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In the councils of government, we must guard against the acquisition of unwarranted influence, whether sought or unsought, by the military-industrial complex. The potential for the disastrous rise of misplaced power exists and will persist.”
-President Dwight D. Eisenhower (from his Farewell Address)
Introduction
The Invesco Aerospace and Defense ETF (NYSEARCA:PPA) (the “Fund”) is an exchange traded fund (“ETF“) that provides exposure to companies operating across the aerospace and defense (“A&D“) industries (collectively, the “Industry“).
I am bullish on the Fund for a number of reasons.
For one, according to a recent Deloitte Report concerning the Industry (the “Report“):
[Eighty-eight] 88% of surveyed senior executives indicated that they believe the general business outlook for the [I]ndustry for the next year is “somewhat to very positive.” There are more reasons for this optimistic outlook. These include growth in new technologies and segments…, evolving business models in areas such as space, and the use of digital thread and smart factories. All these factors should help the [I]ndustry grow and create new markets in the coming year.
Second, the federal defense budget for fiscal year 2023 has increased materially (8%). With the US fighting proxy wars against Russia and China, high levels of defense spending appear designed to send a message to our possible enemies. In what is likely a new cold war of sorts, I do not expect high levels of defense spending to end any time soon.
Finally, the Industry tends to be “recession proof”. In this regard, with the Fund showing positive returns in 2022 compared to the S&P 500 losing close to 20%, it appears that the equity markets are not pricing in a recession for the Industry (even if it is doing so for the market in general).
For these and other reasons, I reiterate that I am bullish on the Fund and A&D companies in general.
Fund Background
Per its website, in normal conditions, the Fund invests at least 90% of its assets in the companies compromising the Fund’s underlying index, known as the SPADE™ Defense Index (the “Index“). The Index is composed of common stocks of companies that are critical to the Industry, including companies that are (according to the Fund’s website):
involved with the development, manufacture, operation and support of U.S. defense, military, national/homeland security, and government space operations.”
The Index uses size, liquidity, and revenue screens in selecting the constituent companies. The Fund’s portfolio of such companies are weighted by market-cap, subject to a 10% cap on the weight of any individual holding.
The Industry in 2022 and 2023
2022
The Industry remained stable through 2022 and has been buttressed by the Russian invasion of Ukraine, which has had the effect of increasing defense budgets for military equipment globally. As alluded to above, the US defense budget for FY2023 emphasizes perceived strategic threats from China and Russia. In light of the foregoing, the Fund was up approximate 10% in 2022 (9.80% to be exact).
According to the Deloitte Report (linked above), and in light of the backdrop of the Ukraine War:
European nations are modernizing armed forces with a planned increased budget to address rising geopolitical tensions. These nations have announced an increase of about $204 billion in the defense budget in the first three months of the invasion focusing primarily on future military technologies.”
Of course, such modernizing of armed forces should be supportive of the Industry and the Fund.
2023
Ongoing supply chain disruptions and talent shortages may pose challenges for the Industry in 2023. Meeting environmental mandates is also a challenge. The Industry is investing a lot of capital to meet these challenges, however.
For example, to reduce the risks associated with rising or volatile jet fuel prices and decarbonization mandates, aircraft manufacturers (e.g., Boeing (BA), Lockheed Martin (LMT), etc.) are expected to be investing in more fuel-efficient designs and otherwise exploring lower-and-zero-emission commercial aircraft for the future. In addition, A&D companies will increasingly leverage smart factory technologies to streamline the design and development of products and achieve improved efficiencies. Because of COVID-19, workforce shortages and the Russian/Ukraine war, 2023 should see increasingly more resilient supply chains, including more onshoring and automation.
In sum, the Industry will require a lot of investment in 2023 and beyond and, as such, the future looks bright for the Fund’s portfolio of blue chip companies.
Portfolio
The Fund consists of more than 50 holdings and the top 10 according to its website (on January 9th) are included below. What jumps out, of course, is that such holdings are established blue chips.
|
TICKER |
COMPANY |
% OF FUND |
|---|---|---|
| (BA) | Boeing Co/The | 7.54 |
| (RTX) | Raytheon Technologies Corp | 7.08 |
| (LMT) | Lockheed Martin Corp | 6.67 |
| (NOC) | Northrop Grumman Corp | 6.52 |
| (GD) | General Dynamics Corp | 6.42 |
| (HON) | Honeywell International Inc | 5.74 |
| (LHX) | L3Harris Technologies Inc | 4.56 |
| (GE) | General Electric Co | 3.54 |
| (AXON) | Axon Enterprise Inc | 3.19 |
| (TDG) | TransDigm Group Inc | 3.04 |
Fund Basics
TICKER: PPA (NYSE)
CUSIP: 46137V100
EXPENSE RATIO: 0.58%
NUMBER OF HOLDINGS: 56
AUM: $1.7 BILLION+
REBALANCING: Quarterly
INCEPTION: 10/26/2005
Risks
The principal risks of investing in the Fund are outlined in the Fund’s prospectus. Notable risks for 2023 include supply chain disruptions, talent shortages, and inflation, among others. Increased costs due to the foregoing factors could materially reduce the operating margins of the Fund’s holdings.
In addition, over the longer term, one has to wonder whether Congress will be forced to slow spending on the Industry, which is currently at astronomical levels and growing. Moreover, the costs incurred (and to be incurred) by the Fund’s portfolio companies to meet decarbonization mandates will likely be material.
Finally, disruptive private companies like SpaceX could pose a competitive threat to a number of portfolio companies.
Concluding Thoughts
The Fund has performed well in 2022 and that outperformance is likely to continue over the longer term as the macro backdrop (war and proxy war, increased defense spending, green investment, automation, etc.) is supportive of future gains.
Currently, I have no exposure to the fund but am looking to opportunistically add exposure in 2023 [See my 2023 Forecast for my current portfolio allocations].
The Fund has been around for more than a decade, has been able to accumulate material assets under management (more than $1.7 billion) and has satisfactory liquidity.
While I would look for a pullback before adding capital, I am bullish on the Fund and the Industry in general over the next couple of years.
Do your own due diligence!
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