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Over the past few years, the bearish argument against investing in defense and aerospace has been that looming budget cuts would result in lower spending on national defense in the United States and elsewhere. But those fears have not materialized; in fact, many exchange-traded funds (ETFs) focused on defense and aerospace have outperformed the market. For example, the iShares U.S. Aerospace & Defense ETF (ITA), the Powershares Aerospace & Defense ETF (PPA) and the SPDR S&P Aerospace & Defense ETF (XAR) have each returned 7% to 9% over the past year, while the S&P 500 Index is up 6% in the same timeframe.
Defense budgets have largely remained intact or have endured only modest cuts in many cases. The United States defense budget stood at $585 billion in 2015. On the commercial side, business conditions remain very strong. As a result, these three ETFs could continue to outperform the market.
Top Holdings and Industry Focus
There are many similarities among the top holdings for ITA, PPA and XAR, as well as some key differences. ITA’s top three holdings are Boeing (BA), United Technologies (UTX) and Lockheed Martin (LMT), which collectively represent 23% of its holdings. PPA’s top three holdings are United Technologies, Honeywell (HON) and Boeing. Lastly, the top three holdings for XAR are BWX Technologies (BWXT), L3 Communications (LLL) and TASER International (TASR).
The ITA and PPA funds mimic each other, and both ETFs have invested heavily in large-cap defense companies, while the XAR fund counts smaller companies among its top holdings. Among the individual companies, Boeing, United Technologies and Honeywell are more oriented towards the commercial market, while Lockheed Martin and General Dynamics (GD) are highly reliant on governments. For example, Boeing and United Technologies derive two-thirds and 45% of their annual revenue, respectively, from commercial markets. Meanwhile, Lockheed Martin and General Dynamics generate 79% and 75% of their respective revenue from defense budgets and government defense spending.
Lockheed Martin and United Technologies recently made a large deal that will extend each company’s respective focus area. United Technologies recently sold its Sikorsky Aircraft business to Lockheed Martin for $9 billion. This acquisition should complement Lockheed Martin’s existing portfolio well, and is a natural fit given the company’s strong position in aerospace and defense technologies.
Opportunities in the Commercial Market
By contrast, the Sikorsky sale will allow United Technologies to reduce its exposure to defense in order to focus more on its core commercial business. This is a wise management strategy to employ, since commercial aerospace markets are growing. For example, aerospace growth has picked up due to increased demand for travel in the Middle East and Asia-Pacific regions. For Boeing, there is high potential for growth because the commercial airline order backlog for planes is at a historic high.
Deliveries of commercial aircrafts rose 3% last year, representing the fourth consecutive record year. Aircraft demand has enjoyed a prolonged boom, with few signs of reversing. The major plane manufacturers have collectively received a record $1.8 trillion of orders over the next decade.
Why Outperformance of Defense & Aerospace ETFs May Continue
The three major aerospace and defense ETFs mentioned here (ITA, PPA, XAR) have outperformed the market over the past year, and that outperformance trend may continue. Based on solid underlying demand and firm economic conditions in their core markets, particularly at the commercial level, the major aerospace and defense companies should continue to grow revenue and earnings at high rates. That would naturally flow through to the ETFs. As a result, investors interested in gaining a broad exposure to these industries may want to research ITA, PPA or XAR.
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