In theory, things should not have been this good this year for aerospace and defense stocks and the exchange traded funds that house them.
Debt ceiling debates and sequestration were seen as hurdles to the industry. In reality, all three dedicated aerospace and defense ETFs have soared this year, but the SPDR S&P Aerospace & Defense ETF (NYSEArca: XAR) has been the leader with a year-to-date gain of 44.3%. [10 Small Sector ETFs With Big Returns]
Although the aerospace and defense industry is perceived as being beholden to Uncle Sam’s whims, the outlook heading into next year is bright and that could mean more upside for XAR. One good reason: All that talk of slack earnings growth does not apply to XAR constituents.
“Q3 2013 earnings growth of the A&D industry was 16.1% vs. 4.3% average earnings growth reported by S&P 1500 companies. Markets have responded positively to the strong earnings growth; however, industry relative valuation metrics do not fully reflect this (A&D P/B is currently at a discount to S&P 500, but historically trades at a slight premium) which may present a relative value opportunity,” according to State Street Global Advisors Head of ETF Investment Strategy David Mazza.
XAR is not excessively allocated to the most widely held A&D names, such as Dow components Boeing (NYSE: BA) and United Technologies (NYSE: UTX) or Lockheed Martin (NYSE: LMT). Rather, the ETF is an equal-weight spin on the industry as its top-10 holdings have weights ranging from 4.19% to 5.13%. [ETF Spotlight: Aerospace & Defense]
Still, XAR as enough leverage to the commercial aircraft business to benefit from significant order backlogs.
“Orders for new commercial aircraft are at historic highs due to airlines replacing aging fleets and/or expanding current fleets. In an effort to increase fuel efficiency, airlines are also retrofitting current fleets with more fuel efficient engines which is driving strong order flow among parts manufacturers and suppliers. This activity has created a large backlog of orders for the Aerospace industry segment, and offsets weakness in the Defense industry segment, which supports a bullish outlook for the industry,” said Mazza in an email exchange with ETF Trends.
Adding to the bull case for XAR is that aerospace and defense firms are part of the industrial sector, which is historically one of the better performing sectors at this time of year. Perhaps more importantly, industrials perform well when interest rates rise because rising rates can go hand-in-hand with economic growth. [Industrial ETFs: November Strong]
As Mazza points out, “the A&D industry has a beta of 1.9 to US GDP growth relative to the S&P 500’s beta of 1.7.”
XAR has a weighted average market cap of $21.8 billion, according to State Street data, but the average market cap in one of its rivals is close to $29 billion. The slight tilt toward small and mid-cap A&D names could benefit XAR because some of those names are less leveraged to the defense spending cycle.
“Going forward, earnings seem poised to increase as evidenced by the record aircraft orders announced at the recent Dubai Airshow,” said Mazza. “This may provide further support to share prices as investors seek out growth opportunities and, in fact, may benefit small companies that have less exposure to defense spending.”
SPDR S&P Aerospace & Defense ETF
