Published April, 2003

Defending Your Portfolio

Given the current dynamics in the global geopolitical environment, much attention has been placed recently on national defense and homeland security. Indeed, Value Line analyst Morton Siegel explains that spending for defense is clearly on the upswing. He points out that this increase in spending is not an entirely domestic phenomenon, and that it is occurring in other countries as well, particularly with our NATO allies.

Many technology companies stand to benefit handsomely from the increase in government spending on defense and security. But governments are not the only entities concerned about security. Many companies are beefing up their computer-network security to thwart any potential attack of cyber-terrorism.

Wendell Laidley, co-manager of RS Information Age Fund, says that security stocks performed well as 2002 drew to a close and 2003 began, and he adds that this sector stands to benefit handsomely from the increased government spending on homeland security. He and several other mutual fund managers recently shed light on some of the defense- and security-related technology names they hold.

Laidley recently cited two significant new investments in the area of security: Internet Security Systems (ISSX) and Websense (WBSN). Internet Security Systems provides intrusion-detection technology. Its security solutions include software products, managed security services, and consulting and training services. Websense, by comparison, is a leading provider of content filtering, or employee Internet management (EIM), software. Its products enable businesses to monitor, manage, and report how their employees use the Internet.

Value Line analyst Randy Shrikishun recently discussed Websense, explaining that the company is well positioned for growth. He says that it remains the leader in EIM software, an enviable position that has helped the company expand at approximately 19% annually. A subscription to the company's services is prepaid and can be purchased for a one- to three-year period. Repeat customers, in the form of renewal rates, are holding at 75%, though he looks for this to climb as the company rolls out new product upgrades.

Shrikishun anticipates that the company's revenues will grow by 45% this year, thanks, in part, to increased government spending. And, management is ramping up research and development (R&D) spending, which Shrikishun believes will result in superior product enhancements and help the company maintain its dominant position within the market.

Avoidance and Immersion

Co-manager Marc Klee, of John Hancock Technology Fund, explains that he has largely avoided pure defense-technology stocks because he views them as too richly valued. Instead of a direct defense play, he has exposure to technology names that serve a broader market that includes defense. He points to Aeroflex Incorporated (ARXX), which has contributed nicely to the fund's upside performance of late. The manager notes that Aeroflex's products, which include microelectronic and testing solutions, are used by many industries, including defense.

Although few tech names are regarded as pure defense plays, there are some that focus on security. One such company is Symantec Corp. (SYMC), a stock that recently found its way into Franklin DynaTech Fund, which is co-managed by Rupert Johnson and Robert Dean. Dean says Symantec, which specializes in application-system software products, is developing attractive new offerings, and that it looks well positioned for long-term growth.

Value Line analyst Charles Clark agrees. He says that the company has been benefiting from strength in its consumer-products group, as new releases of Norton AntiVirus and Internet Security have been well received in the market. He adds that the Enterprise Security segment has also grown nicely, thanks, in part, to recent acquisitions.

Clark points out that many companies are increasingly incorporating the Internet into their operations. Thus, network security and intrusion-detection systems are also increasing in importance. And, Symantec's market presence positions it to capitalize handsomely on these dynamics.

William Keithler notes that Symantec was a top performer in INVESCO Technology Fund during the trailing six-month period ended February. He explains that the market serving the government, particularly homeland security, will likely be favorable this year. Keithler adds that defense and homeland security, as well as simply improving the information-technology (IT) infrastructure of the entire government, is a major initiative that will benefit many companies. He points out that firms such as Oracle (ORCL) and Cisco Systems (CSCO) are poised to benefit from the increase in government spending, but he cautions that it will still be just a small slice of their overall revenue pie.

Keithler mentions NetScreen Technologies (NSCN) and Network Associates (NET) as two companies that are also consumer driven, but should benefit nicely from an increase in spending on security. NetScreen Technologies develops integrated network security solutions, including virtual private networking (VPN), and firewall and intrusion detection and prevention. Network Associates, meanwhile, is a leading supplier of virus protection, network management and security, and encryption software.

Value Line analyst Warren Thorpe looks for Network Associates to grow nicely this year, as a result of strong demand for consumer and home-office desktop-computer-security software. Further, the company recently entered deals with key PC makers Dell Computer Corp. (DELL), Sony Corp. (SNE), and Apple Computer, Inc. (AAPL) , whereby Network Associates will distribute its anti-virus software on their machines. Further, the company entered into an agreement with AOL Time Warner (AOL) to provide online virus protection to its members. The deal with AOL opens up a market of about 2.3 million subscribers.

Thorpe anticipates that the increasing interest in corporate network security and management will continue to climb, bolstering the company's products along this line. In particular, he believes that sales to the government will rise significantly this year, especially given the higher security-risk environment.

Further, Thorpe looks for continued headway in sales-and marketing-expense reductions, which should widen margins. In all, he is optimistic on the company's long-term growth prospects.

Although some mutual fund managers have been reluctant to go for a straight defense play, others have not shared such trepidation. For instance, Keithler notes that INVESCO Technology Fund holds Lockheed Martin (LMT), which is a pure defense play. Management-team members Mayo Smith and Ivan Arteaga state that Gabelli Growth Fund also has a slight position in the aerospace giant.

Lockheed provides a broad range of products and services, including space and missile systems, aeronautics, electronics, and information systems. Morton Siegel, the Value Line analyst, points out that Lockheed's earnings surged in 2002, partly as a result of strong earnings from continuing operations. He notes that the company has reduced its debt burden, and with it, interest expense. And, he believes that the company will sell about 200 to 300 F/A-22 aircraft to the U.S. Air Force, helping it to fully cover all of America's fighter-aircraft needs.