Defense stocks have been the quiet sector outperformer of the past three years across both US and European markets. Lockheed Martin, Northrop Grumman, RTX, General Dynamics, and the smaller US prime contractors have produced total returns that have outpaced most cyclical sectors. The European defense companies — BAE Systems, Rheinmetall, Saab, Leonardo, Hensoldt, and several specialised manufacturers — have produced even more dramatic outperformance, with several of these stocks delivering multi-hundred-percent returns since the 2022 inflection point that began the European rearmament cycle.
The structural drivers of the outperformance are genuinely durable in ways that the market continues to underprice. The European NATO commitment to defense spending at significantly elevated levels, the US defense budget trajectory under both political parties, and the global geopolitical environment that has hardened across multiple flashpoints all support a procurement cycle that operates over multi-year and multi-decade time horizons rather than the cyclical quarters that typically dominate equity market positioning.
Understanding why the defense sector outperformance has been sustained, what the specific procurement dynamics actually look like, and which companies have the strongest competitive positions for the continuation of the cycle provides important context for evaluating both the defense sector exposure and the broader implications of sustained geopolitical reality for global investment allocation.
The European Rearmament Commitment That Has Not Been Fully Discounted
The European NATO members’ commitment to defense spending at 2 percent of GDP and beyond — and the specific spending plans that several governments have announced for periods well above the 2 percent threshold — represents a structural change in the European defense procurement environment that the market has been slow to fully discount. The aggregate increase in European defense spending from the pre-2022 baseline to the current commitment levels represents hundreds of billions of euros in incremental procurement over the next decade, supporting sustained revenue growth for the manufacturers who can satisfy the demand.
The specific procurement programs that have been initiated or expanded include the various air defense systems (Patriot extensions, IRIS-T expansion, the European Sky Shield Initiative), the artillery and ammunition production capacity expansion (driven significantly by the lessons of the Ukraine conflict about munitions consumption rates in sustained conventional warfare), the ground combat vehicle programs across multiple European nations, and the broader military aircraft, naval, and electronic warfare procurement that operates on multi-year and multi-decade timelines.
The broader European equity outperformance has been substantially supported by the defense sector contribution, and the defense sector dynamics deserve specific consideration separate from the broader European macro analysis. The defense procurement is driven by political commitment rather than by the cyclical economic dynamics that affect most other sectors, which means the defense sector revenue visibility is genuinely different from typical industrial cyclical dynamics.
The specific European defense beneficiaries have been varied in their performance based on their product positioning. Rheinmetall has captured significant value as the dominant European producer of ammunition and ground combat systems. Saab has benefited from increased fighter aircraft and submarine demand. Leonardo has captured value across helicopters, electronics, and various other defense categories. BAE Systems has benefited from sustained UK and international demand. Hensoldt has been particularly successful in the electronic warfare and sensor systems segment that has received elevated funding given the modern combat environment’s emphasis on electromagnetic spectrum capability.
The US Defense Budget and Procurement Reality
The US defense budget continues to operate at substantially elevated levels in real terms, supported by both political parties’ general commitment to defense spending despite political differences on specific priorities. The annual defense budget exceeds $850 billion in the current cycle, with the trajectory continuing to grow modestly in nominal terms even as inflation considerations affect the real growth rate.
The specific US defense procurement priorities that affect the major contractors include the various nuclear modernisation programs (replacing the Cold War-era nuclear delivery systems), the F-35 program that continues to support Lockheed Martin’s revenue, the various unmanned systems and AI-related defense modernisation, the shipbuilding programs that support General Dynamics and Huntington Ingalls, and the broader missile and air defense procurement that affects RTX, Lockheed, and the various other prime contractors.
The honest assessment of the US defense procurement environment is that the cycle is structurally supportive of the major contractors but has more specific competitive dynamics than the European cycle. The US procurement process produces specific winners and losers among the prime contractors based on program awards, performance, and political dynamics that affect specific programs. The aggregate US defense contractor exposure provides reasonable broad sector returns; the specific contractor selection requires more careful evaluation of program positioning.
