What are War Babies

War babies is a name given to securities in companies that are defense contractors. These securities are called war babies because they are viewed as securities of firms that produce most of their revenues from war-time circumstances, including firms that operate in security and defense sectors. Also known as "defense stocks."

BREAKING DOWN War Babies

Aviation, aerospace and shipbuilding and munitions companies, which fall into the industrials sector, top the list of defense contractors that are considered war babies. The largest of these include Northrop Grumman, Boeing, Lockheed Martin, General Dynamics, United Technologies and Raytheon. When a war is imminent, these stocks tend to outperform the market because of the potential for increased business and national defense contracts and revenues.

War babies have outperformed the broad market over most time periods since 2006, when the largest ETF tracking the industry was created. This span has covered U.S. military engagements in Iraq and Afghanistan. Since the 2016 presidential election, defense stocks have increased their performance edge as defense spending has accelerated.

Demand is fairly constant for defense stocks as the U.S. spends more than $500 billion per year on defense. Defense spending as a percentage of U.S. GDP has spiked in past global conflicts including World War II, over 40% of GDP, and the Cold War, about 10% of GDP, and has generally averaged 3-5% of GDP. The war babies also benefit from exporting aircraft and other military gear to allies ramping up defense spending such as Saudi Arabia and Israel.

Gaining Exposure to War Babies

Due to the long-term nature of government defense contracts, defense stocks tend to be large, stable companies with low to average earnings and revenue growth rates. Due to their consistent cash flow generation, many of these stocks pay dividends.  

Investors can gain exposure to the defense industry through four sector ETFs. The largest is iShares U.S. Aerospace & Defense (ITA), which holds 39 stocks with the top six holdings – all large cap defense contractors – accounting for more than 40% of assets. SPDR S&P Aerospace & Defense (XAR) has 36 holdings but provides equal weighted exposure to the defense industry, providing greater diversification than ITA. Meanwhile, Invesco Aerospace & Defense (PPA) covers 54 defense stocks.

For investors seeking extreme exposure to the war babies, Direxion Daily Aerospace & Defense Bull 3X Shares (DFEN) is a leveraged ETF that seeks to provide three times the performance of the industry. Keep in mind that the use of leverage will distort returns over longer time periods.