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Tracking The Defense Sector
By Scott Sacknoff


Illustration By Barton Stabler

The crafting of an investment strategy is a delicate balance between choosing opportunities that lead to the growth of a portfolio while hedging against risk, whether associated with interest rate changes, inflation, business philosophy, consumer confidence, industrial output or changing world and political conditions.

From a market and business continuity standpoint, there is no greater element of risk than that due to war or terrorist action; these typically are difficult to predict far in advance, and their consequences can be severe. Political and world stability have long been considered as a standard assumption when evaluating the prospect for growth within markets or nations. So, it is surprising that the availability of financial products focused on companies involved with defense and homeland security has largely been neglected.

 
With annual sector revenues in excess of $500 billion a year and a constant media focus on the subject since 9/11 (as this article is being written, the terror alert for financial institutions in the New York area and Washington , D.C. , has just been raised to Orange ), the defense sector represents one of the most important parts of the U.S. economy. Yet until the launch on July 6, 2004 , of the SPADE™ Defense Index on the American Stock Exchange (symbol: DXS), there has been no fund-friendly benchmark enabling financial institutions to launch index-based products. As we will highlight later, when considering the historically solid performance of the sector over the last several years, combined with a negative or limited correlation with much of the market, it is surprising that there has not been more focus on the sector from an investment standpoint.

In this article, we examine whether there is a need for products based on the defense sector; where it fits in with sector strategies; and whether it should be a core element of a portfolio. Throughout, we highlight the considerations that went into crafting a fund-friendly index.

 

Market Snapshot

For those unfamiliar with the sector, companies involved in the defense sector represent some of the most well known blue chip manufacturers. Lockheed Martin, Northrop Grumman, General Dynamics, Raytheon and Boeing are all household names and members of the S&P 500. While these 'prime contractors' are known for their manufacturing capabilities in developing aircraft, ships, submarines and missiles, there are a number of large-, mid- and small-cap firms that have a significant involvement in the sector whose names and activities are largely unknown. From equipment for soldiers to communications systems to the development of a network to monitor an integrated battlefield, each year the U.S. Department of Defense spends in excess of $400 billion to purchase equipment, perform R&D and operate the military. On top of this amount, the U.S. government has budgeted an additional $50-plus billion to homeland security efforts, and the companies leverage their skill base to attract still another $40 billion from civil and commercial endeavors. Combined, the component firms that represent the SPADE(TM) Defense Index have a market capitalization in excess of $300 billion, with nearly a quarter offering dividends and almost all of them routinely profitable .



12/30/97 through 6/9/04

Defense In The Broader Marketplace

Some may look towards defense index-based products as a hedge, to reduce the overall risk to their portfolio should the market decline due to a terrorist action or war. The sector also presents some interesting characteristics, however, for professionals interested in crafting a long-term, balanced sector portfolio and for those dealing with short-term sector-rotation.

The results of a blind backtest performed on the SPADE(TM) Index from December 30, 1997, to June 9, 2004, are presented in Table B. (In a blind backtest, the historical additions/subtractions are applied to the existing rules without knowledge of the final performance. This produces a more accurate result than backtests where the methodology is tweaked to identify the ideal performance.)

As indicated in the table, the SPADE(TM) Index outperformed both the S&P 500 and the S&P Super Composite Aerospace/Defense in each of the comparative timeframes. On a year-by-year basis the SPADE(TM) tended to outperform the broader market during recent declines and rose, though not as much as the NASDAQ, during positive market years.

Perhaps more important to those investing in sectors is the lack of correlation between the performance of the SPADE(TM) and that of the broader market, and the sector indexes employed by S&P 1500 in their SuperComposite. 


Nov 00 - Nov 03

Is There A Need For A New Benchmark?

Undoubtedly, if you're still reading this the question you've asked yourself is, aren't there indexes that cover the defense sector? The answer is yes. The most widely known are the equal-dollar defense indexes created by the American Stock Exchange and the Philadelphia Stock Exchange, which track between 15 and 17 companies and were created for the purpose of trading options. The S&P, as part of its S& P1500 SuperComposite, tracks a number of subindexes, including aerospace/defense, which comprise only a handful of firms. None of these three have managers who actively monitor the sector or employ a set of rules and methodology that make them friendly to managers of investment products.

When the ISBC first approached the American Stock Exchange regarding the creation of a new index to benchmark the sector, we did so with the creation of financial products in mind. It was our goal to develop rules that led to an index offering a diversified, balanced portfolio that would benefit long-term investors in the sector while providing short-term and hedging opportunities.

The first step was establishing rules that would make a fund RIC-compliant by choosing stocks with sufficient trading volume and market capitalization, and expanding the universe of companies to ensure that no company (or group of companies) could dominate the index, while employing a modified-capitalization methodology. The rebalancing timeframe was chosen to be quarterly to limit trading turnover. Possibly unique to the SPADE(TM) was the inclusion of a rule requiring $10 million in quarterly revenues. While not substantial, this simple rule in an index would have eliminated a number of companies from consideration (mostly nondefense), in particular those that went public during the NASDAQ bubble and are no longer with us today.

Most importantly, the rules were designed to keep its inherent subjectivity to a minimum. In a criteria-based index the computer outputs a list of companies that meet a rule, such as all firms with a P/E less than ten. The manager of a criteria-based index has no ability to influence the inclusion or exclusion of specific firms. In a sector-based index, there will always be an element of subjectivity in determining the universe of stocks as companies are evaluated to determine if their business activity meets the defined criteria. In the case of the SPADE(TM) Index, decisions regarding whether a firm plays an important role in the industry are the role of the manager; all firms must still meet the criteria set forth in the rules.

As an example, with respect to homeland security, the question becomes whether a firm is involved in national security or is primarily involved on the local level. With thousands of firms promoting their products as having homeland security applications, many of them biotech firms, determining the universe of stocks involved in a sector is something that comes from years of experience and requires constant monitoring of the sector.

Lastly, a comparison with the defense indexes offered by PSX, AMEX and S&P1500 SuperComposite Aerospace/Defense SubIndex reveals that their composition does not reflect the defense sector as a whole, and ignores companies involved with major defense initiatives such as unmanned aerial vehicles (UAVs), battlefield simulation and information technology, communications and satellite systems.

Overall, the rules that were established to govern the SPADE(TM) would have kept turnover between 12.2% and 18.6% from 2000 through 2003. 



CONCLUSION

The next five years looks much like the past five, with the primary risk to the financial performance of defense companies being political forces and world stability. Considering the current global state of affairs, dramatic changes by the White House or Congress to the budget allocated for defense and homeland security would be politically unacceptable.

Historically the defense sector has produced solid returns, and in the past few years with limited correlation to the broader market and other economic sectors. Whether the investment goal is to reduce the overall risk to a portfolio due to external global events, or to craft a more diversified and balanced portfolio, it seems that the inclusion of index-based products based on the defense sector index should be a core element of an investment strategy.
 

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