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In May aerospace and defense stocks, nearly doubled the performance of the S&P500, gaining more than 6% in the month. YTD, the sector is now outperforming the S&P500 by more than 150 bps. In fact, the SPADE Defense Index, the underlying index to the Powershares Aerospace & Defense ETF (PPA), did not just hit year-to-date highs at the end of May but ALL-TIME-HIGHS; levels even higher than the sector saw at the peak of Pentagon war spending several years ago.

Surprised? You are not alone. Last year at this time, the news was filled with stories calling for the demise of defense stocks. Between the fiscal cliff, sequestration, and already announced defense cuts, the possibility of a trillion dollars in defense cuts over the next decade was sure to decimate defense stocks. But like the title of a classic 1960s musical, "a funny thing happened on the way to the forum"--instead of continually sinking stock prices, there was a 25% decline from the all-time-high, a stabilization (bottom), and then a steady run-up along with the rest of the market.

Aerospace & Defense stocks are above 50- and 200-day moving averages
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Aerospace & Defense stocks are above 50- and 200-day moving averages

Bullish Pattern: Ascending Triangle with Breakout above Resistance
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A bullish pattern: A multi-year ascending triangle with breakout above resistance

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As I've mentioned for more than a year, there would be tremendous uncertainty in predicting the direction of the sector until at least mid-2013. It would depend on exactly how the sequestration and budget cut discussions played out (i.e. would sequestration even happen or would there be a grand bargain between Congress and the White House) and exactly how would the Pentagon institute cuts that would be made. As such, any attempt to craft a forecast for defense stocks would be purely guesswork. There were cases to be made for 50% declines, a flat performance, or substantial gains. It all depended on factors that even the Department of Defense did not know the answer to.

So what happened?

1. Budget cuts and sequestration occurred but have not yet impacted the sector as much as once feared. The Pentagon is developing an approach that provides the least possible impact on the supplier base. The multi-pronged plan can best be defined as:

  • Delays in the launch of new programs, which frees up money in near-term budgets
  • Shifting multi-year procurement, which also frees up money near-term
  • On April 3rd, Secretary Hagel "declared war on overhead" during a speech at the National Defense University. As part of this "back-office" functions will see cuts and a restructuring of the military health and pension system is likely. The latter has the potential to meet all, if not most, of the cost reductions that are anticipated. As anyone who has dealt with pension systems, you know that even the smallest of changes, spread out over decades can have a huge impact on monies required today.

2. An increase in business from non-U.S. government defense sources -- namely a significant increase in international defense sales which many firms are, or who have targeted revenues on the order of 25%. Additionally, many defense firms also maintain business lines that provide hardware and services to the commercial aerospace sector -- a sector that at the early stages of a multi-year growth period.

3. The Pentagon maintains several thousand "major" contracts and it is very rare for any of the public defense companies to have a program represent as much as 5% of revenues. So reductions to specific programs are occurring but are diversified across a broad supplier base, reducing the impact to any individual firm. Additionally, cuts are being made to new awards and contracts, not to those already let; reducing the immediate impact to quarterly revenues and earnings. For example, the U.S. Air Force request for proposal for a new aircraft trainer anticipated by FY2016 for operations in 2020, now has an operations planned for 2023 or 2024.

4. Quarterly revenues and earnings surprised to the upside. With many defense firms reporting in May, the numbers released came out stronger than many analysts anticipated. Lockheed Martin (LMT), Raytheon (RTN), and Northrop Grumman (NOC), all reported positive news.

5. Healthy balance sheets. Unlike the downturn that occurred after the Soviet Union fell, this latest peak in defense spending has been known for years giving companies time to get their houses in order -- spinning off lower margin businesses, boosting cash, refinancing and taking advantage of low interest rates, and reducing overhead for leaner times. From a balance sheet perspective, companies are as healthy as they've been.

6. Shareholder friendly companies. Some of the best firms when it comes to returning capital via dividends and share buybacks can be found in the sector. Several companies offer dividend distributions from 2%-4%, significantly higher than that from the S&P500 as a whole, and many have been pursuing buybacks. Northrop Grumman's announcement that it plans to buy back 25% of the outstanding stock was a surprise because of its sheer size.

Still there is another dynamic is at play.

If you've read this far, there is something unusual which not only lends itself to why the sector is gaining but also why there was a floor to the sector (something that will require additional research to confirm and which I plan to pursue).

Trading volumes are down significantly. Compared to 2009 and 2010, Lockheed Martin, General Dynamics, Raytheon and others are trading on average about a third fewer shares per day, say 1.7 to 2 million per day vs. 3-4 million per day. Likewise, the ETFs have seen trading volume drop, with PPA going from 75,000 to 100,000 on average to 10,000 to 20,000 per day while assets invested in the ETFs covering the sector dropping from 1.1 billion at their peak to 130 million today -- even as the price of the ETFs continue to rise.

So what is happening?

It appears that there is a core group of investors who recognize that the defense sector, at roughly 4%-5% of U.S. GDP, is core to their portfolio and they will likely not sell under any circumstance. History has showed that after re-investing dividends, the sector produces relatively few down years and when they do, it recovers from any downturn within roughly two to three years. At least this has been true since the launch of the SPADE Defense Index (with data back to 1997) and via a 'back of envelope' calculation extending that to the early 1980s. With stock held by investors (individuals and institutions who have it as a core to their holdings) essentially taken out of circulation, there is a defined floor. One would normally see a rotation from individual stocks to ETFs when a sector declines (a) if new investors who came in near the top want to stay exposed to the sector but can capture tax losses, or (b) investors want exposure to the sector but don't want to determine the specific winners and losers. The share count drops in the ETF funds since 2010, indicate that this rotation never happened. 'Short-term' investors using the ETF rotated out. Core investors that own stock in individual companies likely have significant long-term gains, so switching to an ETF would create a taxable event. Since the peak in fund shares owned from the peak in 2010 to early 2011, few new investors have rotated into the sector because of the government budget and sequestration issues. Meanwhile the stocks of the individual companies (and by nature, the funds that hold them) continued to see an uptick in price. Why? It is likely that with few shares being sold, share buybacks outpaced available shares on the market. New buyers attracted to the dividend and buyback policies added to there being a net positive inflow.

Going forward ...

At the end of May Goldman Sachs and other investment firms raised the forecast for defense companies and added it to its conviction buy list. In fact, the Goldman Sachs statement said that the uptick could continue for the next several years. As new buyers recognize that fears from the budget and sequestration may be overdone, the positives associated with international sales, commercial aerospace opportunities, and shareholder-friendly actions and we could see a margin expansion as prices begin to re-inflate.

The key to this I believe will be watching the trading volumes of the companies and the ETFs. Since the Goldman Sachs announcement, I've already noticed an uptick in volume. Looks like investors are beginning to warm to the sector.


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YTD, Aerospace & Defense vs. the S&P 500 (green line)

The author manages the SPADE Defense Index (NYSE: DXS), the underlying index for the Powershares Aerospace & Defense ETF .

Source: Aerospace And Defense Bulls Are Running