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Investors Should Give This Misunderstood Sector a Shot

Investors Should Give This Misunderstood Sector a Shot
(Getty/Dennis Flaherty)

By    |   Thursday, 06 April 2017 04:19 PM

Markets are generally right most of the time. No, I can’t get more specific than that. After all, they do get it wrong, particularly with individual stocks and sectors. That makes it critical for investors to pick through their opportunities wisely.

Sometimes, there’s a huge difference between what a company’s worth and where it’s trading. Where that occurs, you’ll often find fear. It could be fear of a specific event related to that company, like a pending drug approval. It could be a fear about the broader economy, in which case you tend to find more values across the board.

In any event, most of the time, there are a few fear-based opportunities. But right now, there’s a small sector where fear is waning—but it’s still on the decline. It’s a misunderstood sector, but one that still looks incredibly profitable going forward.

I’m talking about the firearms sector. The short history is simple. During his presidency, Barack Obama made the case for gun control at every opportunity. Every unfortunate event that played into that narrative was hyped up as an opportunity to pass restrictive legislation. Obama also had no reservations about bypassing the legislative process and appointing judges to Federal courts with a restrictive view on gun ownership. It stood in direct contradiction to the Heller decision that the Supreme Court decided back in 2006 that protected an individual right to keep and bear arms.

While Obama’s hyped-up talk didn’t amount to much at the moment, it spooked anyone interested in firearms into buying now, before a potential ban later. Obama became the firearm industry’s best salesman. Hillary Clinton upped the ante during her presidential run as well, moving further left than socialist Bernie Sanders on the issue.

The firearms companies were in a bind. Sales were booming, but they could have been cut off at any moment. Mr. Market generally liked the uptrend of higher sales, but there was a cap on how high the market was willing to pay for companies that might face legislative or judicial destruction within just a few years. This kept a lid on prices for the firearms companies.

The election of pro-gun Donald Trump changed the narrative. At least, it should. This week’s confirmation hearings for Neil Gorsuch, who supports the Heller decision, should also bolster the case that individual firearm ownership is still here to stay.

But since the election, firearms companies have sold off 20-30 percent. Why? For starters, sales have started to slide accordingly as well. On the surface, that makes sense. But the market wasn’t overpricing shares when sales were surging. There wasn’t a corresponding rally to explain the current correction.

So what’s going on? An odd sort of fear. We’re seeing investors pull money out of a sector that was just going through an existential crisis and came through just fine. That’s usually good news. But that sector will likely have smaller sales going forward.

So what? Knowing that an industry is safe from a political axe is exactly the kind of thing I want to hear as an investor. People should be buying firearms to enjoy them for sport, shooting practice, hunting or self-defense. They shouldn’t be buying out of fear; that’s a terrible reason to buy but one that governments create from time to time. The existential crisis, which created the big value in the first place, is off the table. But there’s still lingering fear, and we can use that to our advantage.

There’s a light at the end of the tunnel. FBI background check numbers came back higher for March 2017 versus February. The slide in sales may have already halted. Whether it goes higher from here or not, however, the firearms stocks are still bargains worth buying at today’s prices.

The industry is dominated by two publicly-traded names. The first, American Outdoor Brands Corporation (AOBC), recently just changed its name from a more recognizable brand: Smith & Wesson. The name change reflects the current weakness in firearms sales, and better reflects the company’s other holdings in knives and other outdoor gear.

Shares have shed a third of their value from their peak in the past year, despite handily beating earnings estimates in all four quarters of the prior year. They also trade at 8 times earnings, less than a third the price of the average S&P 500 stock. Profit margins remain solid, and the company continues to buy back shares. With only $1 in net debt for every $10 in equity, they’re underleveraged and can handily thrive even if firearms sales continue to decline.

The other publicly-traded name in the industry is Sturm, Ruger & Co. (RGR). The firearms manufacturer sounds a lot like AOBC. It’s cheap, investors don’t like it and it’s been sliding for months. But shares look attractive on a current and forward basis. So even if earnings slide, that should already be well priced into shares. Sturm, Ruger has a bit more leverage than AOBC, so it might be a wilder ride.

Even better, the company pays a dividend to reward shareholders instead of buying back shares. But there’s a catch with that dividend: it’s tied to earnings. Anyone holding the stock while sales were booming got bigger dividends then they’ll likely get in the future Income-oriented investors who like steady quarterly dividends should definitely look elsewhere than this name.

Yes, slowing sales will mean slowing earnings for the firearms companies, and that could continue to spook investors. But there’s clearly a lot more going on here than meets the broad narrative.

The biggest problem facing the firearms industry was extinction. That’s huge! It meant any dollar invested had a chance of being completely lost. That fear is off the table. With that fear now gone, yes, gun sales are down sizably. That’s a different type of fear, but it’s a manageable one. I expect we’ll see sales stabilize at a lower level in the next few months. The gun ranges are still packed, and buying cheap ammo can still be problematic. While gun sales might be down, people are still enjoying their guns, which means sales aren’t going to magically disappear entirely.

That still makes the firearms companies one of the best sectors to invest in right now. It’s been unloved for two entirely different reasons right now. The fears will subside.

Andrew Packer is a Senior Financial Editor with Newsmax Media. He currently writes the Insider Hotline investment advisory, serves as investment director for the Financial Braintrust, and writes the monthly newsletter Crisis Point Investor.

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Firearms is one of the best sectors to invest in right now. It’s been unloved for two entirely different reasons right now. The fears will subside.
investors, sector, shot, guns, firearms
Thursday, 06 April 2017 04:19 PM
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