Politically instability has prompted various nations to step up their defense capabilities. The direct beneficiaries of a volatile geo-economy are undoubtedly the aerospace and defense players. This has given U.S. defense firms a chance to taste success in the “rest of the world”. Countries allied to U.S. policy are spending substantially on sophisticated artillery to wage war on terror and sectarian forces.
The crisis has been acutely felt with the meteoric rise of the Islamic State of Iraq and Syria (ISIS) – an organization termed as “the network of death” by President Barrack Obama.(Read: Prepare for a Trump Presidency with These Stocks & ETFs)
Factors Driving the Sector
The new budget increases defense spending, a logical step given the mounting unrest in the Middle East and other regions. It is important to note that no country in the world can match U.S. defense spending levels. This is quite evident from Pentagon’s fiscal 2017 budget proposal of $582.7 billion, including a base budget of $523.9 billion. This highlights a $2.2 billion increase over the FY16 enacted budget of $521.7 billion. The contemporary political scenario, marked by Russian assertiveness and the rise of the ISIS, has reshaped spending priorities to a large extent.
Among the priorities, the Pentagon will seek a major boost in FY17 defense budget to fund the fight against the Islamic State. The $7.5 billion funds request marks about a 50% increase from the FY16 allocation.
The Obama administration has decided to boost the European Reassurance Initiative budget to $3.4 billion for fiscal 2017 to support military training and exercises. This is almost a four-fold increase from 2016's $789 million that will likely help the U.S. reinforce its military stance in Europe in view of Russia’s ominous moves in Eastern Europe since the annexation of Crimea in Mar 2014 and the ensuing war in eastern Ukraine.
The proposed budget will also seek to enhance spending in several key areas, including cybersecurity, electronic warfare and crucial U.S. satellites. Again, $8.1 billion of funds allocation for submarines (with over $40 billion in the next five years) is poised to benefit the likes of Huntington Ingalls Industries, Inc. (HII) and General Dynamics Corp. (GD).
Meanwhile, big defense operators are expanding their market share, with foreign sales acting as a key driver. Defense companies like Raytheon Co. (RTN) are in the spotlight as countries in Europe and the Middle East may need to ramp up their defense spending in order to combat threats from the ISIS.
Earnings & Weaknesses
The second-quarter 2016 earnings season saw an earnings beat ratio (percentage of companies coming out with positive surprises) of 90% for the aerospace and defense companies. While earnings declined 27%, revenues grew 2.9% over the prior year. Top contractors, such as, Lockheed Martin Corp. (LMT), Northrop Grumman Corp. (NOC), General Dynamics and Raytheon have posted impressive results, owing to elevated geopolitical risks.
Though economic data has turned up more positive for August and geopolitical uncertainties have improved the outlook for the broader defense space, there are multiple issues at play. The global markets witnessed a Brexit-begotten June and the sell-off induced by that event. On top of that, weak second-quarter economic data has certainly put the brakes on the positive momentum. Apart from tepid economic data, "disproportionate" cuts to modernization and research and development funding could act as major impediments for the defense industry.
Moreover, the strong U.S. dollar, which is a reflection of growth and monetary policy divergence between the U.S. and its trading partners, is a significant headwind for defense companies. The strong dollar has not only showed up as a currency translation drag, but also had a bearing on foreign military sales. (Read: Top Ranked Sector ETFs and Stocks for Q4)
ETFs to Tap the Sector
Below, we have highlighted the aerospace and defense ETFs, which primarily have a U.S. bias. Investing in these funds in basket form greatly reduces the risk of investing in particular stocks. (See all industrials ETFs here)
iShares U.S. Aerospace & Defense ETF (ITA - ETF report)
With a Zacks ETF Rank #1 (Strong Buy), ITA tracks the Dow Jones U.S. Aerospace & Defense Index, providing exposure to companies related to the aerospace and defense industry in the U.S. equity markets (94.9%).
This index has a 100% focus on U.S. companies. The fund has an annual dividend yield of 0.86%.
The ETF, launched in May 2006, is heavily weighted toward the Industrials sector (96%) with the balance going to Technology. This fund holds 37 stocks with about 58.9% invested in the top 10 holdings.
Among individual holdings, the top stocks in ITA include United Technologies Corp., Boeing and Lockheed Martin comprising 8.74%, 8.64% and 7.94%, respectively, of total net assets. With a lilt toward large-cap companies, this fund charges investors 44 basis points (bps) in fees a year.
PowerShares Aerospace & Defense Portfolio ETF (PPA - ETF report)
This ETF tracks the SPADE Defense Index, holding 49 securities and an expense ratio (annual fee) of 0.64%. The Index is designed to identify a group of companies involved in the development, manufacturing, operations and support of the U.S. defense, homeland security and aerospace operations. The index was launched in October 2005.
This fund has a Zacks ETF Rank #2 (Buy) and is highly focused on U.S companies (100%). The fund has so far managed assets of $297.1 million, with large-cap companies hogging the spotlight. The top 10 companies hold a 56.6% share of total net assets.
In terms of holdings, General Dynamics Corp., Boeing and United Technologies occupy the top three positions in the basket comprising 6.66%, 6.59% and 6.57%, respectively, of total net assets.
SPDR S&P Aerospace & Defense ETF (XAR - ETF report)
This fund follows the S&P Aerospace & Defense Select Industry Index, focused on the aerospace and defense sector of the S&P Total Market Index. The Index is one of the 19 S&P Select Industry Indices, each designed to measure the performance of a narrow sub-industry or group of sub-industries as defined by the Global Industry Classification Standards.
With a Zacks ETF Rank #2, this fund charges just 35 bps a year in fees for its exposure. Hence, it is considered one of the cheapest options in the aerospace and defense ETF market.
With holdings of 35 stocks, the top spots are taken up by TASER International Inc., Rockwell Collins Inc. and Lockheed Martin comprising 4.97%, 4.64% and 4.6%, respectively, of total net assets.
Launched in September 2011, XAR has 100% focus on U.S companies.
The fund has managed assets of $206.3 million so far and has an annual dividend yield of 0.76%. The top 10 companies hold a 46% share of total net assets.
To Sum Up
Despite global headwinds, the geo-political conflicts raging in the world and rising demand for defense products in the Middle East and other Asian nations will ensure a steady inflow of foreign contracts. In this context, the above-mentioned ETFs with a favorable Zacks ETF Rank might be good investment picks to play defense.
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