In defence of Europe’s tankmakers

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A fondness for European defence stocks has been a somewhat oddball hobby for most of the last decade or two, but like V-neck jumpers, the sector is firmly back in fashion. So much so, in fact, that it is looking a little overdone. (I didn’t realise the jumpers were out either, but our style pages informed me of my ignorance last week.)

Many investors succeeded in ignoring the defence sector altogether for years, particularly in the period before Russia’s full-scale invasion of Ukraine in 2022. It was, of course, naivety in retrospect but compelling at the time.

Makers of bullets, bombs and tanks fell from favour at the height of the sustainable investing boom. When asset managers could barely open their mouths without uttering the letters E, S and G — investment with environmental, social or governance aims — this sector often got the cold shoulder. Again, Vladimir Putin has succeeded in reminding well-meaning money managers that funding companies that try to protect non-aggressor states from harm can still sit comfortably in a virtue-seeking portfolio. In a client podcast last month, Ian Douglas-Pennant, an analyst covering the sector for UBS Research, joked that his client visits across continental Europe now are often characterised by fund managers asking him for a rundown on everything they have missed while they have been hunting for opportunities elsewhere or constrained by ESG considerations. “Can you bring me up to speed on the last 20 years?” they ask. He is happy to oblige.

The performance of the sector this year has been really something. While shiny US tech stocks and chipmakers have sucked in the bulk of fund managers’ attention, European defence has, if you’ll pardon the pun, rocketed. Goldman Sachs’s basket of European defence stocks has pushed 40 per cent higher just this year.

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Demand for the sector has clearly woken up. Investment manager VanEck said its exchange-traded fund tracking European defence companies has drawn in $500mn in the year since it launched — a build-up that “illustrates the importance of defence nowadays for investors”, said Martijn Rozemuller, chief executive of VanEck Europe. “Traditionally, the defence industry has been a rather sensitive topic, especially in Europe. However, the outbreak of war in Ukraine and other areas of tension and conflict around the world have changed the way many people view defence policy.”

Among the striking examples in the sector, stocks in the UK’s BAE Systems have climbed by 15 per cent this year — streets ahead of the broader UK index. Germany’s Rheinmetall, which makes ammunition, is up a staggering 83 per cent. Bavaria’s Renk has gained 71 per cent just since it listed in February. Among other things, Renk makes slide bearings for tanks. I do not know what tank slide bearings are, and many other buyers of the shares probably do not either, but they do know that with conflict under way in both Israel and Ukraine, and commitments from a host of European governments to lift defence spending, betting on good fortune for companies in the sector makes sense.

These stocks are tiny flecks in comparison to the giant that is Nvidia, with its market capitalisation north of $2tn, but some of the gains are of a similar magnitude, if not bigger. As Douglas-Pennant at UBS points out, plenty of fund managers are latching on to the phenomenon. 

Nothing moves in a straight line in markets, and so it is perhaps no surprise that this week, the trend came a little unstuck. Rheinmetall shed 7 per cent, while BAE dropped 4.5 per cent. It was the worst day for the sector since the 2020 Covid crisis blasted markets.

This still leaves these stocks standing far above where they started the year, but nonetheless, it is a serious knock. One trigger for this appears to have been a note from Goldman Sachs, in which analysts Peter Oppenheimer and Sharon Bell, among others, said while they are “relatively constructive on the European defence outlook, we are not recommending EU defence given the challenging valuation premium and strong run of outperformance”.

The sector has, they suggested, simply done just too well for its own good. Goldman’s basket of related stocks has pushed higher almost constantly since the invasion of Ukraine, leaving them with valuations some 45 per cent higher than the broader market, compared with an average lag of 7 per cent. Time, it seems, for some investors to pause.

It is rare to find a sector in Europe that drops back simply because it has been such a runaway success. Luxury — Europe’s other key investment theme — has taken a hit from investor unease at Kering’s strategy and at the slow-burning economic malaise in China. They are both meaningful reasons for weakness, but not quite the same thing. 

For defence, this week’s wobble stems from a broad community of investors who ignored the sector for years, now hugging it a little too tightly. Longer term, though, it is hard to see a strong case for a serious decline. The US may have its shiny AI stocks but in this geopolitical environment, the manufacturers of Europe’s bullets and tanks really count for something.


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