Investment Trends With...
Mr. Scott Sacknoff
President
The Spade Defense Index

SecurityStockWatch.com: What is the mission of the SPADE Defense Index® ?

Scott Sacknoff : The SPADE Defense Index® was developed by our organization, the ISBC, with the assistance of the American Stock Exchange in order to produce a financial benchmark for investors and analysts interested in the defense, homeland security, and space marketplaces. Via comparison with this benchmark, one can track the performance of their investments with the returns that would have been generated by duplicating a passive index focused on the sector.

Before we get into the basics of the Index, let me just say a few words about where it came from. In the late 1990s, as President of the International Space Business Council, I was invited to a number of meetings in Wall Street so that an analyst not affiliated with the financial sector was available to answer questions. It should be noted that I’ve now worked in various capacities in the defense, homeland security, and space sector for about fifteen years and have been analyzing aspects of it for more than a decade. As part of our efforts on promoting the sector to financiers, we looked into how the sector was perceived and their thoughts on it. One of the first things we did was to try and find an index that matched the broader scope of activities performed by the defense sector of today. We were disappointed to learn that there really was no widely accepted benchmark.

In June of 2004, we launched the SPADE Defense Index (AMEX: DXS). Charts and data are available on most financial websites. Keep in mind that some websites, such as Yahoo!Finance require a special symbol to signify it is an index (eg. ^DXS).


SecurityStockWatch.com: You referred to the Index as a financial benchmark, what do you mean by that?

Scott Sacknoff : Your readers should keep in mind that there is a difference between a financial stock index and an informational one. In simple terms, anyone can add up any number of stock prices or market capitalization, divide by the number of companies and say, ‘here is an index’.

For index-based financial products such as mutual funds and exchange traded funds, or derivatives such as options, there are guidelines (legal, financial, and operational) that would make investing in an informational index less than desirable. This, for example, is why micro-cap stocks are normally not included in an index because individual purchases can influence their price.

The SPADE Defense Index was designed to be fund-friendly, namely that its rules and calculation methodology were set up with the creation of financial products in mind.


SecurityStockWatch.com: Are there any other security related indexes or funds that you’re aware of?

Scott Sacknoff : Considering that the defense, homeland security, and space marketplace represents one of the most important sectors of the U.S. economy and combined generates more than half a trillion dollars of direct economic activity, it seemed odd to us that an index reflecting the industry and benchmarking the sector’s performance was not available.

That is not to say that people have never looked at the sector. Traditional financial sector definitions have placed defense with “Capital Goods” while other definitions have blended it with ‘Aerospace and Commercial Aircraft’. Neither definition we believed provided an adequate benchmark to those interested in the sector.

Of the existing financial indexes focused solely on defense – namely the AMEX’s Defense Index, Philly Defense Index, and S&P 1500 Aero/Defense Index – the rules and methodology governing these were not conducive toward the creation of financial products, they did not appear to be regularly updated to include new firms, and they all were comprised of less than 20 firms, mostly limited to the large defense companies we are all familiar with. Overall, the diversity of activities that make up the defense and homeland security we felt was lacking in the aforementioned indexes.

The creation of the SPADE Defense Index represents the first index whose rules were designed to encourage the creation of Exchange Traded Funds (ETFs) and mutual funds, two areas which we are currently working on.

As far as funds in the marketplace, there are a number of registered financial advisors servicing individual accounts who track the sector and identify opportunities within it. But for publicly accessible investment products, our research has identified only one mutual fund under the broader heading of ‘Aerospace & Defense’ and no easily identifiable products (mutual funds or ETFs) with a focus on homeland security or space.

This is the primary reason why the SPADE Defense Index was created.

SecurityStockWatch.com: So there are products based on your Index on the market?

Scott Sacknoff : Options based on the Index are currently trading on the American Stock Exchange. We are in discussions with several firms regarding the launch of an Exchange Traded Fund and hope to have a product based on the SPADE Defense Index on the market soon.


SecurityStockWatch.com: May we have an overview of the Index components and selection criteria?

Scott Sacknoff : When we began working with Wall Street to develop a new index, our goal was to develop one that reflected the diversity of activities within the sector while being governed by rules that would keep the index ‘fund friendly’. What this means is that the index was designed with the fund manager in mind. This means that the SPADE Defense Index is governed by a set of rules designed to minimalize turnover, subjectivity, and consist of companies that are easily tradable.

So among the rules that govern our index are that companies must be traded on one of the three major U.S. exchanges – the New York Stock Exchange, NASDAQ, and the American Stock Exchange. It also must trade for at least $5 a share, have a market capitalization of at least $100 million dollars, and trade more than a million shares during the course of a month.

The next step, of course, was to define the sector so that it covered a range of products and services beyond those of the large prime contractors involved with aircraft, naval vessels, tanks, missiles and weapons. Today’s defense sector also includes a number of firms working on network centric warfare, unmanned vehicles, and other next generation systems and modernization efforts. We felt it critical that firms involved in these sectors needed to be included to truly represent the defense industry. So in addition to well-known prime contractors such as Lockheed Martin, Boeing, Northrop Grumman, and Raytheon, the index includes companies such as Armor Holdings, FLIR Systems (a sensor company), DRS Technologies (a manufacturer of unmanned aerial vehicles), and Anteon (an information systems company).

