Playing Offense With Defense Stocks

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Includes: ITA, PPA, XAR
by: Invesco PowerShares

Summary

Aerospace and defense firms may be poised to benefit as many governments ramp up defense spending.

Information technology and commercial aerospace firms could also reap the benefits of increased defense spending.

Given current valuations, investors could benefit from exposure to aerospace and defense firms, as well as the information technology and materials sectors.

Increased government spending is boosting the prospects of aerospace, defense and related firms

By Nick Kalivas

After years of decline, 2015 saw a rebound in plans for government defense spending - a trend that shows no signs of abating. At the same time, valuations on aerospace and defense stocks are attractive relative to the broader market. With these trends in mind, I believe now might be a good time for investors to consider adding potential offense to their portfolios with defense stocks.

Defense dominates the headlines in 2015

The following news stories were reported in November and December, illustrating global interest in boosting defense programs.

"Japan to spend a record $41 billion on defense."1

"War on Islamic State brings $50 billion European defense boost."2

"The House and Senate Armed Services Committees … increased the fiscal 2016 spending caps for defense and nondefense activities by $25 billion each."3

"South Korea approves 3.6% increase in 2016 defense budget."4

"US said to move ahead with $1.83 billion arms sale to Taiwan."5

Defense orders pop in November

These headlines indicate a shift from a four-year trend of declining defense orders, which appears to be bottoming even before newly expanded budgets can be deployed and reflected in government data. The US Commerce Department's November durable goods report showed a 44% jump in defense orders from October.6 Defense orders are highly volatile, but the six-month average is starting to climb after an extended period of weakness. Notice the upward trend in defense orders in the following chart.

Unfulfilled defense orders have been declining since late 2012, which has hurt the defense industry's performance. However, the defense order-to-shipment ratio is trending upward over the past year, which suggests that there could be a firming in industry order backlogs (unfilled orders).6 A rising backlog could, in turn, boost confidence in defense company earnings and garner the attention of investors.

In addition, computer and electronic equipment orders rose 0.4% from the previous month in November - building on October's 2.1% gain.6 This is relevant, as the defense industry has become more high-tech over time. In my view, technology companies with exposure to the defense industry are likely to benefit from higher defense spending and increased computer and electronic equipment orders.

Civilian aerospace is still strong

It's also important to note that many defense contractors have exposure to commercial aerospace firms. Examples include Boeing (NYSE:BA), United Technologies (NYSE:UTX) and Honeywell (NYSE:HON).7 Cheap energy prices support airline industry profits and often lead to lower air fares, which can boost aircraft and aircraft maintenance demand. In its third quarter 2015 business outlook, Boeing projected higher air passenger traffic and meaningful replacement demand in its outlook for the commercial airline business. As indicated in the graphic below, unfilled aircraft orders reported by the US Commerce Department are at historically high levels - underscoring the continued strength of commercial aerospace.6

Source: Bloomberg L.P. as of Dec. 23, 2015

Defense and aerospace valuations are attractive

Valuations for defense and aerospace firms are also compelling. As of Dec. 23, the S&P 500 Aerospace and Defense Industry Index was trading at an 8.0% discount price-earnings (P/E) ratio to the S&P 500 Index. Relative valuations were richer in the mid 1990s and mid-2000s, but have come down since early 2014.6

Source: Bloomberg L.P. as of Dec. 28, 2015

A potential alternative for investors interested in defense and aerospace

Investors looking for access to the aerospace and defense sector might consider the PowerShares Aerospace & Defense Portfolio (NYSEARCA:PPA). PPA holds a mixture of traditional aerospace and defense companies, as well as information technology and materials companies that are involved in the defense industry.

Sources:

1 RT.com, Dec. 22, 2015

2 Bloomberg L.P., Nov. 24, 2015

3 Bloomberg L.P., Nov. 4, 2015

4 Bloomberg L.P., Dec. 3, 2015

5 Bloomberg L.P., Dec. 15, 2015

6 Bloomberg L.P., Dec. 23, 2015

7 As of Dec. 31, 2015, Boeing, UTX and Honeywell make up 6.46%, 6.40% and 6.35% of PPA's holdings, respectively.

Important information

The S&P 500 Aerospace & Defense Index is a capitalization-weighted index designed to capture a composite return of the stocks in the S&P 500 Index that are operating in the aerospace and defense industry, according to the Global Industry Classification Standard. An investment cannot be made in an index.

Past performance cannot guarantee future results.

Price-earnings (P/E) ratio, also called multiple, measures a stock's valuation by dividing its share price by its earnings per share.

There are risks involved with investing in ETFs, including possible loss of money. Shares are not actively managed and are subject to risks similar to those of stocks, including those regarding short selling and margin maintenance requirements. Ordinary brokerage commissions apply. The Fund's return may not match the return of the Underlying Index. The Fund is subject to certain other risks. Please see the current prospectus for more information regarding the risk associated with an investment in the Fund.

Investments focused in a particular industry, such as aerospace and defense, are subject to greater risk, and are more greatly impacted by market volatility, than more diversified investments.

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The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: This article was posted on the Invesco PowerShares' blog by an Invesco PowerShares' employee on Jan. 8, 2016 (http://www.blog.invesco.us.com/defense-stocks-aerospace-stocks-valuations).