Investors Get 'Defense'-ive

| About: PowerShares Aerospace (PPA)

The Stock Market’s Volatile August

The 3rd quarter has seen increased volatility in the markets and a run toward ‘defense’-ive stocks with the SPADE Defense Index outperforming the S&P 500 by nearly 6% to date in the 3rd quarter. This was after gaining more than 10% in 2Q07 -- nearly 5% better than the S&P 500.

As issues with housing and the subprime loans permeated through the industry, Wall Street saw one of its wildest August's. Normally a quiet month when many financiers head out on vacation, issues in the credit markets led to a wide range of actions and reactions that saw the the market rise and fall with tremendous volatility. Even though the defense sector is relatively independent of these financial market drivers, it too saw tremendous volatility with the Powershares Aerospace & Defense ETF (AMEX: PPA) trading more than 7 million shares in August -- more than double any previous month since its launch in October 2005.

Even so, the Index remains near its all-time-high levels and inflows into the ETF product continue. Since the beginning of the year, assets tracking the SPADE Defense Index have more than tripled. As investors look for a safe haven or, pardon the pun, a ‘defense’-ive position for near-term investments, money managers and analysts are rediscovering the aerospace and defense sector and putting it among their list of most-favored sectors. If history is a guide, the next two months should see continued interest in the sector. September is the time of year that the Pentagon releases a number of contracts before the fiscal year closes. It is also the time of year when Congress approves the federal budget for the forthcoming year. Three of the last four years have seen the index rise roughly 10% during this period.

What we’ll see in the next two months is a regular focus on defense and homeland security as several reports on Iraq will be released, the 6th anniversary of 9-11 will be remembered, and the White House submits a request for an additional $50 billion to fund operations in Iraq during 2008.

The Credit Market Effect on Defense Sector Mergers & Acquisitions

One of the interesting ‘side’-effects of the credit market issues will be its impact on mergers and acquisitions. For the last several years, private equity firms have competed with industry (and the companies that comprise the SPADE Defense Index) to identify and acquire a number of companies in the defense sector. The competition meant acquisitions were done at higher valuations as more buyers chased the best companies. With financial institutions more closely monitoring the loans they issue, private equity firms will have to put up more cash to fund an acquisition. For those not familiar with the private equity model, these firms rely on cheap capital to fund their acquisitions and the greater the amount they can leverage with credit, the higher their overall returns. What this means is that investors, bankers, and analysts are seeing a slowdown in the number of deals being done by private equity. With defense firms having strong balance sheets and billions of dollars of cash on hand, it is likely that we may see increased activity from the companies that comprise the SPADE Defense Index. After all, acquisitions play a vital role in the growth of companies in the sector both in terms of revenues as well as access to contracts, skilled employees, and government programs.

The Sector’s Price-to-Earnings

In a recent meeting we were asked about whether after the run this year, in which the SPADE Defense Index is outperforming the S&P 500 by some 16%, is the defense sector fully or over-valued? Obviously there are a number of ways analysts try to determine this, but we decided to go back and look at how the price-to-earnings ratio has varied over the past several months. Since P/E variers by industry, sector, or style, typically what analysts do is compare the levels to the norm. The table presented shows the P/E for the PPA as recorded from Yahoo Finance over the past 16 months. And while the P/E has fluctuated over time, it has remained within 5% of its mean.

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