The defense technology and modernisation themes have produced substantial growth for the companies that have positioned for these segments. The broader AI infrastructure investment has affected defense modernisation in ways that benefit specific technology-adjacent defense companies (Palantir for software and AI, Anduril for autonomous systems, the various other defense tech companies that have integrated modern computing capabilities into traditional defense applications).
The Procurement Cycle Duration and Revenue Visibility
The structural feature of defense procurement that distinguishes it from most other industrial sectors is the duration of the procurement cycles and the resulting revenue visibility. A modern military procurement program from initial requirement definition through delivery and sustainment can span 20-30 years. A fighter aircraft program operates over similar timelines. Submarine and naval shipbuilding programs operate over 30-50 year timelines including initial construction and the sustainment activity throughout the platform lifecycle.
This procurement cycle duration provides revenue visibility that is genuinely different from cyclical industrial demand. A defense contractor with substantial backlog in major platform programs has revenue visibility that extends years into the future, with limited risk of cancellation given the political and operational commitment that the programs represent. The combination of multi-year backlogs and the political durability of major defense programs creates an income stream that is more stable than most industrial revenue.
The book-to-bill ratios for the major defense contractors have been elevated for sustained periods since 2022, indicating that new orders are exceeding revenue recognition by meaningful margins. This is consistent with sustained backlog growth that will support revenue growth in future years. The specific book-to-bill data for the major US and European contractors has been monitored closely by analysts as a leading indicator of the defense sector revenue trajectory.
The Ammunition and Munitions Sub-Sector
The ammunition and munitions sub-sector deserves specific attention because it has been the most acute and visible expression of the post-2022 defense procurement dynamics. The consumption rates for artillery ammunition, anti-tank weapons, and various other munitions in sustained conventional warfare have substantially exceeded pre-2022 production capacity assumptions, requiring major industrial capacity expansion across the Western defense industrial base.
The specific companies that have benefited from the munitions production expansion include Rheinmetall (artillery ammunition and Leopard tank ammunition), General Dynamics (ammunition production capacity in the US), Northrop Grumman (various missile and munitions systems), Nammo (the Nordic explosives and ammunition manufacturer), and several smaller specialised manufacturers that have received substantial orders to expand their production capacity.
The capacity expansion that the munitions sub-sector has executed represents long-term commitments that provide sustained revenue beyond the immediate Ukraine-driven demand. The political consensus across Western nations about the importance of munitions production capacity (driven by the lessons of conventional warfare consumption rates) supports continued demand even if the specific Ukraine-related demand moderates. The munitions sub-sector therefore has structural support for sustained elevated production through the procurement cycle.
The Software and AI Defense Categories
The intersection of defense procurement with AI and software capabilities has created specific company opportunities that operate differently from the traditional defense prime contractor model. Palantir Technologies has positioned its data analytics and AI capabilities for defense and intelligence applications, with substantial growth in revenue from defense customers. Anduril Industries has built autonomous systems and AI-enabled defense applications that have captured significant contracts from US and allied defense customers.
The strategic question for these defense technology companies is whether they can sustain the rapid growth that the early AI defense procurement has produced as the procurement cycle matures and as the traditional prime contractors invest in matching capabilities. The bull case is that the defense technology companies have structural advantages in pace of innovation, ability to recruit AI talent, and integration with broader commercial AI capabilities that the traditional primes cannot match. The bear case is that the traditional primes have substantially deeper political and procurement relationships that allow them to capture the AI-related procurement value as their offerings mature.
The probable outcome is some combination of both — the defense technology companies will sustain meaningful positions in specific niches where their AI and software capabilities provide clear differentiation, while the traditional primes will increasingly integrate AI capabilities into their broader programs and capture the value from the broader defense AI procurement. The investment implications depend on identifying which specific companies have the most durable positions in their respective niches.
The Risks That Could Disrupt the Cycle
The defense sector outperformance has been sustained for long enough that the specific risks that could disrupt the cycle deserve consideration. The most significant near-term risk is political — the possibility of a shift in defense spending priorities across major Western nations that would reduce the procurement commitment levels that the current outperformance is based on. The political consensus across Western nations about the importance of elevated defense spending has been more durable than typical political coalitions, but it is not immune to changes in political circumstances.
