ITA: probably overvalued despite recent European conflicts (BATS:ITA)

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iShares US Aerospace & Defense ETF (BATS:ITA) is an exchange-traded fund offering investors exposure to “US companies that manufacture commercial and military aircraft and other defense equipment”, with an expense ratio of 0, 42% (not cheap, but in line with similar strategic equity funds). The fund’s benchmark is the Dow Jones US Select Aerospace & Defense Index, and had assets under management of $2.64 billion as of February 25, 2022, reflecting a fairly high level of popularity. The fund is also concentrated in just 33 stocks (as of February 24, 2022).

Interestingly, despite the Russian-Ukrainian war, which notably escalated this month in February 2022 (with new Russian invasions from northern, eastern and southern Ukraine, in the latter case from the Crimea, which was annexed by Russia in 2014), ITA did not even release their pre-pandemic highs.

ITA stock price action with weekly candlesticks

TradingView.com

In all fairness, the war in Ukraine is first and foremost a European war, and although NATO countries have helped Ukraine, large-scale military support could trigger Article 5 of the NATO treaty. This is the key section of the treaty which basically says that an attack on one NATO member is an attack on all, which would risk causing a “World War III” scenario. Ukraine is not a member of NATO. NATO, however, comprises 30 countries, two of which include the United States and Canada in North America. The other 28 members are European.

Nevertheless, recent tensions should support military spending and exports. Just recently, German Chancellor Olaf Scholz announced that German defense spending would be increased to 2% of GDP. With major powers like Russia invading large populations like Ukraine (with a population of over 44 million in 2020), one can easily argue for increased defense spending and other provisions. . That is to say, particularly in Europe, but the entire global sector could see increased sales and “earnings surprises” in the coming years (hopefully mainly due to caution and preparations , and not as a result of actual wars).

In any case, funds like ITA that are directly invested in aerospace and defense could serve as a concentrated form of war-specific insurance within a portfolio. Stocks tend to bounce back after wars, ignoring conflicts in most cases. This is likely to be the case, especially with the Russian-Ukrainian war, as it is local rather than global (at least at present). But sanctions on Russia will almost certainly affect the West in other ways, for example via inflation due to reduced supply/flows of certain commodities (natural gas being one; a major export of Russia). Thus, it is conceivable that ITA may not outperform while the broader market, including ITA, could still suffer from a stagflationary scenario of higher commodity prices and weak “real growth” or zero.

Keep in mind that the market has, so far at least (until the end of February 2022) not placed big bets on ITA. Recent net flows have been positive, but only after a net outflow of funds from ITA over the past year (negative of around $422m).

Flow of ITA funds

ETFDB.com

ITA still remains popular, as previously reported, with assets under management of $2.64 billion. But that follows clean outs, so ITA is probably still a contrarian bet. The lagging dividend yield is currently around 80 basis points as well, so the weak price action in the ITA is good evidence in support of weak net fund flows, as illustrated above .

Still, the ITA could be defensive in more ways than one, with the US likely entering a late phase of its current economic cycle. If/when economic growth slows, it is likely that some government spending such as defense will remain more stable.

Q4 2021 Business Cycle Update

Fidelity.com

On the other hand, ITA is a risky catch. In March 2020, when stock prices crashed globally, the ITA’s local peak-to-trough produced a decline of just over 50%, while major US indices fell by about a third. So you can assume that the downside beta is around 1.5x in a repeated scenario, while the upside beta is obviously not that strong, since the ITA still hasn’t broken through its highs. before the pandemic.

As mentioned earlier, ITA is also concentrated, with its top 10 holdings (listed below) accounting for 76% of the portfolio as of February 24, 2022. The largest holding is Raytheon Technologies Corp. (NYSE:RTX) with a weight greater than 22%.

ITA's Top 10 Holdings

Data from iShares.com

A recent factsheet (accessible online) for ITA’s benchmark, the performance of which it essentially seeks to replicate, gives us data as of the end of January 2022 for valuation purposes. The year-over-year price-to-earnings ratio was poor at 93.86x, which does not reflect the long-term underlying earnings capacity (lack of earnings disruptions due to material factors such as the pandemic). The projected price-to-earnings ratio was 28.76x, with a price-to-book ratio of 4.34x. By dividing the latter by the former, we obtain a forecast return on equity of 15.1%, which is correct for a mature sector. However, the price to book ratio is not cheap.

Morningstar’s current estimates for earnings growth over three to five years, on normalized numbers, show earnings growth rates of 11.72%. Earnings estimates are subject to change, although they tend not to change too significantly. After the first year “bounce” (which is implied due to the low price-earnings ratio, which strongly distorts first year earnings growth), I assume that the growth between the second and fifth year in my analysis in the 12-year region of Morningstar’s % directional estimate.

To discount these profits, I use Professor Damodaran’s current estimate of 5.17% of the risk premium on mature market equities. For the risk-free rate, I will use the US 10-year which currently prevails at 1.9652%. The five-year beta calculated by Yahoo! Finance is 1.37x, which I’ll start with; I use it to scale our ERP from 5.17% up to 37%. However, as previously suggested, this can underestimate the downside beta and overestimate the upside beta, so we’ll get to that shortly.

The conclusion from all the above entries is that the ITA is likely overvalued if we assume a cost of equity of around 9.05% (by my calculations).

ITA ETF Short Term Valuation Gauge

Author’s calculations

If we reduced the beta to 1.00x, that is, if we added no risk to the equity risk premium, the valuation would still point to -27% downside potential. Additionally, if we increase our beta to at least 1.50x in line with high potential beta in a major downside scenario, ITA could offer downside potential (at current valuations) of up to -48%.

On the other hand, long-term equity risk premia are often in the 3.2-4.5% range. Damodaran’s recent ERP estimate of over 5% reflects risk aversion in the first quarter of 2022. If I reduced the equity risk premium to 3.2%, but still increased it by 1.50x, I pegged the US 10yr at 2.54% instead (in line with current 10yr inflation expectations), my adjusted cost of equity would be 7.34%. This would result in a decline, again, of around -29%.

Thus, regardless of view, ITA is overvalued and/or the market is more accurate in assessing the portfolio’s long-term earnings trajectory (being more optimistic than analysts’ estimates). Personally, I would rather not buy funds that match some sort of geopolitical momentum or theme (like increased defense spending) over valuation. I wouldn’t be bearish though, because clearly the case can be made for increased military spending. Overall, I would stay neutral on ITA. I think the meager flow of funds over the past year is probably justified.

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