On 6/9/2011 we initiated a new position in the Aerospace and Defense industry in all of our models with the exception of Dynamic Conservative. The specific security we bought was the Powershares Aerospace and Defense ETF (symbol: PPA), and the top holdings are large companies like Honeywell, United Technologies, and Boeing. This was an intra-sector trade in Industrials as we sold the broad Industrials sector to purchase PPA. There were several reasons we made the relative switch, and we wanted to share a few of them with our clients.
Industrials, as a sector, are extremely overvalued. The sector currently trades at an 11% premium to the market while price-to-book, price-to-sales, and price-to-earnings are reaching extreme measures. However, at the industry level, aerospace and defense companies are currently trading at neutral to slightly undervalued on most valuation methods. Concerns over governmental/defense budget cuts related to the current debt ceiling negotiations weighed the industry down over the last few quarters but we feel the market has priced in the potential for significant defense budget cuts. Analysts consistently revised earnings down at the end of 2010 and beginning of 2011, and have now started to revise earnings up in what we feel are a reflection of that analysis.
The trade also reduced the beta of the Industrial exposure within client portfolios. The broad Industrial sector has a beta of 1.25, which means the industrial sector should move by 1.25% for every 1% move in the S&P, on average. On the other hand, the Aerospace and Defense industry has a beta of 1. Generally speaking, the aerospace industry is viewed as a defensive industry within the overall Industrial sector. The long delivery cycles have made this industry a safer space for investors during soft patches as investors demand higher earnings visibility.
Additionally, there were was good movement in the relative strength (RS) of the industry versus the broad sector. The bottom panel of the chart below reflects the RS improvement. When the RS is moving up it reflects PPA outperforming XLI (broad industrials). Recently, the RS made a lower low which is a sign of strength marked by the black line, and broke the long downtrend from the market bottom in 2009 marked by the red line. Combined with the fundamental analysis, we felt it was a good opportunity to make this relative trade.
