In defense of Defense

With a potential Debt Ceiling deal on the table, it’s a good time to look into defense stocks. We’d highlighted that one of the casualties of the debt ceiling impasse would be defense stocks. In fact, any company that had government contracts were at risk.

But, the recent deal does not have any major changes to the defense spending budget:

Obviously, we weren’t the only ones highlighting this and the defense stocks did sell off in the last couple of weeks.

However, this pull back could make this industry quite interesting for potential longs whether through ETFs or individual companies.

A word of caution here. While it’s not challenging to understand the numbers or the financial statements of these companies, the companies themselves are quite complex in terms of operations and products.

The Macro and Industry

Over the last year, defense spending has ramped up. The geopolitical conflict that we continue to see in Europe and the talk of all the issues surrounding China and Taiwan has certainly had some effects. Defense spending as a percentage of GDP turned positive in Q2, 2022. These are inflation-adjusted numbers and therefore, some of the spending can be attributed to inflation but, nevertheless we do see a spike.

The defense business opportunities over the next 24 months approximate $223BB in awards as estimated by Jeffries, after ~$157BB of total lifetime contract value was awarded in 2022.

According to Morgan Stanley, the defense budget is set to increase dramatically over the next the next few years. But, I wouldn’t really be all that bullish. My view is that we follow the US Government Projections (the red bar) and possibly look for some upside post 2025, depending on how elections play out.

One interesting area of focus within the Aerospace and Defense Industry is “Space”. in the last 5 years, the DoD has increased their Space budget by 2-3 times going from ~$9B in FY2019 to ~$26B in FYE 2024.

The Space budget involves National Security concerns and over 70% of the budget is allocated to R&D which remains classified. The remaining is allocated towards procurement and affects the likes of Northrop Grumman (NOC), Lockheed Martin (LMT) and L3Harris (LHX).

ETFs

There are quite a few Aerospace and Defense related ETFs out there. The most popular one is but, the one we like more is

PPA is the Invesco Aerospace and Defense ETF. The reason we like this more is that the top holdings are more evenly weighted.

PPA has a fund rating of B with Assets Under Management (AUM) of $2B and trades very close to its Net Asset Value (NAV).

The ETF appears to be consolidating within a broader range, with the bottom of that range at about $76.54 and the top $82.13. This consolidation has been a trend for the better part of the last 7 months.

Should buyers come in around the lower end of this trading range it could lead to a resumption of testing the upper range, and possibly even breaking out if we can move above $82.13 on a closing basis. But for now caution is warranted as we see RSI moving lower along with price moving below this large volume shelf near the one-year point of control.

ITA is Blackrock’s iShares U.S. Aerospace & Defense ETF. While I prefer some of the names in the top 10 line up, the 20.8% weighting in Raytheon and 17.6% weighting in Boeing seems excessive to me.

ITA seems to be trying to find a bottom, exploring the bottom of this key high volume node, and at the bottom of its trading range. We need to see the ETF hold $108.60 (trading just a penny above it as of the time of this writing) and start to stage a recovery

If it does then we may have room to explore the range it has been trading within for the last 7 months. With RSI turning lower, and the price below the EMA(8) could make it prone to further weakness if it cannot hold here. So buyers really need to defend price where we’re trading.

Company Fundamentals 

As I said the companies are complex, with various product lines. But, in general, what’s important for these companies is their backlog, ability to secure new contracts and deliver.

In terms of the budget allocation, Jeffries has a great chart that shows who will benefit the most from the budget allocations.

Not surprisingly, Lockheed Martin (LMT) is the biggest beneficiary. But, LMT remains somewhat overvalued over here at 12.57x EV/EBITDA and remains above their 5-year average EV/EBITDA of 11.66x. In fact, most of the top companies remain overvalued compared to their 5-year average with the exception of General Dynamics and L3Harris.

As for sell side research, every company other than LMT has an overweight rating.

Closing Thoughts 

As the charts show, these ETFs are perhaps not ready to be bought as yet but, they are great ideas to keep on the watch list for a swing trade.

On a longer time frame however, I think these companies could also be potential buy and holds but, for that we need to look at the individual companies in more details and dig into the complexity. The stocks are also at a higher price point and therefore, it warrants a much deeper understanding of the space and the companies in particular.