The war dividend – how to invest in defence stocks as the world arms up

The way investors view defence stocks is changing. They are shifting from being seen as slow, plodding businesses to being viewed as genuine growth firms. This shift has led to a sharp rise in share prices and has made defence one of the strongest parts of the market over the past three years. The question is whether this enthusiasm is justified and whether the firms that supply military customers can meet these higher expectations.

For many years after the Cold War, investors expected global defence spending to fall. Governments moved away from large standing armies and focused instead on welfare and social programmes. This so-called peace dividend held back the defence industry for decades. That period has now come to an end. Growing geopolitical tension, highlighted by Russia’s continuing aggression and China’s increasing pressure on its neighbours, has forced Western governments to rethink security. This is not a temporary surge in spending, but a lasting commitment to stronger deterrence and modernisation. It means steady demand for equipment and technology, long-term contracts and a sustained period of high activity across the defence supply chain.

The scale of this shift is already visible in public finances. Western governments are putting higher defence spending into law, turning policy goals into binding budget commitments. These plans focus on advanced equipment and long-term readiness, creating a strong investment case for the sector. The renewed need for scale, common standards and faster delivery supports the prospect of dependable long-term growth for companies that provide essential systems and components across air, land and sea.

MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

The geopolitical foundations of rearmament

After the Cold War, the world entered a brief and unusual era. From 1991 onwards, the US was the only superpower and Western political and economic ideas spread rapidly. But this so-called “liberal international order” never truly took root outside the Western alliance. Its foundations were weaker than they seemed – a fact laid bare by the 2008 financial crisis. That crisis shattered trust in established leaders and institutions. The deep recession that followed wiped out wealth and led to years of sluggish growth. Disillusionment with globalisation fed a rise in populism and nationalism, as people began to associate the US-led system with instability and inequality. The dream of a smooth, borderless global economy started to look naïve.

China avoided much of the fallout. Its economy kept expanding and its share of global output jumped from around 6% in 2007 to roughly 20% today. That resilience gave China’s state-driven model new credibility at home and abroad. The collapse of Lehman Brothers showed the limits of US power – and Beijing saw an opening. With the US on the back foot, China grew more assertive and confident on the world stage.

Since then, global divisions have deepened. China has built its own web of influence through economic and political initiatives. The Belt and Road Initiative, once billed as a trade project, has become a strategic tool spanning more than 150 countries. It sits alongside the Global Security Initiative, the Brics group of nations and the Shanghai Cooperation Organisation – all offering partnerships that come without the political strings attached to Western aid and investment.

The US, for its part, has turned inward. Weighed down by inequality and endless overseas commitments, it has scaled back its presence in Europe and the Middle East to focus on the Indo-Pacific. That has forced allies to spend more on defence, creating not greater stability, but a world that is more divided and heavily armed. The rivalry between Washington and Beijing is now about more than power or trade. It is a battle over whose values will define the next world order – one in which nations are prioritising security and resilience over the efficiency that once defined the post-Cold-War age.

The West's arms race

Western nations are shifting their defence strategy, moving from expeditionary operations toward large-scale deterrence against peer rivals. Expeditionary operations involve deploying smaller forces to distant theatres, such as the Nato-led air and naval mission in Libya in 2011 to enforce a no-fly zone. The new focus on large-scale deterrence involves building massive, high-tech capabilities to prevent a major global power from attacking. This is demonstrated by Nato’s Steadfast Defender exercises, which test the rapid movement of tens of thousands of troops across Europe. This change has led to firm, long-term spending commitments across allied nations as they move quickly to close gaps in military capability.

Nato has formalised this shift. The original 2014 Defence Investment Pledge called on members to spend at least 2% of GDP on defence. At the 2025 Nato summit, members agreed to raise that to 3.5% of GDP by 2035. That provides a clear and lasting foundation for the revenue outlook of defence contractors.

In Britain, spending is rising, driven by the nuclear deterrent and the Global Combat Air Programme (GCAP). The UK is overseeing the delivery of Dreadnought nuclear submarines and remains a key partner in the Aukus pact, which will supply Australia with nuclear-powered submarines. These are vast, multi-decade projects that underpin the industrial base of the sector.

Germany has made one of the most dramatic policy reversals. In 2022, it announced a €100 billion special fund for defence. The money is focused on rebuilding land forces after decades of underinvestment. Germany is also working with France on the Main Ground Combat System project, which aims to create a new generation of European battle tanks.

The US continues to lead the world in defence spending. Its budget now targets faster modernisation and production. The army is pushing ahead with its Next Generation Combat Vehicle programme, which includes the new M1E3 Abrams tank. It also dominates the global arms market through the Foreign Military Sales programme, which secures long-term maintenance contracts for platforms such as the F-35 fighter jet.

