With a lull in budget growth already expected even before last week's Democratic sweeps, defense stocks would seem like a place you would not want to have money.

In fact, over the last week, that sector has seen some bloodshed -- with the minnows of the group taking it the worst.

Our scan of performance in the aerospace and defense sector over the last week shows that eight of the top 10 losers since the November 7 elections have been small-cap and micro-cap names:

VirTra Systems (OTC: VTSI), a manufacturer of military simulation systems, took the biggest hit, dropping over 23% in the seven-day period. Moller International (OTC: MLERE), down 11%, designs and builds vertical take-off and landing (VTOL) airplanes. These are similar in concept to the Hawker Harrier Jump Jets the British military has used for decades. Down almost 9% was United Industrial Corporation (NYSE: UIC) -- makers of many defense-related products, including systems for drone aircraft.

The major defense companies, like Lockheed Martin (NYSE: LMT) and Northrop Grumman (NYSE: NOC), held up well to the Democratic win. The reason is most likely because the 2007 defense budget will still be the largest portion of the total Federal budget. Another major reason is that no political party would want to be seen denying troops of their necessities while they are on the ground in a combat theater. So until the Democrats engineer a troop withdraw, adequate funding should remain in place.

Not all defense stocks took this shift in power badly, though:

One of the big winners of the week was small-cap Hi-Shear Technology (AMEX: HSR). This is a diversified company that makes many aeronautical components, but one of the more interesting military products it makes is laser ordnance for the U.S. Army. It was up almost 26% on the week. Military aircraft engine-part maker Kreisler Manufacturing (NASDAQ: KRSL) was up over 8%. This micro-cap announced huge sales and profit increases for their September quarter.

So the big question is: Are defense stocks a good play these days or should investors now stay away?

The answer: You need to be selective, as always... Let me show you.

Take HEICO (NYSE: HEI), for example. It's a $1 billion, small-cap aerospace and defense company that provides engine parts and services for commercial aircraft, and an extensive suite of test systems for military applications. And with the specter of a falling defense budget in the near term, the company is actually prospering. On August 30, the company reported 3Q06 results, which included record net sales and record operating income. This was the sixth consecutive quarter in which they did so. And in the last six months, its stock has gone up 25%.

Insiders have been making many purchases recently of HEI shares. Four directors and the chairman of the board made purchases at the end of August -- many of which represented substantial percentage increases to their HEI holdings.

HEICO's debt-to-total capital is a very attractive 12%. However, the company has been making a lot of acquisitions, which has been eating into its ability to produce free cash flow. The market, though, is looking beyond this, and sees the cash-generating ability of this business when it does stop its growth-through-acquisition phase.

Unfortunately for us, HEICO's strong performances over the last several years have attached a premium to its shares -- and the stock is now pretty pricey. This is a stock, though, that I would consider recommending if its price pulls back. Make this "one to watch."

Craig Walters
for The Daily Reckoning

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Midway, however, had a significant number of top titles back then that have ultimately been modernized and transferred to Playstation and Xbox. You might remember Spy Hunter or one of their more contemporary titles like Mortal Kombat. These games have spawned sequels, spinoffs, and some have become franchises that are still alive 25 years later.

If Midway sounds like a dynasty in the electronic entertainment industry, its stock is clearly on the ropes...

Midway Games is a small-cap that's been cut in the last 12 months. It's down 54.7% and now has a market cap of $785 million.

Midway started to fall apart in mid-December 2005. During that month, the company's largest shareholder, Sumner Redstone of Viacom (NYSE: VIA), shifted a substantial amount of his direct holdings in the video game company to off-load personal responsibility of over $400 million in debt to a holding company. While Redstone wasn't really dumping Midway stock on the open market at the time, it did turn a lot of negative attention on the game company. Analysts began to pile on with negative statements about its lofty valuation, Redstone's ownership making it basically an illiquid stock, and the company's inability to post positive earnings.

I'll admit I was very hopeful of finding a compelling investment in Midway at these depressed levels. It's still somewhat of a powerful name in a very big market, and we're entering another cycle where lots of dollars are going to be thrown at new video game consoles from Sony and Nintendo. I at least had to see if Midway was going to be a smart buy for this new cycle...

There have been a lot of opportunities for Midway to capitalize on surges in video game sales, but the company has consistently failed to execute. The first Playstation was launched in 1994 and 1995 in Japan and the U.S., respectively. Playstation 2 was launched globally in 2000, and Playstation 3 will be launched in Japan and in the U.S. in about two weeks. Overlapping these releases were new entrants from Microsoft (NASDAQ: MSFT) in the forms of Xbox and Xbox360, Nintendo's 64, GameCube and the upcoming Wii. A few entrants fell by the wayside -- notably Sega and their Saturn console.

Midway didn't just hitch their wagon to one game company, either. They have produced software for virtually all of the systems, and yet profitability has been elusive.

Midway's been losing money since 2000 up through 2005 -- arguably the greatest "video game bull market" in this industry's short history. A big drop in revenue from 1999 to 2000 occurred when Midway exited the coin-operated arcade business...and they never posted an annual profit since.

The Entertainment Software Association (ESA) reports that consumers spent $7 billion on video and computer games in 2005. That's double what was sold in 1996. If we look at Midway's home video game sales during the period between 1998 and 2005, it's sales dropped 34.7% while the industry's sales as a whole marched forward 45.8%. And for most of those years, this company was losing money.

While one could make the argument that Midway shares are hated assets and there is rarely a better time to buy an asset then when no one else wants it, this is one I would avoid.

In the last 12 months, Midway has taken on more debt than they have in the last 10 years combined, and the company is not cash flow positive on any level. Many of their key franchise software titles are getting very long in the tooth and may not remain marketable for much longer.

Management just reported a loss for 3Q06 that was an improvement over 3Q05. However, they did guide full-year earnings to be a loss of $73 million, which is a greater loss than they had previously told the Street.

Traditionally, the months leading up to a new generation video game console's launch is tough on gamemakers who are still producing titles for the existing platforms -- the ones that no one is going to want in a few months. That's why Midway's management is telling investors that recent losses are associated with their efforts to gear up for a strong 2007.

If I were convinced that Midway is going to make a massive turn to consistent profitability, now would be the precise time to take a position. But I'm not convinced.

Craig Walters
for The Daily Reckoning

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