What we noticed when we looked at these companies was that many of these firms were also involved with the space and satellite industry, a key component of the U.S. defense strategy, as well as efforts related to homeland security.

Had this been 10 years ago, the Index would have been developed without the mention of homeland security. Yet most of the companies that comprise the index today would have been included. As an example, L-3 Communications, in addition to manufacturing a number of electronic systems and devices for defense and space applications is also involved with producing baggage scanners for airport. Northrop Grumman is a major player in intelligence information analysis and Raytheon and ITT Industries produce first-responder vehicles.

Having attended several defense-related conferences in the past few weeks, a number of government officials have cited that the most critical element of homeland security is intelligence – that is the gathering and interpretation of data and imagery. The source of this, in many cases, comes from sensors developed by defense-related firms such as Lockheed Martin, Northrop Grumman, and Raytheon.

The inclusion of firms involved with homeland security opened the door to include firms involved with national security such as those that deal with border security. When we looked further into what defines homeland security, we realized that it was really three separate and distinct markets – national security, local security, and biotech detection and remediation.

With respect to biotech, there were dozens, if not hundreds of firms offering ways to inspect analyze, and cure pathogens. For the most part, this seemed to be purely a way for a company interested in other things to get a piece of the multi-billion dollar pie offered by the government. Because of this, we have not identified a firm involved in this area who met the rules governing our index.

Likewise, when we looked at local security, for example companies that provide closed-caption security monitoring, it didn’t seem to fit our definition of protecting our nation or making use of the technology derived from it.

The last issue in our definition dealt with space and satellites. We made the decision to include firms in this area whose primary business was commercial services because their continued growth and acquisition of satellites, ground hardware, and launch vehicles is just too important to the firms that manufacture the systems for commercial as well as defense customers. The health of the sector is the defining point.


SecurityStockWatch.com: How has the performance been year-to-date and the past 1, 3, and 5 years?

Scott Sacknoff : As would be expected, the SPADE Defense Index has outperformed the S&P500 by a significant margin over the time periods you mention. The 1- & 3- year returns have benefited from increased spending of more than $200 Billion to cover the costs of the War in Iraq; the 5-year time period would take into account spending increases following the events of 9/11. When we performed a blind back test associated with the launch of the Index (ie. we identified the companies but did not know the results prior to the test), we went back to 1998 so that data was available before and during the stock market bubble. Since inception, the SPADE Defense Index has outperformed the S&P500 by more than 100%.

Since that timeframe, the Index has outperformed better than average in periods in a stable and declining market. In an increasing market, the Index has gained but not as fast as the broader market.

More details about our performance are available on our website at:
www.spadeindex.com/performance.html


SecurityStockWatch.com: As the government expands the deployment of biometrics, bomb and chemical detection, and a host of other technologies for security, do you see the enterprise sector becoming a bigger user of these technologies as well? Which companies in your portfolio might benefit from that?

Scott Sacknoff : Security is an issue that exists on the local level as well as the national level. In the areas that you refer to, your readers should realize that many of the companies that supply biometric and bomb detection equipment to the federal government for national security and border protection also supply versions of the equipment to private companies. While a firm such as Brinks or ADT might provide the local security services, the equipment they rely on would more than likely come from a similar supplier base. For example, L-3 has a division involved with the manufacture of scanners used for scanning luggage in airports. These scanners are also used in other facilities around the country.

Overall, there is a trend toward more security in the private sector, especially at firms that would consider themselves to be targets, ie. defense contractors, biomedical research firms, etc. This is being encouraged by the government as can be exhibited by the recent decision by the Pentagon to move many of their offices/contractors out of the Crystal City Building Complex and into buildings that offer greater security with enhanced buffers. Keep in mind that regardless of what happens in the private sector, the U.S. Government will always be the largest single customer for homeland security.

As far as the companies that will benefit, one of the purposes of using an index as a benchmark is that it is designed to reflect the performance of the sector as a whole and should avoid the trap of choosing winners versus losers. While I have my own opinions on which companies are better positioned, as an Index manager it is not something I can address.


SecurityStockWatch.com: In general, what are the market drivers for the companies in your Index for the next 3 to 5 years?

Scott Sacknoff : As would be indicated by my previous answers, the key driver for the companies in the Index is the budget allocated for the U.S. Department of Defense. Although the annual budgets for the Department of Homeland Security and NASA are expected to grow by a few billion dollars in the next few years, the budget for DoD is forecasted to increase by $102 Billion between now and 2011. This is a real number and comes from the FY-06 budget submitted by President Bush. Keep in mind that while it is likely that you will hear about a decline in defense spending in the coming years, it will be a decline in growth rather than an actual decline. It’s the way the government does math. As an example, if the government states in the FY-06 budget that FY-11 expenditures will rise by $102B and in FY-07, they state that FY-11 expenditures will only rise by $90B, this is considered to be a $12B decline rather than the $90B gain it really is. So while the index and individual stocks will likely drop on the announcement, when it happens, total quarterly revenues by the firms in the Index will likely gain and produce a rise.


SecurityStockWatch.com: Thank you very much for your time today, Scott. Is there anything else you’d like to mention?

Scott Sacknoff : Additional details on the Index including the constituents that comprise the Index as well as details on performance and value calculation can be found under the symbol DXS on most financial websites, the AMEX Stock Exchange, or at spadeindex.com Investors wanting to be notified about equity products become available should send an email to info@spadeindex.com