The fiscal pressure that elevated defense spending creates is a real consideration. Defense spending at the levels that European NATO members have committed to consumes substantial fiscal space that could otherwise support other government priorities, and the political sustainability of these commitments depends partly on the public’s continued perception that the elevated spending is justified by the security environment. A scenario where geopolitical tensions ease meaningfully could produce political pressure to reduce defense commitments, with corresponding implications for the defense sector revenue trajectory.
The broader fiscal pressure on Western governments creates a complex dynamic where defense spending is one of several competing priorities for limited fiscal capacity. The political durability of defense spending has been demonstrated through the current cycle, but the structural fiscal pressure could eventually constrain the procurement growth that the current trajectories imply.
The Valuation and Positioning Considerations
Defense sector valuations have expanded substantially over the past three years reflecting the strong fundamental performance and the increased market recognition of the structural drivers. The current valuations are not at the depressed levels that supported the early outperformance, which means the marginal return from new positioning is more dependent on the procurement cycle continuing than on the multiple expansion that supported earlier returns.
For investors evaluating defense sector exposure in 2026: the structural case for continued exposure remains strong, but the entry valuations matter more than they did in 2022-2023. Selective positioning across the defense sector — emphasising companies with the strongest specific program positions, the most durable competitive advantages, and reasonable valuations relative to growth — produces better risk-adjusted returns than broad sector exposure at current valuations.
The European defense exposure continues to provide stronger relative value than US defense exposure because the European procurement cycle is at an earlier stage of its development relative to the US cycle. The specific European companies that have positioned for the rearmament cycle have produced substantial returns but continue to trade at valuations that reflect their growth opportunity, while US defense valuations more fully reflect the established procurement environment.
For broader portfolio considerations: defense exposure provides specific characteristics — low correlation to broader cyclical equity dynamics, durable revenue visibility, and exposure to the geopolitical themes that continue to shape the global investment environment — that justify dedicated allocation rather than treating defense as an undifferentiated industrial sub-sector. The persistence of the defense sector outperformance has demonstrated that the structural drivers are real and durable, and the appropriate response is portfolio-level recognition of these drivers rather than continued underweighting of a sector that has produced sustained alpha for three years.
The honest position is that the defense sector outperformance reflects genuine structural drivers that continue to support continued investment exposure, that the entry valuations require more careful selection than they did at the cycle’s start, and that the multi-decade procurement visibility provides revenue durability that justifies premium multiples relative to typical industrial sectors. The next several years will continue to test the political commitment to elevated defense spending, but the trajectory of the current cycle suggests continued strong fundamental performance even as the valuation expansion that supported earlier returns moderates.
Testing Defense Stocks Against the Seven Powers Framework
Hamilton Helmer’s Seven Powers framework identifies the competitive advantages that generate durable, compounding returns rather than temporary outperformance. Defense stocks have delivered three years of exceptional returns, and the standard explanation — geopolitical tension, European rearmament, procurement backlogs — is accurate but incomplete. The Seven Powers analysis identifies which of those drivers represent genuine competitive moats and which represent cyclical tailwinds that will eventually normalize. The distinction matters for whether defense returns over the next five years look like the last three or like the mean-reversion that follows most cyclical outperformance.
The strongest defense sector power is Switching Costs, and it operates at a scale that makes most software switching costs look trivial. A nation-state that has integrated Lockheed’s F-35 into its air force cannot switch to a competitor’s platform without retiring the entire training pipeline, maintenance infrastructure, logistics system, spare parts supply chain, and pilot certification program that the F-35 requires. The switching cost of changing a major defense platform is measured in decades and billions of dollars. That is not a moat. That is a geological feature. The multi-decade revenue visibility the article identifies is a direct consequence of this Switching Cost structure: once a platform is adopted, the revenue stream that follows is close to captive.
Cornered Resource is the second relevant power, and it operates through the cleared workforce and classified program access that defines the prime contractors’ competitive position. Lockheed, Northrop, Raytheon, and BAE have accumulated decades of security clearances, classified program experience, and government customer relationships that cannot be quickly replicated by new entrants. A startup that builds better drone technology cannot access the classified threat assessment data that defines the performance requirements for the defense programs being competed. The Cornered Resource is not the technology. It is the security infrastructure, the clearance pipeline, and the classified customer relationships that determine who gets to compete for the programs that generate the revenue.
