Written by Tony Dong, MSc, CETF® at The Motley Fool Canada
Part of being a thoughtful investor is revisiting past investment theses in light of new developments and adjusting accordingly. Only meme-stock bagholders blindly buy and hold individual companies regardless of what’s happening in the market.
With that in mind, I’m rethinking my stance on the iShares U.S. Aerospace & Defense Index ETF (TSX:XAD). Back on May 16, I recommended XAD, and it has performed well since, appreciating 22.3% as of December 12.
However, I’m no longer bullish on XAD – or, by extension, the major U.S. defence contractors it holds. Here’s why this sector isn’t a “buy” for me anymore.
As of December 11, the stocks in XAD are trading at an average price-to-earnings (P/E) ratio of 31.7. That’s significantly higher than the 24.4 P/E of the S&P 500 industrial sector and even the broader S&P 500, which trades at a 24.8 P/E.
By taking the inverse of these P/E ratios, we calculate the earnings yield – a simple “first look” metric that shows how much return you’re getting per dollar invested.
The earnings yield for XAD is just 3.2%, compared to 4.1% for the S&P 500 industrial sector and 4% for the entire S&P 500. Meanwhile, the 10-year Treasury yield, as of December 12, sits at 4.3%.
This comparison matters because it highlights a fundamental issue: the return on defence stocks, based on their earnings, isn’t even competitive with what you can earn from risk-free Treasurys. They offer no margin of safety from a valuation perspective.
Simply put, the earnings yield doesn’t justify buying unless you’re confident that defence stocks will grow their earnings significantly faster than the broader market – a bet I’m no longer comfortable making.
I’m not saying these stocks won’t rise further – momentum could carry them higher – but for value-conscious investors, XAD no longer looks like a good deal.
Defence stocks thrive on geopolitical volatility, but this can be a double-edged sword. The Ukraine-Russia war, the Israel-Palestine conflict, and ongoing Middle Eastern tensions have all contributed to highs for XAD.
However, the domestic political climate in the U.S. presents an increasingly fraught situation for defence contractors. A glaring example is President-elect Donald Trump’s recent conversation with Lockheed Martin (NYSE:LMT) CEO Jim Taiclet about potentially cancelling the $1 trillion F-35 contract.
Even if this doesn’t come to fruition, the mere mention introduces significant volatility as investors price in the possibility of losing such a massive deal. For defence contractors, the backlog is everything – losing a cornerstone program like the F-35 would be devastating.
