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By Robert Goldsborough

This summer's federal budget negotiations and uncertainty over upcoming federal spending have hammered aerospace and defense stocks, as investors have feared the impact of further budget cuts on those firms' results.

For investors who have seen this carnage that aerospace and defense firms sustained over the summer and believe that the sell-off may be overdone and are interested in investing in the subsector, an exchange-traded fund may be the answer. The ETF structure allows investors to go with a basket of firms in the subsector and thus avoid single-stock investing, given the broad uncertainty surrounding just which aerospace and defense contractors may be the winners and losers in future rounds of budget cuts.

Two ETFs offer investors broad exposure to the aerospace and defense subsector. First, however, let's take a look at where things stand, budget-wise.

A Federal Budget Under Pressure
Over the summer, the messy budget and debt-ceiling process resulted in a deal between President Obama and Congress that makes it easy to see that all parts of the federal budget are going to come under pressure in coming years, but that defense spending likely will be on the chopping block sooner rather than later.

Legislators are far from any kind of a broad consensus on any possible future cuts to mandatory federal spending such as Social Security, Medicare, and Medicaid. And interest payments on the national debt remain mandatory payments as well. The many relatively small discretionary items that are the most controversial among legislators--think funding for National Public Radio, or NPR, or Amtrak--may tend to attract the most headlines, but the truth is that after interest payments, defense spending, and entitlements, all of what is left falls in a catchall category known as "non-defense domestic discretionary spending" that makes up less than one fifth of the federal budget.

Recognizing, then, that desired budget cuts cannot be made up by that relatively small discretionary category, Morningstar's equity analysts hold the belief that defense spending is going to be cut at some point soon. Further bolstering this view is the fact that although President Obama and Congress reached a deal over the summer to lift the debt ceiling and cut the rate of growth of some spending, that pact was predicated on reducing the budget deficit in the future by another $1.8 trillion in cuts that are to be decided on in the coming months by a bipartisan, 12-member committee of Congress known as the Super Congress. And built into this summer's deal is a "hammer" of sorts: If that committee either cannot achieve a consensus on those cuts--or if that group's suggested cuts are not agreed to by all of Congress--then a package of automatic cuts would then go into effect that would total $1.8 trillion by making equally sized cuts to Medicare providers and defense spending. "We recognize such stabilizers have failed in the past, but the current situation appears more likely, as the next portion of the debt-ceiling increase is predicated on spending cuts," wrote my colleague Neal Dihora in a presentation on August 18 (log-in required).

While it's always possible that Congress could decide that it can't abide by such significant cuts and go ahead and undo those automatic cuts, we think that one way or another, the nation's defense budget is going to get cut. And the markets clearly think so, too: From July 1 through Friday, defense-contracting bellwether Northrop Grumman (NOC) slid 26%, and industry titan General Dynamics (GD) fell 19.6%. Both firms fell far more than the S&P 500, which was down 12% over that same interval. Even Boeing (BA), which has significant government exposure but which also has meaningful exposure to commercial aviation as well, has underperformed in that same interval, dropping nearly 14% during that time frame

Clearly, the defense sector is out of favor. Are the companies in the space currently undervalued? Morningstar's equity analysts believe that many of them are, including General Dynamics, Raytheon (RTN), Rockwell Collins (COL), Northrop Grumman, and Boeing, along with more-diversified but defense-oriented conglomerates such as United Technologies (UTX) and Honeywell International (HON).

Using an ETF to Invest in a Basket of Aerospace and Defense Firms
Investors who have seen the carnage that aerospace and defense firms sustained over the summer may now be interested in investing in the subsector. For those that are leery of single-stock investing, given the broad uncertainty surrounding just which defense contractors may be the winners and losers in future rounds of budget cuts, an ETF may be the answer. Currently, there are two ETFs that focus solely on aerospace and defense firms. Both are trading significantly below Morningstar's fair value estimates for the funds, which are calculated by aggregating and weighting our equity analysts' estimates of fair values for the ETFs' underlying constituents. In addition, we should note that our analysts have updated the individual defense stocks' fair values for likely upcoming budget cuts.

