BAML: 2016 could be a great year for defense stocks, especially if a Republican wins

Last week, Raytheon - the maker of the Tomahawk and Patriot missile systems - reported strong revenue and earnings growth, and the stock rallied.

According to Bank of America Merrill Lynch analysts, this isn't the end of the good news for Raytheon, or for the rest of the defense industry. In fact, this kind of good news comes around only every four years.

In a note outlining its optimism on Raytheon, BAML brought up research it conducted a few months ago finding that defense stocks beat the market during presidential elections.

"Defense outperformed the S&P 500 in seven of the last nine presidential-election years since 1980," the note said, "with an average return of 17.2% versus 4.3% for the S&P 500."

The reason is the nature of how the companies make money. "Defense firms rely so heavily on contracts and funding from the federal government, so their earnings and performance are more closely tied to political changes rather than market forces," the note said.

During the most recent presidential-election year, 2012, the stocks of the defense companies tracked by BAML - Raytheon, L-3 Communications, Northrop Grumman, Lockheed Martin, Huntington Ingalls, and General Dynamics - grew an average 19.1%, compared with 13.4% for the S&P 500.

In some presidential years the difference can be massive. In 2000, defense stocks beat the S&P by 44.7%, and in four presidential years tracked by BAML - 1980, 1992, 2000, and 2008 - the difference was at least 10%.

Additionally, even midterm years are good for defense companies. "Defense outperformed the S&P 500 in 12 of the last 18 election years since 1980, with an average return of 12.6% versus 5.6% for the S&P 500," BAML said.

The note also projected that these companies should have a vested interest in the outcome.

Based on BAML's evaluation of congressional role calls and other data, a victory by a Republican nominee will have much bigger benefits for defense investments and in turn their earnings. "Our analysis shows that the best-case scenario for defense in FY19 is a Republican president with a FY16-FY19 [compound annual growth rate] of 8.4%," the note said in respect to the growth in federal defense investments.

If a Democrat wins the White House, BAML expects a growth rate of only 2.8% per year.

According to the International Institute for Strategic Studies, the US spent $581 billion on defense last year, which accounted for 36% of all defense spending in the world. The budget, however, has been declining since 2011, when the US spent $695 billion, according to the BAML research.

The report did warn, however, that in the year after elections defense stocks fell back to earth. "Defense underperformed the S&P 500 in nine of the last 17 post-election years since 1980, with an average return of 12.6% versus 14.7% for the S&P 500," BAML said. That included five of the nine post-presidential-election years.

If history is any guide, it's a good time for investors to jump into defense stocks before the presidential race, and their prices, really takes off.