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Tickers in this Article: SWHC, RGR
Apocalyptic fears have gripped the minds of Americans over the past few years, and Hollywood has capitalized on them with movies, television series and reality shows. While a zombie virus may be far-fetched, fears of inflation and market volatility are better grounded in reality.

Out of Alabama comes a story that underlines what becomes important if inflation really does get out of control. A would-be car buyer whose credit was less than exemplary made an unconventional down payment -- a shotgun.

While this is certainly more of a lesson in subprime lending standards going beyond real estate, there is a small sliver of knowledge to take away here. In a highly inflationary environment, gold becomes less important than "real" hard assets -- practical items like food, water, shelter and, of course, weapons.

Before the survivalists start sending this article to everyone they know, let's step back and take a look at the gun-making industry from a pragmatic point of view. We know that fear creates opportunities for profit, and this is reflected in the number of gun sales amid the Obama administration's position on gun control.

Shares of gun makers have soared this year: Smith & Wesson (Nasdaq: SWHC) is up 34%, and Sturm, Ruger & Co. (NYSE: RGR) is up 63%. Even after Congress rejected new restrictions on gun ownership, these companies have continued to post record gains.

Smith & Wesson has been reporting impressive numbers and yet remains undervalued by Wall Street. It has a price-to-earnings growth (PEG) ratio of just 0.3, and in its most recent quarter, earnings rose 42% from the same period last year. Margins have been climbing as well, to 42% from last year's 37%. Management is optimistic and has raised its expectations for next year, to $615 million in revenue and earnings per share (EPS) in the range of $1.30 to $1.35. The company also expects annual growth of more than 30% over the next five years.

Smith & Wesson's price-to-earnings (P/E) ratio of just 8.5 compares favorably with its largest competitor, Sturm Ruger, which trades at 15.3 times earnings. Smith & Wesson looks better from a price-to-sales standpoint as well, at 1.2 versus 2.3 for Sturm Ruger. The fact that Sturm Ruger reported EPS gains of 72% but has a forward P/E of 18 is evidence that the Street views its growth as unsustainable.

Smith & Wesson is also committed to developing better products, as seen in its increase in R&D spending, up to $1.3 million from $1.1 million in the same quarter last year. The focus on superior weapon manufacturing seems to be paying off. Recently, the company signed a five-year contract with the Los Angeles Police Department, which was impressed by the quality of its trademark M&P pistol series.  

Smith & Wesson is growing at more than twice the industry's expected rate of 13%, but considering that it's trading at less than 9 times earnings, SWHC would still look like a buy if it were growing at half its expected rate. SHWC currently does not pay a dividend, but management recently announced a $15 million round of share buybacks.

The average analyst target price for this stock is about $13.50, which gives Smith & Wesson 27% upside from current price levels.



Risks to Consider: The full impact of the government shutdown has yet to be determined and may negatively affect the company in the short term. Gun laws and regulations are always a political issue, and adverse developments could weigh on the stock.

Action to Take --> Smith & Wesson appears undervalued at its current price, and its expected growth rate, share buybacks and R&D spending -- to say nothing of the charged political environment around gun control -- are potential catalysts. Diversified investors may want to consider adding SWHC to their portfolios.

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