Counter-Positioning is where defense’s competitive landscape becomes most interesting relative to the AI technology sector. Enterprise AI adoption is creating a new category of defense-relevant capability — autonomous systems, AI-assisted intelligence analysis, cyber offense and defense — that the legacy prime contractors are not optimally positioned to develop. The new entrants in defense AI — Palantir, Anduril, Shield AI — are attempting a Counter-Positioning move: building AI-native defense capabilities that the legacy primes cannot replicate without cannibalizing their existing program structures. Whether that Counter-Positioning succeeds depends on whether the procurement system changes fast enough to allow AI-native capabilities to compete on equal terms with legacy platform contracts.
The European rearmament commitment is a genuine multi-year demand catalyst that is not fully reflected in the current order books. Rheinmetall and BAE’s ground vehicle and ammunition backlogs extend years into the future at production rates that are already being expanded. The corporate capital return context is relevant: defense companies are returning capital at rates that imply confidence in the demand visibility — they are not hoarding cash for uncertain times but distributing it because the procurement contracts make revenue sufficiently visible to support distributions. That is the behavioral signal from the management teams closest to the actual backlog data.
The Seven Powers risk in defense that the three-year return does not yet reflect is Network Economies — or more precisely, the absence of them in the legacy platform model. Software businesses generate network effects that compound returns as the user base grows. Defense platforms do not. The F-35’s value does not increase because more nations operate it; the contract is the unit of revenue, and the revenue is fixed by the contract rather than by a growing network. That means the defense sector’s returns are durable but not compounding — they grow at procurement cycle rates rather than at network economy rates. Prediction markets on European NATO defense spending through 2027 are pricing continued demand growth — which means the cyclical tailwind still has runway. But the Seven Powers analysis would price that tailwind at a modest multiple, not at a software-style compounding multiple. The sector is genuinely strong. It is not structurally exceptional in the way the recent returns imply.
The Inversion Problem: What Failure Would Actually Look Like for European Defence Stocks
Charlie Munger borrowed a rule from the mathematician Carl Jacobi: invert, always invert. When you are tempted to ask why something will succeed, force yourself first to enumerate every mechanism by which it could fail. Applied to European defence stocks in the current rearmament cycle, inversion produces a cleaner picture than optimism usually allows.
The failure case begins with fiscal arithmetic. European defence spending commitments are made by governments running structural deficits and relying on domestic bond markets that depend on ECB support frameworks negotiated during a different rate environment. If sovereign spreads widen—and Treasury auction dynamics have already shown how quickly bid-cover ratios can deteriorate when sentiment shifts—procurement budgets become the first line of adjustment. Defence ministers sign contracts. Finance ministers control disbursements.
The second failure mechanism is portfolio rotation. The 60/40 portfolio breakdown pushed institutional capital toward real assets and duration-sensitive positions with unusual conviction. A correlation regime shift—if bonds and equities resume their historical negative relationship—would redirect flows back toward fixed income and compress the multiple expansion that has driven defence sector outperformance more than earnings growth in most cases.
Currency is the third lever. European defence contractors report in euros but procurement programs often denominate materials costs in dollars. A sustained move in FX translation versus operating performance creates margin compression that does not appear in order book announcements. The headline contract value stays fixed while unit economics quietly deteriorate.
Technology substitution is a slower but structurally important failure path. AI power demand forecasts have a phantom-load problem that defence budget modeling shares: announced capability timelines are real, but the funding pathway from announcement to deployed unit assumes a political continuity that European coalition governments rarely sustain across election cycles. Software-defined defence systems compress procurement timelines in ways that disadvantage traditional prime contractors whose competitive advantage is manufacturing scale.
Munger’s inversion exercise does not necessarily invert the conclusion. It clarifies the conditions. European defence remains a structurally supported theme if fiscal commitments hold, if NATO credibility remains intact, and if procurement agencies execute with discipline. But passive institutional demand has been absorbing defence sector exposure without distinguishing between contractors with genuine cost discipline and those riding a sentiment wave. When the wave corrects, that distinction will matter considerably more than the order book. Inversion does not tell you to avoid a position. It tells you what would need to remain true for the position to pay off, and in European rearmament, the list is not short.
