CA - XAR: An Equal-Weight Defense ETF For A Dangerous World

Summary

• With Putin's horrific war on Ukraine, the allied Russia/China strategic partnership, and the recent spy balloon invasion, global military tensions are rising.
• Russia's invasion of Ukraine has been met by a unified and robust response by the U.S., NATO, and the Democratic "West."
• The result is increased spending on military-related hardware, software, and intelligence shipments to Ukraine as well as significantly increased defense spending by NATO.
• Considering U.S. defense companies dominate the West's global defense spending, a diversified fund like the SPDR S&P Aerospace & Defense ETF might be just the ticket.

Since its inception in September of 2011, the SPDR S&P Aerospace & Defense ETF ( XAR ) has ridden it modified equal-weight strategy to deliver average annual total returns of 16.1%. While the equal-weight strategy means that the XAR ETF is more heavily weighted to the relatively smaller players in the space as compared to the big companies you are more likely familiar with, investors can't argue with the long-term success it has delivered. Today, I'll take a closer look at the XAR ETF to see if it might make sense for an allocation of capital within a well-diversified portfolio.

Investment Thesis

As summarized in the bullets above, the world is becoming an increasingly more dangerous place. Russia's war on Ukraine has resulted in two countries - Sweden and Finland - who have been "neutral" for decades, finally seeing the light and joining NATO.

In December, NATO announced its budget for 2023 (emphasis added):

The civil budget is set at €370.8 million, and the military budget is set at €1.96 billion, representing a 27.8% and 25.8% increase , respectively, over 2022.

Also in December, President Biden signed the Fiscal 2023 National Defense Authorization Act into law - allocating $816.7 billion to the Defense Department. That was up 6.3% from $768.2 billion in 2022, but does not include the additional ~$50 billion in direct military assistance to Ukraine.

The point is, U.S. and its NATO allies are ramping up defense spending in order to respond to increasing militaristic threats by Russia and China. That being the case, let's take a look at the XAR ETF to see how it has positioned investors for success going forward.

Top-10 Holdings

The top-10 holdings in the XAR ETF are shown below and were taken directly from the State Street Global Advisors' XAR ETF webpage - where investors can learn more detailed information about the fund. The top-10 holding equate to what I consider to be a very well diversified 42% of the entire 33 company portfolio:

I say well diversified because, in theory at re-balancing time, the equal-weight portfolio would be allocated roughly 33/100 - or 3.3% - in each of the 33 companies. That being the case, what you see in the top-10 list above are the 10 companies that have performed the best since the last time the portfolio was reconstituted.

The #1 holding with a 4.6% weight is Spirit AeroSystems ( SPR ). Spirit - which designs and fabricates commercial and defense aerospace components and structures - is up 12.9% YTD. The company is currently burning cash but is recovering from the Boeing ( BA ) 737 disaster: in Q4, the company delivered 81 737 shipsets during the quarter - up 17% q/q and 59% yoy.

The TransDigm Group Incorporated ( TDG ) is the #2 holding with a 4.5% weight. TDG designs and produces a plethora of aircraft devices for the U.S. and global market. These include: electro-mechanical actuators, ignition systems and engine technology, specialized pumps & valves, AC/DC electric motors & generators, power controls, sensor products, as well as winches and lifting devices for cargo loading and handling systems.

Other than a dip-down due to Covid-19's negative impact on the aerospace industry, TDG has a strong track record of growing revenue and earnings. The company is expected to earn $22.30/share this year:

TDG currently trades with a forward P/E = 32.8x and has a market-cap of nearly $40 billion.

With a 4.3% weight, Boeing is the #4 holding and the stock is up nearly 9% YTD. Boeing is still recovering from the 737 MAX debacle (the stock is down 38% over the past 5-years), but is- finally - making steady progress on that front, including an expected new order for 15 737 MAX jets from Hong Kong's Great Bay Airlines. That is considered to be a major win over Airbus. Boeing is also a leading U.S. defense company (at $22.1 billion in 2021, #2 according to Bloomberg Government) and recently bagged a $1.62 billion Air Force contract.

Maxar Technologies Inc. ( MAXR ) is the #5 holding with a 4.3% weight. Maxar provides earth intelligence and space infrastructure solutions for the U.S. and its international allies. The company operates through two segments: Earth Intelligence and Space Infrastructure. Maxar offers earth imagery and geospatial advanced satellite systems to commercial and military customers. Maxar also offers analytic services for national security and commercial solutions.

As the graphic above shows, Maxar stock vaulted higher in December on a for $6.4 billion cash buyout bid by Advent International . This points out one of the advantages of an equal-weight ETF like XAR: it has relatively over-sized allocations to the smaller companies, which have historically been attractive acquisition targets in a defense sector dominated by huge companies like Lockheed ( LMT ), Boeing , Raytheon ( RTX ), and General Dynamics ( GD ).

XAR's top-10 holdings are rounded out by #10 Howmet Aerospace ( HWM ). Howmet is +17%+ over the past year. The company operates through four segments to supply the global market with: Engine Products, Fastening Systems, Engineered Structures, and Forged Wheels. Last October, Seeking Alpha reported that activist investor Elliott Management, which disclosed a 3.7% stake in Aerojet Rocketdyne in a 13-F filing, is also a large holder of Howmet. A source speculated that a potential marriage of Howmet and Aerojet Rocketdyne ( AJRD ) may make sense.

As a whole, the XAR ETF has a valuation level higher than the overall S&P500 while its yield, as expected given its relatively higher weighting in smaller companies, is less than the broad S&P500:

That being the case, the primary investment opportunity here is obviously capital appreciation - not income. The expense fee of the XAR ETF is 0.35%.

Performance

As mentioned earlier, the XAR ETF has an outstanding life-of-fund average annual return of 16.1%.

The following graphic compares the 5-year total returns of the XAR ETF with some of its competitors: the iShares Aerospace & Defense ETF ( ITA ), the Fidelity Select D&A Portfolio ( FSDAX ), and the Invesco Aerospace & Defense ETF ( PPA ):

As can be seen in the graphic, within the D&A sector, the PPA ETF has outperformed XAR by ~5.8% over the past year, but otherwise it trounced its competitors by significant margins. I added the S&P500 as represented by the Vanguard S&P500 ETF ( VOO ) to show some perspective. Clearly, the S&P500 has outperformed the D&A sector over the past 5-years, but investors should consider that this time frame includes the impact of Covid-19 which, as you know, was a very difficult time for the commercial aerospace industry.

Risks

The aerospace sector is certainly not immune from the commercial impact of higher interest rates, high inflation, relatively high energy prices, and slowing global growth. That said, strong government spending in the defense sector helps to mitigate the potential for negative commercial impact. However, currently the commercial air-travel industry is performing very well - so the sector is hitting on both cylinders right now.

Defense spending and, specifically support for Ukraine, could come under significant pressure from the Republican Party - particularly from the party's rising "star" Marjorie Taylor Greene, who appears to be a leading mouthpiece for the party. In November of last year, Greene reportedly said that Ukraine would not receive any more funding if Republicans would have taken control of Congress in the midterm elections , per the Hill . This is not surprising, considering that Greene is a big supporter of President Trump, who arguably pivoted U.S. foreign policy away from America's Democratic and NATO allies toward Putin and Russia.

Summary & Conclusion

The XAR ETF has a proven long-term strategy of delivering strong total returns for investors. The equal-weight portfolio is an excellent way to benefit from the relatively smaller companies in Defense & Aerospace that frequently become targets of takeover bids by the larger companies that dominate the sector. XAR is a BUY.

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