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Aerospace & Defense is more important than it’s been in years, and this ETF stands to benefit

People are talking about how many countries might be involved in the recent major global conflict between Russia and Ukraine. Defense spending has increased significantly during the Biden administration as a precaution, which is excellent news for the aerospace and defense (A&D) industry. Investors seek to invest in the aerospace and defense sector to capitalize on this development. In today’s FA Alpha, we’ll look at Invesco Aerospace & Defense ETF (ARCA:PPA), a popular ETF for the industry, from a Uniform Accounting perspective.

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The Russia-Ukraine war is among the most prominent global conflicts in recent history. It has sparked debate about how many countries might end up getting involved. There’s even talk about this escalating into a full-on world war.

Thankfully, this possibility seems not likely to happen for now but taking the necessary precautions is always important for the country’s safety.

As a country that spends a huge amount of money on security purposes, the U.S. is taking these precautions beforehand by increasing its defense budget.

U.S. House of Representatives passed a bill in July, which paved the way for a record-breaking defense budget of over $800 billion.

Under the Biden administration, defense spending has seriously increased and this is excellent news for the aerospace and defense (A&D) industry.

The aerospace and defense industry is the one making various aircraft, ships, spacecraft, weapon systems, and defense equipment that helps protect the U.S. and its allies.

As the industry awaits record-breaking government spending in the next year, companies are positioning themselves to better benefit from this opportunity.

On the other hand, investors are looking for ways to be exposed to the aerospace and defense industry, to ride the wave of this significant tailwind.

One of the most popular ways to be exposed to the industry is the Invesco Aerospace & Defense ETF (ARCA:PPA).

The ETF tries to capture the whole A&D industry.

Let’s have a look at the Invesco Aerospace & Defense ETF using Uniform Accounting to see how the industry is performing.

Economic productivity is massively misunderstood on Wall Street. This is reflected by the 130+ distortions in the Generally Accepted Accounting Principles (GAAP) that make as-reported results poor representations of real economic productivity.

These distortions include the poor capitalization of R&D, the use of goodwill and intangibles to inflate a company’s asset base, a poor understanding of one-off expense line items, as well as flawed acquisition accounting.

It’s no surprise that once many of these distortions are accounted for, it becomes apparent which companies are in real robust profitability and which may not be as strong of an investment.

See for yourself below.

Using as-reported accounting, investors would think the aerospace and defense industry is unprofitable.

On an as-reported basis, many of these companies are weak performers. The average as-reported ROA for the top 15 holdings is 5%, which is below the U.S. corporate average of 12%, and below cost of capital levels around 6%. This implies that the defense contractors aren’t able to make a profit. Its customers are mostly governments, so this makes it seem like governments aren’t willing to reward A&D contractors.

Once we make Uniform Accounting adjustments to accurately calculate earning power, we can see that most companies in Invesco Aerospace & Defense ETF are stronger than investors might think.

As the distortions from as-reported accounting are removed, we see that TransDigm Group (TDG) doesn’t have 6% returns. It actually has a 55% Uniform ROA.

Similarly, Booz Allen Hamilton Holding’s (BAH) Uniform ROA is 42%, not the 8% figure as-reported metrics would suggest.

To find companies that can deliver alpha beyond the market, just finding companies where as-reported metrics misrepresent a company’s real profitability is insufficient.

To really generate alpha, any investor also needs to identify where the market is significantly undervaluing the company’s potential.

These dislocations demonstrate that most of these firms are in a different financial position than GAAP may make their books appear. But there is another crucial step in the search for alpha. Investors need to also find companies that are performing better than their valuations imply.

Valens has built a systematic process called Embedded Expectations Analysis to help investors get a sense of the future performance already baked into a company’s current stock price. Take a look:

This chart shows four interesting data points:

  • The average Uniform ROA among Invesco Aerospace & Defense ETF’s top 15 holdings is actually 18%. That’s higher than the corporate average.
  • The analyst-expected Uniform ROA represents what ROA is forecasted to do over the next two years. To get the ROA value, we take consensus Wall Street estimates and convert them to the Uniform Accounting framework.
  • The market-implied Uniform ROA is what the market thinks Uniform ROA is going to be in the three years following the analyst expectations, which for most companies here are 2023, 2024, and 2025. Here, we show the sort of economic productivity a company needs to achieve to justify its current stock price.
  • The Uniform P/E is our measure of how expensive a company is relative to its Uniform earnings. For reference, the average Uniform P/E across the investing universe is roughly 20x.

Embedded Expectations Analysis of Invesco Aerospace & Defense ETF paints a clear picture. Over the next few years, Wall Street analysts expect the companies in the ETF to slightly improve in profitability, and the market expects similar improvements.

Analysts forecast the portfolio holdings on average to see Uniform ROA rise to 20% over the next two years, while the market is pricing to see returns increase to 22%.

For instance, Raytheon Technologies (RTX) currently has a 13% Uniform ROA. Wall Street analysts think that Raytheon’s profitability could improve to 16%. However, the market already gets it. Embedded expectations highlights that the market also expects Uniform ROA to reach 14%.

Howmet Aerospace (HWM) is another good example. Its Uniform ROA was 12% in 2021. This year though, analysts expect Uniform ROA to rise to 17% but the market seems to be expecting much better performance from the company with the market-implied Uniform ROA sitting at 28%.

Overall, the portfolio consists of high-quality names which are known for their historical success and names that can benefit from record-breaking defense spending. However, before making any investment decision, investors should be careful about the valuation and analyze them accordingly.

This just goes to show the importance of valuation in the investing process. Finding a company with strong profitability and growth is only half of the process. The other, just as important part, is attaching reasonable valuations to the companies and understanding which have upside which has not been fully priced into their current prices.

To see a list of companies that have great performance and stability also at attractive valuations, the Valens Conviction Long Idea List is the place to look. The conviction list is powered by the Valens database, which offers access to full Uniform Accounting metrics for thousands of companies.

Click here to get access.

Read on to see a detailed tearsheet of one of Invesco Aerospace & Defense ETF’s largest holdings.

SUMMARY and Northrop Grumman Corporation Tearsheet

As one of Invesco Aerospace & Defense ETF’s largest individual stock holdings, we’re highlighting Northrop Grumman Corporation’s (NOC:USA) tearsheet today.

As the Uniform Accounting tearsheet for Northrop Grumman Corporation highlights, its Uniform P/E trades at 27.4x, which is above the global corporate average of 18.9x, and its historical average of 23.5x.

Average P/Es require average EPS growth to sustain them. That said, in the case of Northrop Grumman Corporation, the company has recently shown -3% Uniform EPS growth.

Wall Street analysts provide stock and valuation recommendations that, in general, provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.

We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Northrop Grumman Corporation’s Wall Street analyst-driven forecast is for EPS to shrink by 0% and grow 5% in 2022 and 2023, respectively.

Furthermore, the company’s return on assets was 11% in 2021, which is above the long-run corporate averages. Also, cash flows and cash on hand consistently exceed its total obligations—including debt maturities and CAPEX maintenance. Moreover, its intrinsic credit risk is 90bps above the risk-free rate. Together, these signal low credit risks.

Lastly, Northrop Grumman Corporation’s Uniform earnings growth is below peer averages, and above peer valuations.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

This portfolio analysis highlights the same insights we share with our FA Alpha Members. To find out more, visit our website.

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