Small defence stocks: the backbone of the sector

Small defence stocks can often be overlooked. Back in January 2024, few, if any, investors had heard of the micro-cap Filtronic. The company, which designs and produces components for communication systems, had muddled along for the best part of 15 years, barely breaking even and relying on shareholders' cash infusions to keep the lights on. That all changed in April 2024 when Filtronic signed a strategic partnership with SpaceX. Over the following two years it secured a series of game-changing contracts with Elon Musk's space group, transforming its fortunes. Revenue nearly quadrupled and the share price is up nearly 1,800% since the beginning of 2024. Filtronic is just one of a host of small, publicly traded companies that have been transformed by the influx of cash into the global defence market over the past two years. Most of these small businesses fly under the radar of large institutional investors, who are unable or unwilling to invest in small or mid-caps. That means there's a fantastic opportunity out there for investors who are willing to put in the extra legwork.

Small defence stocks: looking beyond the global giants

The global defence industry is dominated by the so-called “primes”, the giants of the industry that manage multi-billion-pound or multi-billion-dollar contracts awarded by government bodies. These major players, such as BAE Systems, Lockheed Martin and Northrop Grumman, coordinate complex supply chains, manage hundreds of subcontractors and are ultimately held responsible when things go wrong. In some respects, these primes also act as banks and lenders to the subcontractors that make up the vital supply chains for the industry. The majority of defence contracts are multi-year projects that take years to design and deploy, with tens or hundreds of suppliers for each long-term project. It falls to the primes to manage the project cash flows and individual payments to suppliers – something government bodies would struggle to oversee.

For most institutional investors, primes are the only way into the defence industry. Despite its blistering rally over the past two years, Filtronic's market capitalisation still sits below £1 billion; that's far too small for a large fund manager to take a meaningful position without affecting the share price. By comparison, Lockheed Martin, Boeing, and Northrop Grumman's market capitalisations range from $70 billion-$180 billion. But the primes don't have as much control as they might think.

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A recent study by the Bruegel think tank found that in Europe the ten largest military contractors capture between 67% and 90% of total public military-procurement spending across key countries such as Germany, Poland and the UK. In the UK, 39% of procurement expenditure in the 2024-2025 financial year went to just ten strategic suppliers, with BAE Systems alone representing 16.3% of all core Ministry of Defence expenditure for the year. This is the highest recorded share going to a single supplier since records began in 2008. But this figure is a bit misleading. Take the company's current contract to produce eight Type 26 Global Combat Ships for the Royal Navy, which, when agreed in 2017, cost £3.6 billion. The firm estimates around 40% of the total cost of manufacturing the vessels will flow through to some of the 3,000 small and medium-sized enterprises (SMEs) in its supply chain.

It's the same for the other Type 26 agreements signed with Canada and Norway. According to BAE's own estimates, it has a total of 5,800 suppliers across the UK and it spent £5.8bn with these SMEs in 2024, supporting 61,000 jobs – almost 20% more than the group's direct employee base. A similar structural dependence is visible in Germany, where the defence Mittelstand (the SMEs that form the backbone of the German economy) supports the giant global primes, such as Rheinmetall.

Boosting small defence stocks

When it comes to supporting small defence stocks, the US is undoubtedly the world leader. It has for many years been making a concerted effort to increase contract awards to small businesses. The Department of War regularly publishes statistics on its efforts to award contracts to small businesses and breaks down the targets set for primes and subcontractors. In the federal fiscal year 2024, the department raised prime contract awards to small businesses by $4.9 billion.

The US also has a world-leading network for scaling businesses and integrating them into supply chains. In recent years, its Accelerate the Procurement and Fielding of Innovative Technologies (APFIT) programme has helped SMEs move from the venture capital to growth stage, offering as much as $50 million directly to SMEs or non-traditional defence contractors to broaden the US military's supply chain and increase resilience. In one example, towards the end of last year, Gremlin Low-Cost Munition received $35 million in funding to provide affordable, precision-strike capabilities for the US Marine Corps, part of an overall push to design and mass-produce cheap missiles.

