ITA: Boeing Allocation Dims Outlook For This Defense ETF (BATS:ITA)

Investment Thesis

As global geopolitical tensions remain elevated, military spending has started a meaningful uptick. A slew of conflicts witnessed since late 2020, starting from the east-Caucasus regions to eastern Europe and lately seen in the Middle East, have put sovereign entities across the world on guard. These tensions have also spilled out onto global shipping routes and trade regions.

This research note will illustrate how global military spending is increasing and how defense stocks stand to benefit from the uptick. As can be seen below, some prominent ETFs that offer exposure to Defense stocks performed at par with the S&P 500 Index.

The iShares U.S. Aerospace & Defense ETF (BATS:ITA) is one such ETF in the list of leading ETFs that offer exposure to the defense sector. However, due to the fund’s exposure to Boeing, I am not convinced ITA would be the best ETF to gain exposure to Defense leading me to rate this ETF as a Hold.

About the ITA fund

The iShares US Aerospace & Defense ETF is managed by iShares, the ETF specialist of global asset management firm Blackrock. The ETF is designed to track the performance of the DOW JONES U.S. SELECT AEROSPACE & DEFENSE index which measures the performance of companies that manufacture, assemble and distribute aircraft and aircraft parts primarily used in commercial or private air transport. In addition, the index also measures the performance of companies that produce components and equipment for the defense industry, including military aircraft, radar equipment and weapons. This index is re-balanced once a quarter. By tracking the index, the ITA fund’s goal is twofold:

• To invest in companies that manufacture commercial and military aircraft as well as other defense equipment.

• To provide investors with targeted access to domestic aerospace and defense stocks that are listed on the broad stock market Dow Jones U.S. Index and are classified in the DJICS Aerospace and Defense subsectors.

I have added a chart below that shows the Top 15 Holdings vs. the Constitution of ITA’s Funds by categories.

Peer Comparison

Here is how ITA compares with some of its peers. The list below is ordered by largest-to-smallest fund in terms of Assets Managed.

With an expense of 0.4%, it is relatively cheap to invest in ITA, especially if I account for the dividend yield that is higher than its peers. Also, ITA is the largest ETF among its peers to provide exposure to the Aerospace and Defense sectors. With approximately half a million shares exchanging hands on a daily basis, this also makes ITA the largest traded defense-focused ETF as compared to its peers, but it still is not as large as other ETF themes that focus on other sectors such as technology or consumer discretionary.

ITA also has a large portion of its assets allocated to the Top 15 stocks, specifically Boeing (BA) and RTX Corp. (RTX), as can be seen below as I compare and contrast ITA’s fund composition versus that of the Invesco Aerospace & Defense ETF (PPA) and SPDR S&P Aerospace & Defense ETF (XAR).

In my opinion, the fund composition has been a standout factor over the years as ITA gets outperformed by its peers, XAR and PPA. Specifically, for ITA, I do not think Boeing should hold such a large weight, especially because its revenue from Defense accounts for just over a third of its overall revenue. On top of that, Boeing has been plagued with fundamental issues in its airplanes, leading to Boeing’s CEO’s resignation this week. I believe these structural issues could weigh down on Boeing, which eventually creates headwinds for the ITA ETF due to the large exposure of the fund’s assets to Boeing’s stock. Plus, RTX also appeared to have engine issues last year. ITA’s combined exposure towards Boeing and RTX, as shown in an earlier chart, stands at over 31%.

ITA has also seen large outflows from the fund, which contrasts with the inflows seen by its other two peers, as can be seen in the chart below.

Macro Outlook

As I started off this post, I mentioned how the outlook for the defense sector looks bright as global demand picks up. SIPRI (Stockholm International Peace Research Institute) reported last week how European arms imports have almost doubled, with the USA and France being the biggest beneficiaries. The report also showed how the USA’s exports of defense equipment increased by a massive 17% in the years after the pandemic compared to before the pandemic. Forecasts suggest defense spending in the U.S. will now increase at a compounded growth rate of over 2% after defense outlays suddenly expanded by 19% in 2023. This may not seem like much, but the same forecast shows spending increased during the 2000-2010 period of geopolitical instability.

With defense outlays on the rise again, as I noted in the forecasts above, companies in the defense sector stand to improve from the increased budget allocation towards military equipment, ammunition, and defense machinery, which is where companies in the ITA, XAR, and PPA funds stand to benefit. To observe the momentum in the macro outlook, I will be monitoring the budget reports of major countries, including the U.S., as well as the biannual reports on defense spending from SIPRI.

In terms of valuation, however, I believe ITA may be fully valued given that the underlying index it tracks trades at a forward multiple of 27x earnings. This is higher than the S&P 500’s forward PE of ~21, which by its own standards is also high given that the S&P 500’s 5-year average is 19 and the 10-year average is 17.7. The valuation multiples for ITA are also not appealing enough in my opinion which is why I think a HOLD rating is warranted at this time.

Risks and other factors to consider

Personally, I would prefer if the world had fewer geopolitical conflicts, but the spate of such occurrences has led countries to shore up their defense equipment. If the conflicts subside and sovereign entities do not see the need to add to their defense equipment, it would cause slowdowns in the revenue of the companies in the ITA ETF.

In addition, 2024 is an election year, and most defense stocks are politically called out during election campaigns, which may cause some instability in the market caps of these stocks represented in the ITA.

Conclusion

The ITA ETF has an interesting value proposition by offering investors exposure to the aerospace and defense sectors, but the current nature of its fund composition, which is largely skewed towards some large names like Boeing, may cause headwinds in the performance of the ETF. While the outlook of the defense sector looks appealing at the moment, ITA does not seem like the best candidate to gain exposure to this sector warranting a Hold.