Fund Spotlight: Fidelity Select Defense & Aerospace ( FSDAX )

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The fund’s holding pattern ended there, as investors started to feel more sanguine about the defense procurement budget for fiscal year 2007. Their confidence was rewarded on February 6, when the White House requested a Pentagon budget of almost $440 billion—an increase of 7%, and 48% higher than the 2001 defense budget. The request included $157 billion earmarks for equipment and research and development, line items that spelled good news for the stocks in this portfolio. Congress must approve these requests, but it’s not likely to change them dramatically: The Republican-controlled House and Senate aren’t likely to oppose the Bush administration’s defense spending plans, particularly with mid-term elections looming in November.

Stocks that had languished with relatively low valuations since fall suddenly shot upward in late January, resulting in a roughly 10% gain for this fund between January 20 and February 22. FSDAX jumped from number 25 on the Sector Momentum Table to number two in a matter of three weeks.

Furthermore, the defense budget should continue to grow as the White House requests supplemental funding packages to fund operations in Iraq an Afghanistan. The latest request indicated that another $50 billion would be needed for fiscal 2007, with the details coming out in the spring. The prospect for continued funding increases encourages analysts that defense contractors’ valuations have room to run.

That said, shareholders should be aware of this fund’s risks. Its focus on the defense industry makes it extremely sensitive to political factors, as recent history has shown. And while manager Andrew Hatem has a fair amount of leeway to invest in a variety of sub-sectors of the defense and aerospace industries, from shares of airplane builders to technology firms to satellite television companies, he tends to concentrate the fund’s holdings in less than 50 stocks. What’s more, 58% of assets recently sat in FSDAX’s top ten holdings, exposing the fund to significant company risk.

That sort of concentration presents another type of risk as well. Investors with diversified stock portfolios may already hold shares of large firms such as Boeing or Honeywell International through other mutual funds. Select Defense & Aerospace recently held more than 13.5% of assets in just those two stocks, potentially giving shareholders more exposure than is prudent.

Given such risks, it’s probably best to keep any allocation to this fund relatively small. But if history is any guide, even a small stake here could make a big difference in boosting future returns.

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