However, there are important differences between the two ETFs that investors should be aware of before investing. Here are details on the two funds:

IShares Dow Jones US Aerospace & Defense (ITA)
The larger of the two ETFs, ITA holds 32 aerospace and defense firms. The ETF tracks a modified market-cap-weighted index, so while larger firms tend to dominate (the top 10 holdings make up more than 56% of assets), the largest ones are capped to ensure diversification. In addition, 41% of ITA's assets are invested in defense firms, while the remaining 58% are devoted to aerospace companies.

The fund's performance has been 89% correlated to the S&P 500 over the past five years. ITA is trading at 89% of Morningstar's estimate of fair value. The fund is the cheaper of the two funds, charging a 0.47% expense ratio. It also has significantly outperformed its rival below, both over the last five years and since the market reached its abyss in March 2009.

PowerShares Aerospace & Defense (PPA)
This fund tracks a modified market-cap-weighted index of 51 aerospace and defense firms. With a broader base of holdings, PPA offers slightly more diversity than the iShares offering. (It's also 92% correlated with the S&P 500 over the last five year--higher than the iShares fund's correlation with the broader benchmark.) But some of that diversity comes from the fund's 15% investment in information technology firms. That means that some of its holdings--including Booz Allen Hamilton (BAH) and Computer Sciences (CSC)--are ones that clearly are not pure-play aerospace and defense names and instead provide management and technology-consulting services to a broad range of government and private-sector users.

By the same token, PPA's holdings generally are geared more toward advanced technologies and may well be the ones that hold up better in an era of scarce defense resources. The fund also tilts less toward commercial aviation than the iShares fund does. The PowerShares fund holds all of ITA's top holdings, and it also owns good-sized stakes in several industrial conglomerates, such as Honeywell International and ITT (ITT), that iShares does not hold. PPA's top-10 holdings make up almost 55% of the fund. PPA currently is trading at 83% of Morningstar equity analysts' estimate of fair value, giving the fund a nice margin of safety. PPA sports an annual expense ratio of 0.60%.

Other Alternatives--Both Inside and Outside the ETF Space
Investors seeking ETFs with modest aerospace and defense exposure could consider one of the broader industrials-sector funds. For example, the very inexpensive and concentrated Industrial Select Sector SPDR (XLI) (0.20% expense ratio) invests 26% of its assets in aerospace and defense firms, while the slightly more expensive and far more diversified Vanguard Industrials ETF (VIS) (0.24% expense ratio) devotes 21% of its portfolio to that sector. IShares Dow Jones U.S. Industrial (IYJ) (0.47% expense ratio) invests 16% of its assets in aerospace and defense firms.

We should note that the broader industrials-sector ETFs actually are trading at much larger discounts to Morningstar analysts' estimates of fair value, in part because the narrower aerospace and defense ETFs have greater exposure to the less attractively valued small- and mid-cap spaces.

In addition, one large defense contractor that is a major weighting in both ITA and PPA, Lockheed Martin (LMT), is something of a standout in the aerospace and defense industry, in that Morningstar's equity analysts believe that the firm currently is trading at fair value. As a result, that also likely has helped make the aerospace and defense ETFs more expensive than the broader industrials ETFs.

Another option is single-stock investing. Investors could consider making investments in behemoths, such as General Dynamics, Lockheed Martin, Boeing, or Raytheon, or in conglomerates with meaningful defense operations, such as United Technologies, Honeywell International, or ITT.

Still another possibility is to venture into the traditional open-end mutual fund space; Fidelity Select Defense & Aerospace Portfolio (FSDAX) (0.88% expense ratio) is an option. It's a managed fund that has lagged both ETFs over the last five years but that has bested both ETFs since the market's nadir in March 2009.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Source: Despite Budget Headwinds, Defense ETFs Look Attractive