The growth of the Aerospace and Defense industry is largely determined by the spending policies of government departments, with the U.S. defense budget being the key driver. As a result, recent cut in U.S. defense spending has triggered serious concerns over the future of the sector. (see Defense ETF Investing 101)
U.S. defense spending is being adversely affected by the Budget Control Act of 2011. The Act has two main parts that could impact future defense spending. The first is a $487.0 billion reduction to the previously planned defense spending for the next decade.
The second part is a sequester mechanism that would impose an additional $500.0 billion cut on defense spending between 2013 and 2021, if the Congress is unable to approve a plan to reduce the U.S. deficit by $1.2 trillion by March 2013..
This month, the U.S. Senate has unanimously approved the 2013 budget of $633.3 billion, up $1.7 billion from the request made. Of this, the base budget is $544.9 billion and $88.5 billion is allocated for overseas operations. The latest authorization that extends U.S. sanctions on Iran and strikes restrictions on biofuel was inevitably lower than the 2012 level of $645.7 billion.
However, the picture is not entirely gloomy. In wake of defense budget cuts, the companies often fall back on joint ventures, strategic alliances and big international orders to pool their resources, allowing them access to new markets (see Can The Defense ETFs Soar Despite Headwinds?).
Until recently, the Pentagon entered into a purchase agreement with Lockheed Martin (LMT) for more jets, albeit at a lower price. While Canada seems skeptical about proceeding with its purchase plan of F-35 from Lockheed, Pentagon assured that it will buy a fifth group of F-35 Joint Strike Fighter jets, a long impending deal pertaining to the costliest weapons program in the U.S. history.
The Pentagon is also expected to ink a deal with Lockheed on the quicker funding for a sixth fleet of F-35s. This could lessen Lockheed’s liability from its earlier work on the jets that was done without any contract.
Further, a number of new emerging markets as well as developed nations, such as India, China, Japan, the United Arab Emirates, Saudi Arabia, and Brazil are boosting their defense spending and generating business for the U.S. However, China is ramping up its military modernization by itself and is likely take the lead in the east (see Get True Emerging Market Exposure With These Three ETFs).
In fact, as per Aerospace Industries Association (:AAI), some major activities currently in store for the U.S. defense sector are foreign military sales, implementation of NextGen, export control reform, extension of the R&D tax credit and progress on NASA’s human space exploration strategy. Its focus on joint ventures, mergers and acquisitions is no less important.
Moderately strong long-term prospects make the Aerospace & Defense fund attractive for investors willing to withstand the near-term drag on the sector. Investors seeking exposure to the U.S. aerospace & defense market may find iShares Dow Jones US Aerospace & Defense ETF (ITA), PowerShares Aerospace & Defense ETF (PPA) and SPDR S&P Aerospace & Defense ETF (XAR) interesting choices.
ITA tracks the Dow Jones U.S. Select Aerospace & Defense Index. It has 34 holdings including stocks like United Technologies Corporation (UTX), Boeing (BA) and Precision Castparts Corp. (PCP). The sector breakdown in this fund is 56% aerospace and 44% defense. With total assets of about $78.9 million, ITA is the largest product in this space (see Zacks #1 Ranked Aerospace & Defense ETF in Focus). The product charges around 47 bps in annual fees.
With an AUM of $46.5 million, PPA tracks the SPADE Defense Index. Boeing, Honeywell International Inc. (HON) and United Technologies are its top three holdings among a total of 49. The sector breakdown for this fund is 81% industrial, 15% information technology and 4% materials. While this choice is an expensive one with around 66 bps of annual fees, its daily trading volume of 13,371 is higher than two other choices in this space. (see more in the Zacks ETF Center)
With an AUM of $16.1 million, XAR tracks the S&P Aerospace & Defense Select Industry Index and of its 35 holdings, the top three stocks are B/E Aerospace, S Precision and Hexcel Corp. Industrials account for 92.7% of holdings while technology makes up 6.71%. The product charges 35 bps in annual fess and its total daily volume is around 1,606 units.
As of September 30, 2012, ITA, PPA, XAR returned a respective of 21.37%, 23.54% and 23.96% over the one-year period. At the current level, it has been noticed that while defense spending will slow down, most of these companies have significant growth catalysts in the commercial aerospace business.
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