Japan is another major player. Faced with growing pressure from China, it is investing heavily in modern equipment. Japan is a key industrial partner in GCAP, working with Britain and Italy on a sixth-generation fighter. The country is also developing long-range strike systems, marking a clear shift away from its post-war focus on self-defence.

France remains committed to maintaining a strong and independent defence sector. Its aerospace and naval industries are central to Europe’s strategic base, and it continues to work with Germany on the Main Ground Combat System (MGCS) project. Timelines are long, but these programmes anchor industrial cooperation across the continent.

The defence stocks well placed to benefit

In the last few years, it hasn’t mattered which defence stocks an investor owned, as they nearly all rose strongly. However, future market advantage will belong to companies with the most dependable income. That strength comes from owning generational platforms and providing essential support services.

BAE Systems (LSE: BA) is the cornerstone of the UK defence industry, securing the nation’s nuclear future. The firm boasts a record order backlog of £75.4 billion, more than double what it was 10 years ago. Its largest long-term revenue driver is the naval nuclear franchise, specifically the SSN-Aukus and Dreadnought submarine programmes. BAE is investing significantly in its facilities at Barrow-in-Furness to double capacity, securing production volume for decades. Its acquisition of Ball Aerospace also successfully expanded its already large exposure to the robust US defence market. BAE is a diverse global business that generates only a quarter of its revenue in the UK, with the US making up almost a half. Perhaps its biggest risk is Saudi Arabia, its third most important market, if the country is pulled closer to China’s sphere of influence and is pressured to consider Chinese defence equipment.

Rolls-Royce Holdings (LSE: RR) is roughly one-third exposed to defence and is strategically essential, primarily through its unparalleled expertise in naval nuclear propulsion. Rolls-Royce Submarines supplies the nuclear propulsion plant for the entire UK nuclear submarine fleet and will supply all the nuclear reactors for both the UK and Australia’s new SSN-Aukus submarines. This provides a critical, long-term franchise integral to the UK/US strategic nuclear partnership. Rolls’s defence segment targets a midterm operating margin of 14%-16%, but the division is supported by the massive strength of the civil aerospace division, which recently reported an almost 25% operating margin. This robust commercial cash flow provides the finance needed for the significant capital investments demanded by the Aukus project.

Babcock International Group (LSE: BAB) focuses on long-term support contracts, particularly for marine and nuclear divisions. The firm is the prime contractor for the UK Royal Navy’s Type 31 frigates. More importantly, its Arrowhead 140 frigate design has become a commercial success. The ship has already won export contracts from Poland and Indonesia, providing a major earnings catalyst. The Cavendish Nuclear arm provides highly predictable revenue streams through long-term support and facility-management contracts across UK nuclear licensed sites. This focus on long-duration services minimises the margin volatility associated with high-risk platform development.

Qinetiq Group PLC (LSE: QQ) operates a unique, low-risk model centred on technology and testing services. Its financial future is underpinned by the Long-Term Partnering Agreement with the UK Ministry of Defence, recently extended for another five years to 2033. This £1.5 billion extension covers testing and evaluation for future capabilities, including GCAP and innovative weapons systems. The service-based revenue structure provides predictable earnings.

Following its restructuring, Melrose Industries’s (LSE: MRO) defence exposure lies within its structures division, which supplies airframe components. Defence represents 34% of the US revenue in this segment. Management is working consistently to improve margins, anticipating that the structures division will achieve an operating margin in the low teens by 2029. Melrose, as a key component supplier, is using strong demand and inflation to renegotiate long-term contracts and turn higher volumes into higher profits.

Rheinmetall (Frankfurt: RHM) is an important high-volume defence stock for land defence and ammunition in Europe. The company has reported a surge in defence sales recently, concentrated in vehicle systems and the weapons and ammunition division. Management projects consolidated sales growth of 25%-30% in the 2025 fiscal year, supported by strategic investment to create new capacity across Europe. Rheinmetall’s ammunition division, benefiting from scarcity, is generating very high margins. It is strategically poised to capture a significant share of Nato Europe’s equipment spending.

As the world’s largest defence contractor, Lockheed Martin Corporation (NYSE: LMT) holds massive strategic platform, such as the F-35 and Aegis systems. Its business is structurally dependent on platforms that define the next generation of warfare. However, the firm is susceptible to fixed-price (FFP) contractual risk. This is where the company bears the risk of significant cost overruns. Programme charges are commonplace in defence contracting; in recent quarters, Lockheed Martin has taken significant hits from them. This volatility highlights that, while sales volume is guaranteed, earnings can be uncertain. Despite the increase in business since the start of the Russia-Ukraine war, Lockheed Martin is one of two shares profiled here (along with L3Harris) that have disappointed. Arguably, however, it is one of the cheapest and most diverse ways of gaining exposure to defence trends.

