Aerospace, Defense Funds Are Quietly Beating the Market in 2014

NEW YORK ( TheStreet ) -- Aerospace and defense funds have been soaring lately although you'd think no one was noticing.

During the past year, iShares Dow Jones U.S. Aerospace & Defense ETF (ITA) returned 37.4%, compared with 17.6% for the S&P 500 Index. Another exchange-traded fund that gained more than 30% was PowerShares Aerospace & Defense (ETF) (PPA). The big gains came as many companies in the sector reported surprisingly strong earnings.

Defense stocks had been under a cloud because of the spending reductions caused by the sequester that went into effect in March 2013. But the Washington cutbacks did less damage than many Wall Street analysts expected.

Worried about declining sales, defense contractors prepared for the sequester by laying off employees and cutting costs sharply. In addition, foreign sales remained strong. As a result, profit margins proved resilient.

Can the sector continue climbing? Yes. Even if defense spending shrinks in coming years, some businesses seem likely to grow. Sales abroad should climb as countries such as Japan and Korea increase their defense budgets. The industry should also enjoy growing demand from civilian airlines. As the global economy expands, more people are flying.

According to the International Air Transport Association, global airline traffic increased 5.2% in 2013. That growth should continue at a 5% rate in coming years. The gains should be even stronger in the emerging markets of Asia and Latin America. The positive outlook is causing many airlines to increase their orders for new planes.

"Orders are at historic highs as many airlines are expanding or replacing aging fleets," says David Mazza, head of ETF investment strategy for SPDR ETFs.

The strong demand is boosting Boeing (BA), which is a big holding in all the defense and aerospace ETFs. The company's revenue increased 8% in the first quarter, while earnings gained 14%.

Boeing's performance should remain robust for years. The company has a backlog of $440 billion worth of orders. The fuel-efficient 737 plane is proving especially popular and has recorded 2,000 orders.

Strong sales from Boeing will help a host of parts suppliers, says Tobias Welo, a portfolio manager at Fidelity Investments.

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