Smaller companies in the industry have fared worse recently, presenting a possible buying opportunity
By Jinjoo Lee
In some ways, there has never been a better time to be a smaller, nimbler defense company. But you wouldn't know this from their stock prices.
The Middle East and Russia-Ukraine conflicts are depleting weapons stockpiles and highlighting the unfavorable math of using interceptors worth millions of dollars against drones that are a fraction of the cost. Meanwhile, the Trump administration is pushing to bring speed and competition in military procurement.
Yet small to medium defense stocks have kept sliding over the past few weeks, continuing their underperformance since the start of the Iran war. The State Street SPDR S&P Aerospace & Defense ETF, an equal-weight index with higher exposure to smaller defense names, is down 21% over that time, worse than the 15% decline in the iShares U.S. Aerospace & Defense ETF, which has higher exposure to large, traditional contractors such as RTX and Boeing. The small-cap heavy ETF trades at roughly 36 times forward earnings, down from an average of 44 times over President Trump's second term.
One reason is the flood of initial public offerings in the sector this year, which has added to the supply of smaller defense stocks investors could pick from. These have included six U.S. IPOs and five debuts in Europe, according to Capital Alpha Partners. Most have fared poorly since they started trading.
Midterm election anxiety has been weighing on the broader sector, too. The likelihood of a Democratic Party sweep has been steadily rising since the summer, climbing above 60% starting in mid-September, according to Polymarket. With the U.S. budget deficit expected to exceed 6% of gross domestic product, high interest rates are also fueling government budget concerns, according to Byron Callan, analyst at Capital Alpha Partners.
Most at risk is the $350 billion portion out of Trump's $1.5 trillion defense budget request for the current fiscal year that will need to be paid for through reconciliation. This $350 billion funding request included $54 billion for drones and $49 billion for artificial intelligence.
This doesn't need to spell doom for the sector, though it could rule out the most bullish spending scenario. Industry analysts tend to think that the defense budget for the current fiscal year will land somewhere above the $1 trillion budget for the prior fiscal year and below the $1.5 trillion proposed by the president. There is bipartisan support for military spending, after all, and the push for more defense innovation actually started about a decade ago under the Obama administration, Callan notes.
Even though $1.5 trillion is an eyewatering number, it represents less than 5% of GDP, which isn't a staggering sum for a period of high geopolitical tensions. During the Cold War, the U.S. spent 5% to 10% of GDP on the military each year, according to Brookings.
But even a squeezed defense budget might not be such a bad thing for smaller companies if it means the government is forced to look for cost-effective solutions. If the military can't buy as many F-35s or Patriot interceptors as it hoped, it might opt to buy drones and unmanned aircraft, Callan said.
Late last month, Defense Secretary Pete Hegseth said he is creating a four-star combatant command for autonomous warfare, which will be directed to buy new drones and robotics. One of its priorities will be to quickly establish an American-made pipeline of cheap, unmanned systems. Separately, Hegseth also said SpaceX's Elon Musk, Anduril's Palmer Luckey and former House Speaker Newt Gingrich would lead a study about the future of warfare.
Might this be a good time to buy the dip? If history is a guide, it could be. Defense stocks have typically outperformed the market in the year following midterm elections, according to a report from RBC Capital Markets. On average, defense stocks have outperformed the market by 13.6% during the year that the president loses at least one chamber in the midterms, according to the report, which analyzed market performance since 1986.
Picking the winners could be tricky, however, particularly in crowded markets such as drones. One approach could be to focus on the smaller companies that have exposure to multiple defense platforms, such as Karman or Mercury Systems, according to Ken Herbert, analyst at RBC.
Karman, for example, supplies highly engineered systems for missiles, interceptors, drones and space. Wall Street expects the company to boost its top line at a healthy compound annual growth rate of 22% over the next four years. Mercury Systems provides computing and electronics for aircrafts, ground vehicles and missiles, among other systems. It is well-positioned for an environment that prioritizes more technology on the battlefield because every platform will have to have more computing power, according to Herbert.
Both Karman and Mercury Systems trade at a forward earnings multiple of about 40 times, not cheap but considerably lower than the high multiples they previously commanded. Karman and Mercury Systems' multiples averaged 100 times and 60 times, respectively, over Trump's current term.
Midterm jitters and high rates are understandably clouding the outlook for military spending, but they don't reduce America's need to restock its depleted weapons stockpile or to prepare for a changing battlefield. This could be a good time for investors to get exposure to the sector, albeit in a selective way.