ITA: Long-Term Outlook Is Favorable But Expensive Valuation In The Near Term – iShares U.S. Aerospace & Defense ETF (BATS:ITA)

ETF Overview

The iShares U.S. Aerospace & Defense ETF (ITA) owns a portfolio of U.S. industrial stocks. The ETF basically tracks the performance of the Dow Jones U.S. Select Aerospace & Defense Index. Stocks in ITA’s portfolio are mostly large and giant-cap stocks that have competitive advantages over its smaller peers. Stocks in ITA’s portfolio should have a good growth outlook thanks to long-term air passenger traffic growth trend in the next few decades and near-term defense budget growth in many countries. However, ITA appears to be expensive if we compare its valuation to the S&P 500 Index. Therefore, we think investors should wait for a correction as this will provide a better risk/reward profile.

Data by YCharts

Fund Analysis

These are moaty companies with high barriers to entry

ITA’s portfolio of stocks are mostly large-cap or giant-cap stocks. As can be seen from the table below, 43.64% and 28.3% of ITA’s portfolio consists of giant-cap and large-cap stocks. These companies usually are in better financial position than small and mid-cap companies and have established their leading positions in the industry often with high barriers to entry. Some of the companies in ITA’s portfolio also enjoy monopoly or duopoly position in the industry. As a result, these companies should be able to protect their margins and enjoy economies of scale. These companies also have been through numerous economic cycles. Hence, ITA’s exposure to giant-cap and large-cap stocks should be beneficial.

Boeing represents over 20% of ITA’s portfolio

Concentration risk can be high for ITA as its top 5 holdings represent about 58% of its total portfolio. As can be seen from the chart below, Boeing (BA) alone represents nearly 21% of the total portfolio. This stock has not performed well in the first half of 2019 due to the grounding of its 737 MAX. While share price weakness can persist if the grounding issue continues, we think Boeing still holds competitive advantage in the passenger jets market as it is one of the two largest jet manufacturers in the world.

Source: iShares Website

Long-term outlook remains favorable in the aerospace & defense sector

We like the long-term outlook of the aerospace & defense sector that ITA is in. As can be seen from the chart below, total passenger fleets in the world are expected to double to 50,660 fleets by 2038 thanks to forecasted 4.6% compound annual growth rate of passenger traffics in the next twenty years.

Source: Boeing Commercial Market Outlook 2019-2038

This presents a big opportunity for stocks in ITA’s portfolio. As can be seen from the chart below, there is a need to meet the demand of more than 44 thousand new fleets if we include 19 thousand fleet replacements. Therefore, we expect companies in ITA’s portfolio to take advantage of this strong secular growth trend in the next decade.

Source: Boeing Commercial Market Outlook 2019-2038

In the defense subsector, defense budgets in the U.S. have been on the rise under the current Trump administration. In addition, geopolitical tensions are likely not going away any time soon. In fact, as pointed out by Deloitte’s article on the 2019 Global aerospace and defense industry outlook, NATO countries appear to be focusing on increasing defense budgets to counter potential threats from Russian and Middle East. In addition, other U.S. allies such as Japan and Taiwan are also increasing their defense budgets. Therefore, we expect this subsector to remain robust in H2 2019 and 2020.

ITA is expensive relative to the S&P 500 Index

ITA has achieved a total return of 461.2% in the past 10 years. This is significantly higher than the S&P 500 Index’s 254.5%.

Data by YCharts

However, past performance does not necessarily guarantee future performance. Because of the price appreciation of the stocks in ITA’s portfolio in the past few years, ITA’s valuation appears to be much more expensive now. As can be seen from the table below, its average forward P/E ratio of 22.71x is nearly 4.5x multiples higher than the S&P 500 Index’s 18.25x. Its price to cash flow ratio of 15.71x is also significantly higher than the S&P 500 Index’s 9.45x. We feel ITA’s premium valuation is not warranted as it has slightly lower sales and cash flow growth rates than the S&P 500 Index. As can be seen from the table, ITA’s sales growth rate of 6.28% is slightly lower than the S&P 500 Index’s 7.12%. Similarly, its cash flow growth rate of 11.59% is also lower than the S&P 500 Index’s 13.33x.

Source: Morningstar, Created by author

Investor Takeaway

We like the aerospace & defense industry that ITA focuses. The outlook appears to be great in the next decade. However, stocks in ITA’s portfolio appear to be trading at a premium valuation. Therefore, we think investors may want to wait for a correction as it will provide a more attractive risk/reward profile.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This is not financial advice and that all financial investments carry risks. Investors are expected to seek financial advice from professionals before making any investment.