The gap between the US and European stock markets has rarely been so wide. This week, the escalation in Ukraine has driven the markets even further apart. One sector, ironically enough, is bravely holding its ground: defense. For investors looking to invest in this sector, there still seems to be ample opportunity, though many grapple with ethical dilemmas.
Laurent Denize, ceo at fund house Oddo BHF, is one of the few who openly speaks about this fraught sector in a challenging call with Investment Officer.
“Since the US elections, it has become clear that Europe needs to increase its defense spending,” Denize said. “We see upward potential,” he added, without naming individual companies. Other fund houses refrain from commenting on the «sensitive» sector. The phrase «ethical objections» is frequently mentioned.
This unfolds against a backdrop of increasing pressure from the United States, where Donald Trump, during his presidency, sharply criticized NATO countries for their inadequate defense budgets. He repeatedly emphasized that the United States would no longer bear the alliance’s disproportionate burden.
NATO partners are now compelled to meet the target of spending 2 percent of GDP on defense. This could provide a boost for the European defense sector, one of the few bright spots in European markets, which lag far behind the US.
The US S&P500 Total Return has gained more than 30 percent in euros this year, while the European Stoxx 600 index has managed less than 5 percent.
The gap widened further last week when the US approved the use of long-range missiles by Ukraine against Russian targets. In response, Vladimir Putin lowered the threshold for deploying nuclear weapons.
The STOXX Europe Total Market Aerospace & Defense Index has risen by four percent this month, while the broader stock index has lost about one percent. The European defense index boasts an impressive growth of over 30 percent this year, reflecting the increased defense budgets in Europe.
EU funding sparks debate
Earlier this month, the European Union approved 300 million euros in funding to support cross-border defense procurement. The projects, involving 20 member states, mark a significant step toward a more integrated European defense industry, which is reflected in market valuations.
Companies like German arms manufacturer Rheinmetall, whose stock has already risen by over 90 percent this year, are directly feeling this increase in demand. The company’s defense division is expected to more than double over the next three years, according to ceo Armin Papperger.
The defense division accounts for the largest share of revenue for Rheinmetall, which forecasts a turnover of 20 billion euros by 2027. Last year, the group posted revenues of over 7 billion euros and an operating margin of nearly 13 percent. With an order book exceeding 39 billion euros, primarily from the German government, the company is a central player in modernizing the armed forces.
Other major players, such as Safran (up 30 percent in 2024) and Leonardo (up 59 percent in 2024), are also strengthening their positions. Safran reports unprecedented demand for air defense systems and cybersecurity solutions, while Leonardo benefits from partnerships like the new joint venture with Rheinmetall.
Interestingly, venture capital is now flowing into the arms sector as well. Tech investor Klaus Hommels recently announced plans to invest more than 100 million euros of his own capital into European defense startups. According to the founder of venture capital fund Lakestar, who was an early investor in companies like Spotify, Facebook, and Revolut, the need for Europe to bolster its defense has long been evident.
However, the funding is not without controversy. Critics argue that European defense companies are already performing well and do not require additional subsidies. Proponents, meanwhile, stress the importance of European security and industrial competitiveness in an uncertain world.
Valuations
Although they are more expensive than their historical averages, European defense companies are still trading at a discount compared to their US counterparts. However, some investors believe that most stocks have already priced in significant future orders for NATO army upgrades and seem a bit expensive.
“Some sort of arrangement between Russia and Ukraine could create short-term headwinds. But we fear that demand for defense spending will only increase due to geopolitical skirmishes and overt hostilities around the world, particularly in the Middle East and between the US and China,” said Jan David Meyer, senior portfolio manager at Taunus Trust AG.
“Still, we won’t invest and would caution investors to wait for setbacks rather than investing now at high multiples,” he said. Nevertheless, it is primarily ethical concerns that keep many fund houses, including Taunus Trust, away from the sector.
Globally, defense stocks are currently more expensive than average, with a price-to-earnings ratio of 19 and an enterprise value-to-EBITDA ratio of 11—about 30 percent above the long-term average since 1986. European defense companies, on average, have a price-to-earnings ratio of around 17 and an enterprise value-to-EBITDA ratio of around 10.
European valuations
European stocks, more broadly, are struggling with waning popularity compared to US stocks. The valuation differences are striking: European stocks are currently trading at 14 times expected earnings, while the US multiple averages 24.4.
According to Roelof Salomons, chief economist at BlackRock Netherlands, the core issue lies in the lack of catalysts to change the long-term outlook. “I’m itching to act, but I don’t see it yet,” he wrote in a client note last week. “US stocks are not cheap, but the economy is growing strongly and sentiment is positive. The opposite seems to be the case in Europe.”