August 2025
INVESTMENT VIEWS
OUR PARTNERS AT WALTER SCOTT
After years of underinvesting in its military capacity, Europe is rapidly increasing defense spending. Responding to the twin shocks of a threatened reduction in U.S. military support and Russian belligerence in Ukraine, European Union (EU) member states have lifted spending by 30% in recent years. A further €100bn is expected by 2027.1
Those European countries that are members of NATO are likely to have to go even further. Mark Rutte, the secretary general of the transatlantic alliance, has called for a “quantum leap” in spending. Share prices of European aerospace and defense (A&D) have reflected this surge in the first half of the year, comfortably outstripping a +20% return of the wider MSCI Europe index.2
Control of destiny
Walter Scott’s international strategy has a longstanding underweight exposure to the A&D industry. This position is not predicated on any inherent negative bias; no industry or sector is off our research radar. Rather, we have been largely absent for reasons consistent with our investment philosophy.
COMING IN FROM THE COLD
Defense expenditure is rising after years of flatlining
Before we invest in a company, we try to establish the extent to which it has control of its own destiny. How wide is its competitive moat? Does it have pricing power? Is it too reliant on a single or small group of customers? We believe that the greater the control of destiny, the greater the likelihood a company can sustain high levels of growth and profitability over time.
For several reasons, however, traditional A&D businesses have historically lacked the necessary control of destiny we look for:
- Defense budgets, procurement policy and contract structures are partially driven by political rather than economic factors.
- Companies can be heavily reliant on single contracts.
- Contracts are often necessarily opaque due to classified information. Strategic autonomy is limited by the need to align with government demand.
This is particularly true of the European “defense primes”, the handful of large, strategic military contractors with direct government relationships and historically dominant shares of national procurement budgets.
The world has changed…
According to the Peace Research Institute Oslo, 2024 marked a historic peak in state-based conflicts, with 61 active conflicts across 36 countries — the highest number recorded since 1946. Given today’s proliferation of geopolitical tensions, it is hard to argue convincingly for this trend to meaningfully reverse in the medium term.
Faced with an increasingly fractious world, defense budgets are likely to continue to grow as governments make up for years of underinvestment. Judging by the recent performance of A&D companies, the market seems to share this view. Before we think about potential opportunities in the A&D sector, we believe it is important to think about what higher defense spending might look like.
...and so has warfare
The structural increase in spending outlined above is happening at a time when warfare is undergoing a technological transformation. The conflict in Ukraine is a petri dish for the use of advanced technology for military purposes, notably drones and artificial intelligence (AI). According to a recently published paper by Chatham House “Ukraine has built a defense-tech ecosystem that is reshaping the rules of modern combat.”
The ability to withstand Russia’s vastly superior manpower has not just been due to individual technologies, however. It is also the result of Ukraine’s ability to “regularly outpace Russia in the innovation cycle.” Put simply, warfare is being disrupted by technology more frequently and with greater impact than at any time in history.
There is already evidence that governments are taking the lessons of Ukraine on board. In the UK, the government’s recent Strategic Defense Review vowed to establish “a leading tech-enabled defense power.” “With technology changing warfare so quickly,” the review warns “business as usual is no longer an option.”
Brains over brawn
The evolution of warfare reorients the compass for investors looking to gain exposure to the structural tailwind of higher defense spending.
If incremental advantage in conflict now lies in disruptive technology rather than sheer mass of conventional weaponry, we can expect the companies providing the former to secure a greater share of future defense spend. More cybersecurity, sensors and software; less bombs, bullets and tanks.
This shift in emphasis presents opportunities for more specialist tech-focused A&D players, as well as non-A&D tech companies, to muscle in on rising procurement budgets at the expense of the defense primes. Here, the U.S. offers a glimpse of the future.
Tasked with developing the “Golden Dome” missile defense system, the U.S. Department of Defense is encouraging the involvement of non-traditional contractors with “innovative and disruptive capabilities.” Expect similar exhortations from European governments.
Furthermore, while we continue to question the control of destiny of the primes, more specialist A&D players and tech companies have greater scope to innovate and deliver valueadd capabilities. This should allow them to further grow their share of procurement budgets.
Potential snafus
We are aware of the potential investment opportunities arising from the evolving geopolitical and military landscape. We have visited A&D and related companies in Germany and Sweden, as well as in the U.S., and they have provided valuable insights into not just the positives of the current spending tailwind, but also the challenges. For example, the need to invest significantly in capex to fully capture potential opportunities or the difficulties of ramping-up production to meet rising demand.
There are two other points that we believe merit close consideration when thinking about potential A&D opportunities:
- First, one does not have to be a cynic to view political rhetoric with a degree of skepticism. A Europe of strained government finances is one where difficult choices must be made and not every electorate will find the trade-offs demanded by higher defense spending palatable. Don’t bank on every “promise” of investment materializing.
- Second, we are conscious that the valuations for A&D stocks have traveled a long way in recent months, reflecting lofty expectations for future earnings growth. A great deal of this is likely already baked into share prices.
Staying disciplined
Whether our ongoing research and analysis of specific names converts to portfolio investments will hinge on our assessment of their ability to reliably compound earnings over our long-term investment horizon. The world might have changed, but our commitment to rigor and diligence remains the same.
About Walter Scott
Walter Scott is the global equities-focused investment firm within BNY Investments.
AI, or artificial intelligence, is the ability of computer systems to perform tasks that typically require human intelligence. Capital expenditures (Capex) are funds used by a company to acquire, upgrade, and maintain physical assets such as property, plants, buildings, technology, or equipment. MSCI Europe Index captures large and midcap representation across Developed Markets countries in Europe.
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