Investors in aerospace and defense are playing with fairly high stakes these days. Over the last five years, the sector’s stocks in the Standard & Poor’s 500 have outperformed the broader index by 20 percentage points. In the aggregate, U.S. aerospace stocks now trade at 17 times the projected next-12-month earnings, a premium to the market multiple of 15 times projected earnings.

“You’re not going to get the same performance out of the aerospace stocks that you did in 2004, 2005, 2006,” warns J.B. Groh, an analyst covering the sector for Great Falls, Mont., brokerage firm D.A. Davidson & Co. “You can still beat the market, but not in the same dramatic fashion.”

Groh, 39, doesn’t speak from vast experience–he started covering aerospace and defense in 2004. But he’s had an admirable track record since. According to research firm StarMine, which tracks analyst performance, over the past 36 months, Groh has bested an industry return of 89% (cumulative) by 50%. In our most recent analyst ranking, conducted in partnership with StarMine, Groh was the No. 1 stock picker in his category.

Underlying that success has been his preference for the commercial rather than the defense side of the sector. When he first chose the companies he would cover several years ago, Groh saw a contrarian play in recommending suppliers of equipment to the airlines.

At the time, both sectors had been hit by the effects of the war in Iraq, a so-so economy and severe acute respiratory syndrome, or SARS. The latter, a viral illness first reported in Asia, was blamed for 774 deaths in 2003 and whipped up fears that aircraft cabins were prone to contagion. In mid-2003, traffic across the Pacific dropped 40%.

“I thought, well, you still have to travel,” says Groh.

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These are difficult times for companies offering technical services to the federal government. The grind of waging war in Afghanistan and Iraq has threatened agency technology budgets and darkened the outlook for big Beltway businesses such as CACI International and SRA International.

Covering this area from Stanford Group’s Washington offices, Erik Olbeter has kept his footing. For eight months in 2006, for example, he cautioned against shares of Dynamics Research, an Andover, Mass., company that does engineering work for defense and intelligence customers. The stock dropped 44% during that period.

But it wasn’t all bearishness that won Olbeter his No. 8 StarMine ranking among all analysts for 2006 stock calls. Last August, he put a buy rating on DynCorp International , at $10. By the end of the year, shares of the company, which provides governments with services ranging from narcotics eradication to vehicle maintenance, had climbed to $16.

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Investing in the defense business these days is a musical-chairs situation. Both military budgets and stock valuations in the defense and aerospace sector look historically high. When will the music stop?

We can’t answer that question, but we can offer up individuals likely to make the right calls in this tricky environment: the defense and aerospace analysts winning awards in our annual analyst survey, published this week on Forbes.com.

Our ranking, prepared for us by research firm StarMine, assesses analysts in two areas: the outcomes of their 2006 stock recommendations (buy, hold, sell) and the accuracy of their earnings forecasts for the four quarters through March. For more on the methodology, click here.

In terms of stock recommendations, these three folks won top spots among defense and aerospace analysts: J.B. Groh of D.A. Davidson & Co., Troy Lahr of Stifel Nicolaus and Heidi Wood of Morgan Stanley. J.B. Groh is a repeat winner, climbing up to first place from his No. 3 ranking last year.

Of those three, Troy Lahr is geographically closest to Washington, D.C. Stifel Nicolaus, part of Stifel Financial, is headquartered in St. Louis but has a big presence in Baltimore, thanks to its 2005 acquisition of Legg Mason’s brokerage business. Lahr, who came to Stifel via Legg Mason, says the robust defense industry presence in Maryland was one factor in his becoming a defense analyst six years ago.

These days, Lahr’s wary of prospects for big military contractors such as Lockheed Martin and Northrop Grumman. Defense budgets, he expects, will increase in the 5% to 7% range in the next year or two. “Beyond that, it’s probably going to start slowing down” he says. “A lot of these companies are really at peak valuations relative to the growth outlook.”

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