RTX Corporation (formerly Raytheon Technologies, NYSE: RTX) specialises in missile systems, air defence and naval programmes. RTX is benefiting from a depletion in missile stocks as Western-aligned nations support Ukraine. The missiles division has secured major awards for systems such as Amraam and Stinger. Like many defence companies, RTX has non-defence exposure. This comes via its commercial jet engines, Pratt & Whitney, which are a major competitor to Rolls-Royce’s. The stability provided by its commercial aerospace segments acts as a financial buffer, but lowers the net impact of defence spending.

Northrop Grumman Corporation (NYSE: NOC) focuses on strategic deterrence programmes, such as the B-21 Raider bomber and the Sentinel Intercontinental Ballistic Missile (ICBM). Its backlog stands at more than $90 billion and stretches decades into the future. Management expects the acceleration of production to drive significant sales growth. Like Lockheed Martin, Northrop faces FFP execution risks, but is making strategic choices to sacrifice immediate margins on early B-21 production to secure long-term dominance.

General Dynamics Corporation (NYSE: GD) is a diverse firm, with both defence and non-defence segments. It is split into four similar sized divisions: marine systems (submarines); technology (defence information systems); combat systems (land) and aerospace (Gulfstream). The combat systems segment is a primary beneficiary of European land rearmament, securing contracts for the Piranha and Ascod vehicles. The company’s overall operating margin expansion is driven by both defence and the highly profitable Gulfstream private-jet business.

L3Harris Technologies (NYSE: LHX) is a high-tech company specialising in command, control, computers, communications, cyber, intelligence, surveillance, and reconnaissance (C5ISR) and space systems. The firm reported an outstanding book-to-bill ratio, which compares orders received to orders delivered, of 1.5 times, suggesting demand is accelerating. Focusing on high-demand, high-margin technology, and not on older legacy manufacturing, is a priority. This approach aligns with allied budgets that favour integrated, multi-domain operations. The firm was the product of a merger of two rivals in 2019 and the shares have thus far failed to live up to the promise, but the outlook has been improving.

Thales (Paris: HO) provides exposure to technology and digital warfare. A quarter of the business is owned by the French state. It is a complex business that is considered strategically important by the French government. Thales is a technology company as much as a defence business, having made large investments in areas such as cybersecurity, artificial intelligence and quantum technology. Additionally, it produces avionics for aircraft and short-range missile systems.

Understanding the risks

Demand for defence is secure, but it’s not without risks. Fortunately, these are largely offset by long-term contracts and government planning. The first risk involves finances. Western governments face tight budgets. In the UK, the new defence target of 3.5% of GDP is demanding. Ageing populations and high debt levels make this goal tough to maintain. However, long-term contracts ease this concern. Programmes such as Aukus and GCAP last for generations. Governments commit to infrastructure and they sign contracts for development and production that span decades. These agreements ensure steady revenue for contractors, even if budgets face short-term cuts.

The second risk stems from the changing nature of warfare. Conflicts are beginning to focus on drones, cyber threats and technological espionage. Current spending often targets traditional platforms, such as tanks and ships, which may not address new, unconventional threats. However, listed companies benefit from guaranteed spending, regardless of the platform’s effectiveness. Long-term government defence plans secure this funding, protecting UK and Western-aligned firms. The third risk involves public opinion. As governments shift money from welfare to military strength or raise taxes to fund both, public support may weaken. This political challenge could delay or reduce future budgets, affecting defence companies.

Still, there is an extraordinary opportunity here for defence companies that are facing levels of sustained growth not seen for almost 40 years. BAE Systems is the obvious pick for those seeking broad exposure. It is no longer the cheap stock it once was, but it gives pure exposure to defence spending that provides exposure to both UK and US defence spending. It operates across a large number of product types and has secured contracts that could run into decades. For those looking for a cheaper business, Lockheed Martin, the world’s largest defence business, is on a discount to the sector. It requires investors to look beyond the problems caused by the fixed-price contracts, but is the purest way of gaining exposure to the US defence budget.

Babcock gives exposure to long-term support contracts, which are vital in maintaining programmes and facilities. Finally, L3Harris has struggled slightly in recent years from issues created by its merger, but it looks as if its problems are behind it. Should that be the case then earnings growth could come through at a rate even higher than the other defence stocks.

This article was first published in MoneyWeek's magazine. Enjoy exclusive early access to news, opinion and analysis from our team of financial experts with a MoneyWeek subscription.