Why you should hold guns

The US gun industry is worth $2bn a year which undoubtedly represents a potential investment opportunity - if you're comfortable investing in the sector. Eoin Gleeson picks a stock with a strong position in the firearms sector.

One of the most bizarre responses to the massacre on the Virginia Tech campus two months ago came from local gun-shop owner John Markell. Asked if this kind of tragedy warranted tighter gun control in the US, he replied that the problem was that there weren't enough guns. If the other students had been allowed to carry firearms, he reasoned, it wouldn't have become a massacre in the first place. Twisted logic, perhaps, but the notion that "an armed society is a polite society" has helped make the gun trade a $2bn industry in US. Regardless of your take on the morality of the country's gun laws, as long as guns remain what The Economist describes as "part of the national religion", Americans will continue to snap up the three million guns the country produces each year. If that's something you feel comfortable with, then it undoubtedly represents a potential investment opportunity.

The US gun industry is worth $2bn a year, with the $1.1bn hunting rifle and long arms industry roughly twice the size of the retail handgun market. Yet despite the nation's enduring love of weaponry, US gun makers have struggled in recent years. Sales of firearms have slowed over the last decade at America's two major manufacturers, Smith & Wesson and Sturm, Ruger & Co, even though the latest figures available from the US Department of the Treasury show overall gun sales up 2.6% in 2005.

It all comes down to changing technology. Up until the 1980s, the firearm of choice for US police departments, for example, was the Smith & Wesson revolver. The firm was famous for producing big-bored guns with unrivalled stopping power, such as the .44 magnum, popularised by Clint Eastwood in the film Dirty Harry. But the introduction of semi-automatic weapons in the 1980s made these revolvers all but redundant. While Smith & Wesson clung doggedly to its iconic, but less practical brands, US police switched to smaller, lighter guns produced by European firms, such as Italy's Beretta and Austria's Glock. The firm's market share tumbled from 95% to 10%, says BusinessWeek. And because the gun sector tends to grow about 3% annually, success usually means taking sales from another gun maker, says Steven Sears in Barron's.

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But US manufacturers are making a comeback. A focus on producing lightweight weapons specially designed for the police has seen new contracts roll in. So far, 216 police departments have committed to Smith & Wesson's new lightweight plastic pistol, says Ben Steverman in BusinessWeek and with 17,000 police departments across the US, there's great potential here. Private-equity firms are also muscling in on the action, buying privately held gun makers, such as Remington, in an effort to bring about their own turnaround plays. "This underscores the profit potential in modernising troubled gun makers," says Barron's.

The leadership of the US military is pushing for troops to carry domestically made weapons, with plans to shift from 9mm to .45 calibre handguns, a size dominated by US manufacturers. The Defence Department's contract with Beretta expires this year, and Smith & Wesson is well positioned to win the business, worth up to $600m, says Shannon Roxborough on Smallcap Investor. We take a detailed look at the company below.

The best bet in the gun sector

Smith & Wesson's (Nasdaq:SWHC) efforts to reinvent itself as the favoured weapon supplier for the US police and armed forces have been paying off royally. Barely profitable when new chief executive Michael Golden took over two years ago, revenue from pistol sales rose more than 59% last year on the back of sales to military and police agencies, says Rich Duprey on Motley Fool.

The company won its first US defence contract in 15 years in 2005, and a year later was awarded a $20m contract to supply Afghanistan's national army with 9mm handguns. But the biggest boost to its fortunes is likely to come with replacing Beretta as the manufacturer of the US Army's favoured sidearm.

While handguns, for sports and law enforcement, comprised 75% of revenue last year, Smith & Wesson has also been expanding into new markets. The group is increasingly moving towards the manufacture of rifles, ammunition and so-called lifestyle products', mainly used in hunting, says Smallcap Investor, and in January it bought leading rifles manufacturer Thomson/Center Arms for $70m. The shares trade on a 2008 p/e of 19.5, but that looks reasonable when Wall Street analysts reckon earnings will grow by as much as 60% this year.

Eoin came to Money Week in 2006 having graduated with a MLitt in economics from Trinity College, Dublin. He taught economic history for two years at Trinity, while researching a thesis on how herd behaviour destroys financial markets.

Eoin acts as managing editor of MoneyWeek's newsletters.