Two 2-Sigma Observations You Can’t Afford to Ignore

Now in my 13th year as an aerospace analyst, this is my first ever sector launch. Years ago my apprenticeship turned into an inheritance so this is uncharted territory. To make the most of being an independent analyst my aim is to do only work that matters to your process and to dispense with the commoditized nonsense. This is the first crack at delivering on that promise.

There are two big takeaways in this report that you shouldn’t miss and both are two-sigma observations:

  • First, we are initiating Defense at Neutral. Defense stocks are already pricing in scary geopolitical events in a meaningful way. Relative valuations on a clean basis are 2.3 standard deviations above the mean, 5% higher than the aftermath of 9/11.
  • There are no bears, fund flows into defense ETFs are staggering, and fundamentals (growth/margin) aren’t all that compelling vs prior upturns or other industrial upcycles.
  • Defense stocks are being assigned a high value on their risk-adjusted fundamentals, as well as an implicit call option value for geopolitical risks.
  • Record low volatility suggests that this implicit option value is already incredibly high. However, geopolitical risk is likely here to stay, hence our Neutral rating.
  • Second, we are initiating Commercial Aero at Positive. Cycle debates in aerospace are meaningless right now – demand growth is great and its correlation to GDP growth has been strengthening for over a decade. Stopping this trend seems extremely difficult.
  • More importantly, BA/AIR margins are set to benefit from a once-in-fifty-year mix shift, enabled by foregoing clean sheet designs 5 years ago. The math behind this is simpler than you think.
  • The results are just now hitting the P&L and they should pull OEM margins 2.2 standard deviations above the 50 yr avg in the 2020s.
  • The bad news is that it’s suppliers who are often paying for it.

Our new rating system uses a two-year horizon (and targets) to limit the impact of noise on our investment theses and five rating tiers to help give some color around position sizing in addition to directional bias.

  • Our Buy-Accumulate rated names include: BAH, GD, BA, and TDG.
  • Overweights include: NOC, HRS, AIR, SPR, & WAIR.
  • At Neutral, we include: RTN, LLL, LMT, HII, ARNC, TXT, and UTX, along with announced acquisitions OA and COL.
  • At Underweight is AJRD, which looks ahead of itself short-term.