries out for an explanation.
The claim that investment in defense companies was riskier than investment in the overall market is not compelling. For the 1950s and 1960s Stigler and Friedland found only weak evidence of risk differences among the defense contractors themselves and presented no evidence that an investor in the defense contractors as a group bore greater risk than an investor in the overall market. We found that the systematic risk, as measured by ß, borne by an investor in the top contractors as a group did not differ significantly from the risk borne by an investor in the overall market during the 1970s and 1980s.
These findings establish that the financial performance of the leading defense contracting companies was, on the average, much better than that of comparable large corporations during the period 1948-1989. The findings do not justify a normative conclusion that the profits of defense contractors were too high, particularly in the case of the accounting rates of return (Fisher and McGowan, 1983). By themselves, the findings tell us nothing about why the difference existed, and our efforts (not reported here) to explain the time-series variation of differential MRET during the period 1970-1989 have met with limited success. The huge discrepancy in total market return does establish, however, that defense investors over the long term were receiving rates of return far greater than those of investors in comparably risky nondefense companies. Either (a) the Capital Asset Pricing Model does not capture some relevant risk perceived by investors in defense firms or (b) investors persistently guessed wrong, leaving defense stocks undervalued over very long periods.
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We thank George Stigler and Claire Friedland for sharing their data with us, Jerry Viscione, participants in a Seattle University seminar, and the referees for comments on a previous draft.