The UK and its European allies are working to develop similar programmes, although due to funding constraints and the existing concentration of the sector progress is slow. The UK's Ministry of Defence (MoD) spending directly with SMEs last year accounted for just 4% of the department's total budget, which was flat year-on-year. However, there are plans to raise the current £2.5 billion of annual spending to £7.5 billion by May 2028, assuming all of the MoD's funding plans are signed off by the government. The government has pledged to raise defence spending to 2.7% of GDP from next year, rising to 5% by 2035, but reports suggest a funding gap of around £28 billion in the existing plans and the Treasury is yet to sign off on the ten-year Defence Investment Plan. Still, in January 2026 the government established the Defence Office for Small Business Growth to act as a “single front door” for engagement with SMEs. It's also put together a £140 million drone and counter-drone technology programme that directly involves 20 British SMEs and 11 smaller so-called micro-enterprises.

Hunting for diamonds in the rough

As capital flows into global defence primes, it is becoming increasingly hard to find the diamonds in the rough. However, there's a growing opportunity with these small defence stocks, companies on the edge of the industry, in the early stages of growth. The problem is, there are only a handful of actively managed investment funds on the market that specialise in defence. The market is largely dominated by exchange-traded funds (ETFs), which must track the largest, most liquid companies in the sector. What's more, most of the active funds don't have the deep technical and industry-specific knowledge required to understand how the future of warfare is developing and where governments are prioritising spending.

The Finserve Global Security Fund is different. This Swedish, actively managed equity fund focuses on defence, cybersecurity and the space industry, with an experienced advisory board. The fund is not available to UK investors, but it's full of interesting ideas, built on the manager's strategy of “capturing structural, long-term mega-trends” with the potential for “above-market growth”. One such idea is Nordrest (Stockholm: NREST), which is capitalising on increased defence spending through its meals-ready-to-eat (MRE) division. As the saying goes, an army marches on its stomach and Nordrest is one of the five members of the MRE programme for Nato. These five firms provide the meal kits issued to soldiers on patrol or exercise, which can quickly be heated up to provide a nutritious meal. Shares in the company have risen by around 180% since the beginning of 2025, driven by its involvement in Nato contracts.

Although the company has a large catering division attached, around 60% of its bottom line comes from the key MRE contracts (even though this division accounts for just 24% of revenue). With a market capitalisation of $410 million, Nordrest is still a minnow in the defence world, but it's a key player in a market that's not going away anytime soon. The management has outlined plans to double Nordrest's MRE capacity over the coming years to deal with increased demand from Nato members. The stock trades at roughly 11 times EV/Ebita on 2026 estimates, adjusted for minority interest: modest for a company growing organically at around 15% annually and compounding further through bolt-on acquisitions bought at cheaper multiples.

Finserve's team also likes Hanwha Ocean (Seoul: 042660), formerly known as Daewoo Shipbuilding & Marine Engineering and one of the “big three” shipbuilders of South Korea, along with Hyundai and Samsung. Shares in the company have jumped more than 230% since the end of 2024, when it made an audacious bet to take on the US primes in their home market. In December 2024, Hanwha Ocean (40%) and Hanwha Systems (60%) jointly acquired Philadelphia Shipyard, catapulting the company into the near-$1 trillion-a-year US Navy procurement system. The shipyard is currently incurring losses, but the firm has earmarked $5 billion to turn it around.

The investment will help Hanwha capitalise on a Korea-US pact as part of the US government's Make American Shipbuilding Great Again initiative. In May 2026, Korea's trade minister and the US commerce secretary formally agreed on a $350 billion investment framework, with $150 billion earmarked for cooperation in shipbuilding. Hanwha's investment will go some way towards improving the efficiency of the American shipyard. In its home market, the group turns out one ship a week from each yard, while the US manages just one a year. This will add to what is an already robust order book for the group, with an overall backlog equivalent to three and a half years of revenue.

A play on the rise of drones

Also featured in Finserve's portfolio is Exail Technologies (Paris: EXA). One of the most interesting trends over the past five years has been the solidification of drone warfare in defence systems. The war in Ukraine has illustrated how a relatively small player on the international scene can fight back against a large superpower by investing heavily in unmanned warfare – this company is a play on that trend. Exail is a French defence-technology company that has carved out a position as the global leader in unmanned mine countermeasures, with a 95% win rate on naval and mine-hunting tenders since 2019. As the impact of drone and unmanned-weapons platforms has become apparent, the company's shares have risen by more than 700% since the beginning of 2025 and its market capitalisation has jumped to around €3 billion. Its flagship product is the UMIS drone system. It is the only product of its kind in a market where competitors usually rely on multiple suppliers to build systems.

