
Investors are optimistic about defence stocks, as military spending worldwide reached $2.4trn in 2023, according to the Stockholm International Peace Research Institute.
Commitments from governments to boost defence spending as global geopolitical tensions arise have driven investors into affiliated stocks and buoyed confidence in the future of the sector.
Overall global military expenditure is on the rise, having reached $2.4trn in 2023, according to a report published by the Stockholm International Peace Research Institute.
Since then, newly elected UK prime minister Keir Starmer made a "cast iron" commitment to increase the country's defence spending to 2.5% of GDP just days into his tenure, as he travelled to Washington for the annual summit of the NATO defence alliance.
As of June 2024, 23 out of 32 NATO countries were meeting the alliance's 2% budget spending threshold, with European members and Canada gradually increasing their average combined investment in defence from 1.4% in 2014 to just over 2% in 2024, hitting $430bn.
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The increased government spending on defence and commitments to spend more has spurred a run on affiliated companies since the beginning of the year.
According to data from MarketWatch, shares in German arms manufacturer Rheinmetall are up 76.1% year-to-date and close to 100% higher than a year ago. Similarly, Britain's BAE Systems share price has risen 14.7% since the start of the year.
Alec Cutler, manager of the Orbis Global Balanced fund, said following a "depressed decade" for European defence stocks, investors are now aware of "how to spell Rheinmetall, and understand that [Swedish defence company] SAAB sells fighter jets, not cars".
According to the manager, there has also been a shift on investors' negative opinions on other sluggish performers in the sector, such as Rolls-Royce and Leonardo.
Overvaluation debate
Roel Houwer, senior product manager at VanEck, said the strong commitment from NATO governments to invest in defence, in combination with the long-term drivers from continued Russia-NATO tensions, along with cyberattacks and strategic competition between US and China, all represented "growth" opportunities for the defence sector.
This, Houwer argued could "substantiate the strong performance and higher prices of defence stocks". Indeed, the rush of investment in several defence stocks have led to concerns around overvaluation.
In April, Goldman Sachs published a research note stating some European stocks were trading at a 45% premium against the STOXX Europe 600 index at the time - in contrast to their average historical discount of 10%.
"We typically see a period of re-rating for two years followed by trading at peak multiples for one to two years before the growth cycle contracts again, with multiple contraction happening as growth rates decelerate," the note read.
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But Michael Field, European equity strategist at Morningstar, argued there were still "plenty of opportunities ahead in the defence sector", with the "largest beneficiaries" being those stocks with specific exposure to weapons and defence systems used in Ukraine, such as BAE Systems, Rheinmetall, and others.
"It is difficult to find defence names that have performed poorly over this period, but there are a few, mainly larger conglomerates with exposures to other areas that have dragged on performance – for example Boeing or Northrop Grumman," he said.
Within the defence sector, cybersecurity has had a "very strong showing", according to Tom Bailey, head of research at HANetf, as cyber threats and attacks have been putting increasing pressure on government institutions and companies alike.
"Geopolitically-motivated and state-sponsored cyber espionage and sabotage are principally carried out against the private sector," he said.
"Uniquely compared to other areas of national security, the private sector itself is expected to pay for and coordinate their defence against this."
Impact of a second Trump term
With growing military spending on the horizon, Field said there are several catalysts for medium-term growth in the defence sector. He priced in a possible second term for former US president Donald Trump, in which case military spending in Europe could rise.
Field also took note of replenishing "dwindling" military stocks in the West, after a significant amount was shipped in Ukraine. According to him, this could take up to ten years in countries like Germany, leading to "higher demand for the foreseeable future".
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Meanwhile, Cutler said the "big question" for investors is whether the long-term growth prospects for the industry have changed for the better.
"Europe needs to see the biggest swing, as it resides in one of the hottest geopolitical arenas and the US protection guarantee is now gone, regardless of who wins the White House," he said.
"And as the US hands off more responsibility to European NATO members, those members are shifting spending to homegrown defence contractors, away from US."