(02/07/14) Aerospace and Defense

The aerospace and defense industry performed much better than the broader market in 2013. Here, we examine the continued appeal of defense and aerospace, thanks to robust sales, plus an average valuation on par with the overall market, explains Mark Salzinger, editor of The Investor's ETF Report.

This industry's two largest ETFs—iShares Aerospace and Defense (ITA) and PowerShares Aerospace and Defense (PPA)—gained more than 50% last year.

Boeing (BA) is the Number Two holding in ITA and PPA; commercial aerospace demand has been especially strong. Recent 12-month averages of aircraft orders have reached levels not seen since 2007.

While defense spending is set to decline, the decrease is not as severe as originally projected. After $37 billion in cuts to the US defense budget for the fiscal year that ended in September 2013, the newest fiscal year is slated to see another $30 billion in cuts, which is about $22 billion less than military services had anticipated.

However, major defense contractors gained strongly in 2013, as their performance shows continued profitability, thanks to cost cutting and continued spending on favored military programs.

Defense contractors also tend to be more resilient than in the past. Years of consolidation have narrowed competition and given larger companies diverse operations: Lockheed Martin (LMT), for example, is not only one of the largest aerospace contractors to the US military, but the Number One information-technology provider to the entire US government.

Foreign sales are another source of revenue. Even though US defense spending is waning, America's allies in Asia are increasing their expenditures in parallel with higher defense spending in China. The Japanese military wants to spend an addition $50 billion, and South Korea plans to spend an extra $7 billion.

From among these two ETFs, we favor ITA. It has been a stronger performer than PPA over the past five years, with an annualized return of 22.4%, versus 18.8%. Its expense ratio is lower (0.46%, versus 0.66%), and it has more in assets (about $293 million, versus $92 million).

ITA holds about 40 stocks, the top ten of which account for more than 55% of the portfolio. No single stock recently accounted for more than 10%.

Boeing gets about 60% of its business from commercial aerospace and 40% from defense. United Technologies (UTX), ITA's Number One holding, generates only about half its revenue from aerospace businesses; the rest comes from a variety of industrial operations, including elevator and climate systems.

ITA's average price/earnings ratio on forward earnings of 17.7 is only slightly higher than that of the S&P 500 Index (SPX), (16.6). Earnings growth expectations for ITA's companies are also slightly higher than those of the broader market (10.3%, versus 9.8%, respectively).

So, while aerospace and defense stocks are no obvious bargain, neither are they especially pricey, relative to earnings, growth, or the broader market, despite strong recent performance.