The Royal Navy has a huge lead here. As part of the UK's efforts to lead a global mission to reopen and defend the Strait of Hormuz, the Royal Navy is deploying a ship with technologies designed to spot and destroy sea mines remotely without exposing people to danger. It will be one of the first of its kind operating in a war zone. The publicity surrounding this mission could be a boon for Exail. It's already formed a collaborative partnership to support the Royal Navy's next-generation autonomous mine countermeasures, and this could open up other markets. Navies worldwide are retiring Cold War-era minesweepers and replacing them with autonomous drone systems (a €3 billion opportunity by 2030), a shift accelerated by the historic jump in defence spending. Exail is well-positioned to capitalise on this trend. Last year, the company recorded an 87% increase in revenue and has an order backlog equivalent to around a year and a half of sales. It is targeting further double-digit revenue growth in 2026.

Providing the nuts and bolts

When you start to trace the supply chains that support the world's armies, it's clear just how deep their roots spread into the economy and how many options there are for investors. Scanfil (Helsinki: SCANFL), for example, manufactures printed circuit boards, electromechanical assemblies and complete defence electronics units for European defence primes under long-term production agreements. Invisio (Stockholm: IVSO), a Swedish company, makes tactical communication headsets designed to protect the hearing of infantry and integrate with standard military radios. The kit is sold to Nato armed forces across about 50 countries. A similar play is Bittium (Helsinki: BITTI), which develops and manufactures encrypted tactical radios for several Nato militaries.

In the UK, it's worth taking a look at Chemring Grorup (LSE: CHG). This company produces kit such as infrared flares and decoy systems that protect military aircraft and naval vessels from missile attack, as well as energetic materials for munitions. Chemring has only one major competitor in advanced plastic explosives in Europe: France's Eurenco Group, which is owned by the French state.

Last year, overall revenue at Chemring expanded by just 2%, marred by delays to UK government spending commitments at the group's sensors and information arm. However, on the countermeasures and energetics side (explosives), revenue rose by a reported 17% and underlying profit by 37%. The firm's order book jumped 35% and is now equivalent to three to four years of revenue in this division.

Chemring is targeting £1 billion in revenue by 2030, up from a reported £500 million today. If the company can hit this target (and analysts believe it can), group earnings before interest and tax could rise to £170 million, according to Panmure Liberum, up from £74 million today, at a 17.2% margin, up from 14.2%. That's if private equity doesn't snap up the business first. There have been rumours circulating for some time about the company's future, with analysts speculating it could only be a matter of time before the group is acquired.

Porvair (LSE: PRV), worth £391 million, supplies specialist filtration systems for military aerospace applications, including hydraulic filtration for fast jets (such as the F-35) and helicopter gearboxes, and fuel filtration for forward operating bases. The company doesn't provide too much detailed information on its contracts with defence customers, but it has said that aerospace-related demand is stronger than expected. It is also seeing a slight uptick in demand for its equipment from the nuclear industry.

Boots on the ground

Avon Technologies (LSE: AVON) is one of the best ways in the world to invest in the niche business of protective equipment. The company manufactures head protection and respiratory units, such as gas masks, for military and first responders globally. Like all of its peers, it is benefiting from increased demand from Nato as countries upgrade their equipment, much of which dates from the Cold War. Revenue in the first half of Avon Technologies' financial year was hurt by its exposure to US government agencies. The government shutdown exposed contract awards and led to double-digit declines in demand for head-protection gear. But there should only be a temporary headwind. Interest in respiratory products drove a 19% increase in the company's order book in this division, adding two additional countries to its customer base and bringing the total to 16 Nato countries now buying from Avon.

As a marker of demand, Avon agreed a 50% increase in the revenue ceiling on a major contract with Nato to supply chemical, biological, radiological and nuclear defence boots and gloves. This kit has a fixed lifespan after which it is no longer effective, giving the company a recurring revenue stream. Around 50% of group revenue is exposed to US spending, which is a headache, but management is making strong efforts to diversify the base. As this continues and growth flows through, Avon's stock is poised for a rerating. Over the next four years, analysts at Zeus have pencilled in 60% profit growth, with revenue expanding by around a third. A cash-rich, debt-free balance sheet also provides scope for mergers and acquisitions to expand the portfolio and capitalise on rising defence spending globally.

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