By Danilo Masoni and Samuel Indyk
MILAN/LONDON (Reuters) – Europe’s rush to boost funding for military spending has sent defence stocks on a tear, though investors are now wondering how much more they’re willing to pay for exposure to the region’s biggest rearmament buildup since World War Two.
Shares in arms makers including Britain’s BAE Systems and Germany’s Rheinmetall had a volatile day on Tuesday, briefly extending Monday’s surge, which followed the clearest sign yet Europe’s leaders were racing to boost spending and help secure peace in Ukraine.
Monday’s surge lifted several defence shares by over 20-30% at one point, with the force of the rally surprising several fund managers. The move followed an already record run for the sector, which has more than doubled in value since Russia invaded its neighbour more than three years ago.
As a result, many defence stocks now trade a record-high valuation multiples, in some cases surpassing those of their American peers and moving closer to those more traditionally associated with high-growth sectors, such as luxury or tech.
Investors bet European governments could lift defence spending more permanently to 3% of gross domestic product from the current NATO target of 2%, helped by Brussels loosening its fiscal rules. Some members, such as Italy and Spain, are still below that 2% threshold.
Meanwhile, German leaders may reform the so-called “debt brake”, which limits borrowing, during the current legislature that ends this month. This would pave the way for a big injection of new funds into a 100-billion euro fund already set up in Europe’s biggest economy.
Recent developments have seen investment banks scrambling to raise their profit estimates and ratings, which looks justified given the significant boost to expected spending.
But among fund managers some prudence is creeping in.
Rory Dowie, portfolio manager at Marlborough, wants to understand the earnings impact and sustainability of increased defence spending, particularly if a Russia-Ukraine resolution emerges under the Trump administration.
“We would be cautious to chase the rally,” he said.
The STOXX Aerospace and Defence index rose as much as 1.6% to a new record high before turning lower on Tuesday. By 1553 GMT, it was down 1.5%. The index is now worth $514 million in market cap, having risen around 170% since the invasion of Ukraine.
PAYING THE PREMIUM
According to Nordea senior strategist Hertta Alava, aggressive buying of defence ETFs might have contributed to Monday’s surprise rally and given how high valuations are, a pullback was possible.
Over the longer term, however, she said defence was likely to remain attractive. “This is one of the few growth sectors in Europe, so investors are probably willing to pay a premium”.
According to LSEG Datastream, Rheinmetall trades at 36 times its expected earnings, the highest on records going back to the late 1980s. Sweden’s Saab, France’s Thales, Italy’s Leonardo, Rheinmetall and BAE trade between 21 and 34.5 times on the same metric, the highest in over two decades.
The largest U.S. defence group, Lockheed Martin, trades at 16 times earnings, roughly the midpoint of its 20-year range.
Angelo Meda, head of equities at Banor SIM, is among those taking a cautious stance, citing production capacity constraints in Europe and risks from scenarios such as a more friendly Ukraine ceasefire or issues with state budgets.
“We’ve now moved beyond the fundamentals,” he said.
Citi said current European defence share prices broadly imply that medium-term growth to 2034 keeps up at the same pace expected for 2024-2028. During this period average yearly growth of profits ranges from 32% for Rheinmetall to 8% for BAE.
“Whether these growth rates will become reality is likely to be dependent on the new level of defense spending as percentage of GDP, which is likely to be more clear over the next few months as Europe steps up to burden sharing with the U.S. and the next NATO summit in June,” it said.
JPMorgan raised its European defence price targets by an average of 25% this week, expecting significant increases in companies’ guidance over the coming months and years.
“We expect the European defence sector to further re-rate, as investors underwrite strong growth and visibility,” they wrote.
(Reporting by Danilo Masoni; Editing by Amanda Cooper and David Evans)
