Most investors have heard the argument for defense stocks on countless occasions. The basic pitch goes something like this: if there's one consumer that never stops spending, even in the weakest economies, it's Uncle Sam. And defense remains a key destination for much government spending; therefore, companies that sell defense products and services to the government are sure-fire winners.

There is truth to this argument. But, as the trite old saying goes, "there's no such thing as a free lunch." This is particularly true on Wall Street. Although the U.S. government may never stop spending, that doesn't mean large defense stocks are a risk-free road to riches.

Government contracts can and do get cancelled and delayed. And when that happens, firms with exposure or reliance on those programs can get hit. For example, in the early 1990s, the A-12 Avenger II Stealth aircraft was a major new aircraft project for the U.S. Navy. Dick Cheney, then the Secretary of Defense, decided to cancel the Navy's orders for the $165 million planes in 1991. The developers of the plane, including McDonnell Douglas, got hit on the news.

And while overall government spending tends to rise steadily over time, spending on certain defense initiatives doesn't always increase. For example, spending on some weapons and missile systems was cut in the 1990s after the end of the Cold War. Overall defense spending fell from $370 billion in 1989 to under $260 billion in 1998, before rebounding sharply over the past decade. That contributed to some severe sell-offs in stocks like Raytheon (NYSE: RTN), a major manufacturer of missile systems.

Security over Defense
But despite these periodic hiccups, the basic argument for investing in stocks levered to continued government spending holds water. And there are areas of the Federal budget less exposed to budget cuts than high-profile, expensive weapons systems.

Since the devastating terrorist attacks of September 11, 2001, spending on national security and safety has ballooned. The list of projects includes upgrades to security systems at airports, more advanced scanning equipment for vehicles crossing U.S. borders, and even sophisticated equipment for identifying and recognizing facial features of known terrorist suspects in crowds. Security spending has also involved buying equipment for so-called first responders -- firefighters, police officers and emergency medical personnel.

Much of this security spending is no longer part of the budget for the Department of Defense (DOD), but is instead budgeted for the Department of Homeland Security (DHS), a relatively new department created after September 11th.

Large-scale defense programs can become political footballs at times; politicians highlight expensive weapons systems spending as a sign of government waste. For example, the U.S. missile defense shield has come under fire recently due to cost overruns and strong resistance by the Russian government. Such high profile and expensive projects are subject to cancellation or delay.

But it's politically tough to oppose spending on a new X-ray system or high-tech equipment designed to keep Americans safer. Seven years after the 9/11 attacks, terrorism remains a major fear among most Americans, and recent attacks in major foreign cities, including London, have re-awakened those concerns. As a result, spending on safety and security should continue to rise in the coming years.

Moreover, U.S. defense spending is likely to top $460 billion in 2008, roughly 16% of the more than $2.7 trillion U.S. federal budget. Meanwhile, funding for the DHS will reach just under $70 billion by 2009. While DHS spending is growing quickly, it remains far lower than the overall defense budget. This should make DHS spending less of a target during the next round of government budget cuts.

New Defense
But it remains a big mistake to ignore the pure-play defense contractors entirely. Even when overall defense spending falls or growth in the DOD budget moderates, certain niche markets should continue to grow.

Every four years, the government publishes the Quadrennial Defense Review, offering a basic plan as to the focus of future spending. In the most recent review, released in 2006, the DOD indicated that the focus of future defense spending will be on high-tech systems designed to help fight unconventional wars rather than large-scale conventional weapons systems.

For example, the review proposed a +15% increase in the size of U.S. Special Forces. To help support these enlarged forces, the Review included plans for more spending on advanced secure communication systems that can allow communications with soldiers imbedded deep in hostile territory.

In addition, the DOD has reaffirmed its support for the so-called Future Combat Systems (FCS), a modernization program for the U.S. military. A cornerstone of this plan is unmanned surveillance vehicles. For example, the DOD cancelled plans for a new helicopter dubbed "the Comanche" and re-allocated those monies to developing new unmanned aerial vehicles capable of tracking the movements of enemy forces or insurgents remotely. The military also has plans for unmanned ground and sea vehicles.

Thus, even if some high-profile conventional weapons projects are cut, the DOD's modernization drive is likely to see continued funding. With the cancellation of the Comanche helicopter, the military has already shown its willingness to cut spending on conventional weapons to help pay for spending on high-tech defense and surveillance equipment.

With this in mind, in a recent issue of Market Advisor, editor Paul Tracy scoured the security and defense industries in search of companies that are likely to benefit from continued government spending in these areas. In the process, Paul found two companies producing highly specialized and advanced security and defense technology. As a result, these two firms are set to earn windfall profits from future government contracts, resulting in expected annual earning growth of at least +20% for the next five years.

To learn more about Market Advisor, including how to access the names of these two firms ready to earn millions from Uncle Sam, please visit this link.