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XAR: Have A Blast Buying Rockets – SPDR S&P Aerospace & Defense ETF (NYSEARCA:XAR)

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Via SeekingAlpha.com

Investment Thesis

What’s second to investing in a monopoly? Investing in an oligopoly. That’s what Aerospace & Defense offers.

Even better, aerospace and defense are part of a sector we might call Things We Cannot Live Without (TWCLW), which makes for a horrible acronym but which also describes why aerospace and defense will never, ever go out of business.

The entire world needs military and defense, especially the United States. The entire world also needs things that fly, move, and all the things that make them fly, move, and sail. The primary customers for aerospace and defense are entities with unlimited ability to spend, i.e. governments. As a result of these factors, most of the sector has fortress balance sheets. Boeing (NYSE:BA) is the exception, thanks to a confluence of events and money wasted on buybacks.

3 Things You Need to Know About Rockets

There are three things you need to know about rockets, which leads to our discussion about the SPDR Aerospace & Defense ETF (XAR).

  1. Rockets are really, really, really hard to build.
  2. Companies get paid a lot of money to build rockets.
  3. If a rocket fails, it’s a catastrophe. It’s not like asking the barista to make a new latte.

We know that aerospace and defense aren’t just about rockets. However, only the companies that understand that failure is truly not an option survive in this sector.

So, to review, we have a group of stocks in a TWCLW sector, which operate as an oligopoly whose customers have infinite money to throw at them – yet, the sector sold off about 40%.

This is a perfect example of a security being mispriced in an emotional market.

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All the above reasons are also why XAR stock enjoyed a 377% total return since inception on 10/2/11 compared to the S&P’s 200% total return.

There are many individual companies to choose from in the sector, but we’ve discovered the downside by failing to diversify when it comes to Boeing. That’s why, instead of picking a single stock in the sector, why not just buy the whole darn thing? Boeing is giving even good investors a hard lesson. Nobody thought it could fall 80%, but nobody could have foreseen the drip-drip-drip of problems that slowly became a tsunami. That’s why diversifying in this sector is a good idea.

So, why go with XAR stock versus the other sector ETFs, namely, iShares U.S. Aerospace & Defense ETF (ITA) or Invesco Aerospace & Defense ETF (PPA).

There’s nothing wrong with them. It’s just a matter of how much exposure you want to Boeing. Let’s make a quick comparison (Source: Author, based on data from Seeking Alpha).

Total Return from 10/11

% Decline from Top

BA Shares Held

Exp. Ratio

XAR

377%

42%

212,000

0.35

ITA

314%

40%

2,988,000

0.42

PPA

297%

40%

217,574

0.59

Source: Author; data from Seeking Alpha

Investors who are betting on a comeback for Boeing have 14x exposure with ITA compared to XAR stock. That’s fine if it fits your risk tolerance. We prefer to shield ourselves from risk.

In regards to risk, there’s another reason we prefer XAR. Have a look at the top ten holdings (as of just prior to the collapse) for:

SPDR Aerospace & Defense ETF (courtesy of Yahoo):

ITA Top Holdings

iShares U.S. Aerospace & Defense ETF (courtesy of Yahoo):

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PPA Top Holdings

Invesco Aerospace & Defense ETF (Courtesy of Yahoo):

While XAR stock is not as large-cap concentrated, it is more equally weighted in its top ten holdings. We prefer the equal weight approach to distribute risk more evenly.

A few other things are playing in the sector’s favor.

We have a hawkish President who loves and wants to defend America, and he will likely be re-elected.

The sector is not as reliant on the general public for revenue. The government won’t need to give loans or grants to the sector because it is already their best customer.

Risks

The good news is, over the long term, there are few risks to the sector. As mentioned, the sector makes TWCLW.

It is possible that, given all the money thrown at the economy for the COVID-19 stimulus packages, that the federal government will curtail defense spending. That could create ripples throughout the sector.

It’s possible a Democrat wins the White House and they control Congress, in which case, we would expect to see curtailed military spending.

Congress might get fiscally prudent and create another “sequester” that curtails funds. Here’s a nice summary from Raytheon’s (RTN) 10-K:

In recent years, U.S. government appropriations have been affected by larger U.S. government budgetary issues and related legislation. The Budget Control Act of 2011 (BCA) established specific limits on annual appropriations for fiscal years (FY) 2012-2021, but was amended a number of times leading to fluctuations and unpredictability in annual DoD funding levels. As compared to the relevant preceding year, the DoD budget fell in FY 2013, remained essentially flat for FY 2014 and 2015, and increased each year from FY 2016 to 2020. BCA caps were raised for FY 2021 from their original level, and FY 2021 DoD funding is expected to be similar to FY 2020. Further, the DoD budget requires the agreement and action of both Congress and the President. In addition, in previous years the U.S. government has been unable to complete its budget process before the end of its fiscal year, resulting in both governmental shut-downs and Continuing Resolutions (CRs) providing only enough funds for U.S. government agencies to continue operating at prior year levels. Further, if the U.S. government debt ceiling is not raised and the national debt reaches the statutory debt ceiling, the U.S. government could default on its debts.

Because of the complexity of every part of the supply chain, if a large number of the specialized workers behind the scenes fall ill or die from the virus, that could significantly affect the sector. That is also true of the parts and components in a supply chain disruption.

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Companies must continue to develop and deliver new technologies.

Conclusion

The sector selloff has created a great opportunity in aerospace & defense stocks. We think that XAR stock provides an excellent risk-reward opportunity at these levels.

Disclosure: I am/we are long XAR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.




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