The German Bundestag’s decision to boost defense spending through debt issuance triggered a correction in European defense stocks. Investors are taking profits on high valuations as questions arise about whether they are still justifiable.
The “expectations treadmill” refers to a situation in which companies must continuously improve performance to meet rising investor expectations.
For European defense stocks, this treadmill is running at full speed. The sector has been on the rise for some time, driven by the growing threat from Russia. Meanwhile, valuations are elevated, and Germany is easing its stance on its debt brake.
Last week, German lawmakers approved plans for fiscal expansion to increase the defense budget, prompting investors to take profits in the following days. In response to the news, Optimix Asset Management decided last Thursday to trim between one-quarter and one-third of its positions in five European defense stocks, which had been added to the portfolio six months ago.
Senior portfolio manager Arjen van der Meer (photo) believes the multiples are becoming harder to defend: “European defense stocks are no longer a no-brainer. Since 2022, Rheinmetall has delivered a return of 1,300 percent. That’s extremely high and comparable to what Nvidia has achieved. But for a capital-intensive company like Rheinmetall, it’s much harder to support such growth on fundamentals than it is for a high-tech company. It has become a game of momentum and catalysts—so caution is warranted.” According to Van der Meer, the market reaction—which Optimix participated in—was a classic case of “buy the rumor, sell the fact.”
Renco van Schie, CIO at Valuedge Partners, has been invested in a defense ETF since the end of 2023 and sees no reason to reduce that position. “We’re talking about a multi-year trend in which the entire European defense industry needs to be rebuilt. Moreover, easing ESG regulations will open the door for institutional capital to flow into the sector.”
High valuations
European defense stocks will need to run hard to keep up with the pace of the expectations treadmill. “Even though order books are well-filled for the coming quarters, valuations remain very high. The forward price-to-earnings ratio for the basket of European defense stocks (consisting of Rheinmetall, Hensoldt, Kongsberg Gruppen, Saab, and Leonardo SpA) is around 40, while the defense industry lacks the scalability of, say, the tech sector,” Van der Meer explained. “That said, the theme is still relatively young, so the sector could still grow into these valuations for the time being.”
High p/e ratios for defense stocks
Van Schie sees parallels with the AI hype: “Just like in the AI rally, we’re seeing that defense companies will need to grow into their valuations. While the scalability isn’t the same as in tech, there are only a few companies in Europe with the specialized knowledge and facilities to produce defense equipment at scale. That makes it logical for expectations and valuations to soar.”
A sense of urgency
The rising investor interest and valuations come as it becomes increasingly clear that Europe can no longer blindly rely on the United States. The urgency for Europe to take responsibility is growing. “Europe needs to learn to stand on its own,” Van Schie said. “The NATO standard of spending at least two percent of GDP on defense is already being met in many cases, but it will still take at least five years before Europe has its own military capability. At present, Europe remains heavily dependent on the US, which still receives two-thirds of Europe’s defense orders.”
Van Schie (photo) describes JD Vance’s speech and Germany’s decision to loosen its debt policy as a “turning point.” The conversation between Trump and Zelensky left little room for doubt: Europe is on its own.
Meanwhile, Russia has its eyes on the Baltic states, home to many ethnic Russians. Van Schie, who participated in a roundtable discussion with the Dutch Parliamentary Committee on Defense last year, said he wouldn’t be surprised if Russia attempts an invasion within the next two to three years. “The urgency is not only about building an independent defense industry but also about ramping up the pace. In the coming years, we’re looking at an arms race to defend Europe’s eastern border.”
Optimix has been eyeing defense stocks ever since Russia’s invasion of Ukraine. Initially, the asset manager remained cautious due to the sector’s controversial image and uncertainty around a potential peace agreement. But as it became clear in the lead-up to Trump’s January inauguration that Europe needed to make significant strides in defense, Optimix decided to take a position after all.
A flood of institutional capital
Once ESG regulations are revised and investing in defense stocks becomes permissible, Van Schie expects a flood of institutional capital to pour into the sector. “Many institutional investors are currently sitting on the sidelines, waiting for regulatory approval to invest in defense. Once the floodgates open at institutional firms like pension funds, a tidal wave of capital will move into the defense sector.”
“They also have a benchmark to consider and have missed out on returns. The pressure to invest in defense stocks will only increase,” Van der Meer added.
Institutional investors can also invest in government bonds that are specifically labeled as “defense bonds,” designated for defense-related investments.