Investing in defence: the easiest way to buy into the boom

The defence sector has firmly returned to favour since Russia invaded Ukraine . The Euro Stoxx Aerospace & Defence index has nearly doubled since February 2022, compared with a 26% increase for the Euro Stoxx 50 index.

Many individual stocks have done exceptionally well. Rheinmetall (Frankfurt: RHM) has quintupled off the back of a huge increase in sales, such as the artillery order mentioned above: it expects revenues to reach €10 billion this year, from €6.4 billion in 2022. Saab (Stockholm: SAAB-B) has quadrupled. Investors quickly latch on to any stock that looks like a new beneficiary of the trend. Norway’s Kongsberg (Oslo: KOG) has seen its shares double this year.

To take the UK market , year-to-date gains among stocks with significant defence exposure include: BAE Systems (LSE: BA) , up 17%, Rolls Royce (LSE: RR) , up 66%, QinetiQ (LSE: QQ) , up 52% and Chemring (LSE: CHG) , up 13%. There was a bit of a dip recently, seemingly attributed to reports that Germany’s finance minister might veto more military aid for Ukraine under plans to reduce spending, but that looks like a pretext for a bit of profit-taking, rather than the start of a major setback.

That said, it’s worth noting two points. First, valuations are already pricing in a lot of bullish news. Yes, order books have grown a lot and provide good visibility for the next five years, but what’s been announced is factored in. Outsized further gains may require big increases in defence spending, which could eventually come, but the political wheels move slowly.

Second, it is true that these are international businesses and benefit from increased spending more broadly, not just in their home markets. France’s Thales (Paris: HO) secured a 15-year £1.8 billion contract with the UK’s Ministry of Defence to improve Royal Navy ships, while Safran (Paris: SAF) secured new contracts with the MoD for Merlin helicopter engines. Yet there is a strong argument that US companies will benefit most from the worldwide increase in defence spending for now (they account for the majority of global arms exports), as illustrated by strong results reported by Lockheed Martin (NYSE: LMT) last month.

So the opportunities for stock picking are more limited. If you believe that defence spending will rise, there’s a good argument for buying the HANetf Future of Defence ETF (LSE: NATP) and get a basket of defence and cybersecurity stocks from Western-aligned countries that give you exposure to the overall trend.

However, there are a few less well-known stocks in the European defence sector that may well be worth a look for those who want to do some stock picking beyond the big American and European names. The Greek defence company Theon International (Amsterdam: THEON) was listed in Amsterdam earlier this year. The company produces night vision and thermal-imaging systems for the defence and security industry. It has an impressive backlog and expects to increase revenues by 50% this year and to generate a 28% earnings before interest and tax margin. It is debt-free and high-cash generative.

German sensors maker Hensoldt (Frankfurt: HAG) , which is involved with Lufthansa Technik Defense and Bombardier in German’s Pegasus airborne surveillance programme, could be worth considering on an enterprise value to earnings before interest, tax, depreciation and amortisation (EV/Ebitda) of 14. Finally, RENK (Frankfurt: R3NK) is another listed German company that supplies gearboxes and power trains for specialist uses, including armoured vehicles.

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