Is the Government Contract World About to Melt Down?
“I suppose the stock market is like this: Here I have a dish of ice cream that costs me ten cents. Robert, the waiter, comes in and says the ice cream is all gone and no more is to be had tonight.
My ice cream suddenly seems more valuable to you and you offer me, say, twelve cents for it. Then Bill, who had intended to order ice cream makes you an offer of thirteen cents. You, being Scotch, can’t resist taking a profit. Bill brags so much about the ice cream that I decide I was foolish to let it go in the first place and buy it back for fourteen cents.
About that time I discover, to my dismay, that the ice cream has melted.”
--Fred C. Kelly, Why You Win or Lose
Abrahams Wolf-Rodda, LLC is a government contracts law firm with a primarily government contractor clientele. Of course, it is important to keep tabs on how your clients are doing. Know your customer.… And year end is a good time to look back and assess where we are and where we are heading.
I wrote a blog at the beginning of 2021 partially about a new Exchange Traded Fund (“ETF”) called the EMLES FEDERAL CONTRACTORS ETF which trades under the symbol FEDX. See https://www.awrcounsel.com/blog/2021/2/17/t-is-good-to-be-king-riding-out-bad-times-in-the-government-contracts-profession?rq=investment. The ETF was created back in October 2020 to track the performance of 22 or so major government contractors, with the 2022 current top three holdings of Northrop Grumman, Lockheed Martin and General Dynamics. As I noted in that earlier blog, I had purchased one share of the ETF so I could monitor the investment performance of the government contracting community. I consider the ETF to be a proxy for the Government contracting world. So, how about an update now on where government contracting stands as an investment meme?
First, let’s go to the numbers. The FEDX Fund itself has had a subpar performance. Spoiler alert — myone share investment is down 5.42% since its purchase. Since its Oct. 14, 2020, fund inception, it is up 9.66% based on market price. That lags its 11.84% preferred comparison index return. See https://emles.com/etf/emles-federal-contractors/. It also significantly trails the return of the S&P 500, albeit that is no surprise since the top 5 technology stocks accounted for more than half the return of that index. No one buys into a government contractor fund expecting the same volatility as the technology funds. It is considered a low risk, lower return investment. Presumably, it will offer you some downside protection when the tides go out.
OK, so you expect boring middle of the road returns in government contracting and you got what you expect. But what about a prediction for 2022? What is coming down the road? I am not giving investment advice. Consult your own oracle for that. But I will observe that government contractors tend to have a “book” of existing multi-year contracts. Those contracts either have escalations built-in, or are cost reimbursement, or get only portions of their costs escalated for nonexempt service labor every option year. But most of the work is done by fixed priced contracts, and, in the service world, those contracts tend to last up to five years (a base year and up to four option years). That means that the contract prices tend to be largely fixed for the five year period and are only escalated in accordance with the bid pricing the contractor submitted and the terms of the contract.
But what does this portend? I don’t think I am ready to accumulate more shares of FEDX ETF beyond the token one share that I hold. In my simple-minded view, many government contractors are locked into fixed price contracts for up to the next five or so years. Those contracts were largely bid on in a low inflation world, with modest annual price escalations built-in, often three per cent or less. If you escalated more, then you ended up high-priced and thus didn’t get the contract award. But now it is quickly becoming apparent we live in a new paradigm of higher inflation. Indeed, inflation is everywhere at the moment. Thus, those fixed price contractors are destined for a run out of their book of business, with the prospect of either reduced profits or even losses, as inflation takes off, costs to perform escalate, but their contract revenue remains fixed. That portends less government contracting community profits going forward. And less profits and higher inflation mean more risks, and lower government contractor stock prices.
Accordingly, in today’s priced for perfection stock market world, in my view, government contractors are about to be set up for a cycle of market underperformance. Yes, government contractors are considered attractive and stable businesses when the world is most risky. But, if the risk is inflation, government contractors lack pricing leverage and power, due to long term contracts. They are thus likely heading towards a fall. If you were thinking about quitting your day job, and living off your government contractor company stock options, now might be a good time to have a plan B if those options decline in value.