Near the end of 2015, President Barack Obama signed a $1.1 trillion budget full of federal spending and tax breaks for fiscal 2016. The new budget deal is a reprieve from situations involving government shutdowns and lengthy stop-gap spending measures through fiscal 2016. It also came as an unusual compromise between the Democrats and the Republicans who have often in the past been in a deadlock.
The new budget increases defense spending, a logical step given the increasing unrest in the Middle East and other regions. As threats turn into ever new shapes involving asymmetric, air-sea power, cyber, urban, non-state organizations, and many more, the defense capabilities of a country need to morph accordingly to contain the adversaries.
A politically unstable planet has led to various nations stepping up their defense capabilities. The direct beneficiary of a volatile geo-economy is undoubtedly the aerospace and defense players. The U.S. defense firms have particularly tasted success in the 'rest of the world'. Countries allied to U.S. policy are spending substantially on sophisticated artillery to wage the war against terror and sectarian forces. The crisis has been acutely felt with the meteoric rise of the Islamic State of Iraq and Syria (ISIS), a situation that President Obama had once coined "the network of death."
Moreover, per a Treasury Department report, the U.S. budget deficit narrowed to $439 billion in fiscal 2015, the lowest level since 2008, as the economy continued to recover from the financial crisis and revenue growth outpaced a rise in spending.
The third-quarter earnings season had seen an earnings beat ratio (percentage of companies coming out with positive surprises) of 77.8% among the aerospace and defense companies. They were not only up against fiscal 2015 budget constraints but were also subject to tepid economic growth throughout the quarter.
Growth remained challenged for most of the third quarter, thanks to a strong dollar and weak energy prices. Moreover, persistent slowdown in China deepened global economic woes. In spite of the macro issues, the top contractors, such as, Lockheed Martin Corp. (NYSE:LMT), The Boeing Co. (NYSE:BA), Northrop Grumman Corp. (NYSE:NOC), General Dynamics Corp. (NYSE:GD), Textron Inc. (NYSE:TXT), and Raytheon Co. (NYSE:RTN) held up well on the back of mounting geopolitical risk and strong commercial sales.
Though economic data has turned more positive lately and geopolitical uncertainty has improved the outlook of the broader defense space, there are still issues at play. A "disproportionate" cut to modernization and research and development funding could act as a major impediment for the defense industry.
In Dec. 2015, Frank Kendall, undersecretary for acquisition, technology and logistics, said in a conference hosted by the Potomac Officers Club that the Pentagon expects to make "disproportionate" cuts to modernization and research and development funding in its fiscal 2017 budget request. This may imply a possible slowdown in production rates of Lockheed Martin's F-35 fighter jet - the single largest weapons program of the Pentagon.
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 the defense players. The strong dollar is not only showing up as a currency translation drag, but is also having a bearing on foreign military sales.
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.
iShares U.S. Aerospace & Defense ETF (NYSEARCA:ITA)
With a Zacks ETF Rank #3 (Hold), ITA has provided a return of 21.53% over the three-year period ended Dec. 31, 2015. This fund 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.
This index has a 100% focus on U.S. companies. The fund has an annual dividend yield of 1.10%.
The ETF, launched in May 2006, presently has nearly $684.1 million in AUM and is heavily weighted toward the Industrials sector (97%) with the balance going to Technology. This fund holds 38 stocks with about 55.01% invested in the top 10 holdings.
Among individual holdings, the top stocks in ITA include Boeing, United Technologies Corp. (NYSE:UTX) and Lockheed Martin comprising 7.82%, 7.73% and 6.83%, respectively, of total net assets. With a tilt toward large-cap companies, this fund charges investors 43 basis points a year.
PowerShares Aerospace & Defense Portfolio ETF (NYSEARCA:PPA)
This ETF tracks the SPADE Defense Index, holding 53 securities in its basket and has an expense ratio - an annual fee - of 0.66%. The Index is designed to identify a group of companies involved in the development, manufacturing, operations and support of U.S. defense, homeland security and aerospace operations. The index was launched in October 2005.
This fund has a Zacks Rank #3 and is highly focused on U.S companies (100%). The fund has so far managed assets of $299.7 million with a focus on large-cap companies. The top 10 companies hold 53.25% share of total net assets.
In terms of holdings, Lockheed Martin, Honeywell International Inc. (NYSE:HON) and United Technologies occupy the top three positions in the basket comprising 6.54%, 6.31% and 6.30%, respectively, of total net assets.
SPDR S&P Aerospace & Defense ETF (NYSEARCA:XAR)
This fund follows the S&P Aerospace & Defense Select Industry Index, focusing 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 #3, this fund charges investors just 35 basis points a year in fees for its exposure. Hence, it is considered the cheapest option in the aerospace and defense ETF market.
With holdings of 34 stocks, the top spots are taken up by Orbital ATK Inc. (NYSE:OA), Transdigm Group Incorporated (NYSE:TDG) and Honeywell International Inc. comprising 4.27%, 4.03% and 4.01%, respectively, of total net assets.
Launched in September 2011, XAR has 100% focus on U.S companies.
The fund has managed assets of $160 million so far and has an annual dividend yield of 1.00%. The top 10 companies hold 40.03% share of total net assets.
To Sum Up
Despite global headwinds, the defense biggies have been proactive in meeting evolving customer needs, particularly for affordable products, besides engaging in corporate restructuring. Moreover, tensions arising out of geopolitical conflict around the globe and 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 a good idea to play defense.