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What Are Your Thoughts on European Defense Companies?
NATO was founded in 1949 by the U.S. and Europe, four years after the end of WWII. The idea behind the alliance was simple — you attack one member country, you attack them all. Over the last fifty years, American presidents (starting with Nixon) have complained that Europe is not spending enough money on defense.
Americans have always outspent Europe on defense, but to be fair, we have a currency advantage. Our military might, combined with a strong political system and a very large and robust economy, elevated our currency to reserve status. Being the world’s reserve currency meant we had constant inflows into the U.S. dollar, allowing us to live beyond our means and not pay the price in skyrocketing rates — and which made it easier to run budget deficits and finance a bigger military. In other words, we received a return on our defense investment in the form of lower interest rates.
Europe was a different story.
The reasons European countries underspend on defense vary, but share underlying commonalities. After starting two world wars in the past century, Germany (the largest economy in Europe) looked at military armaments the way an alcoholic in AA looks at beer, trying desperately to steer clear of them. France — Europe’s third-largest economy — was spending almost one-third of its GDP on social programs, at least 13% more than the U.S. as a percentage of GDP, and conversely only dedicating 1.9% of GDP on defense.
In general, European countries have infused so much socialism and regulation into their economies that their economic growth has lagged behind the U.S. As a result, their GDP per capita (i.e., average salary) is a third lower than in the U.S.
In a world where the U.S. became a cradle of innovation and China turned manufacturing into a science, Europe has perfected the art of drafting regulations — and not much else. It is very hard to think of a single startup or newly created company in Europe. I can only think of one — Spotify in Sweden (the exception that proves the rule). Overregulation, high social spending, high energy costs, burdensome taxation, prohibitive labor laws, and a slew of other structural obstacles killed economic growth in Europe, and thus the ability to spend on defense.
Europe has plenty of highly educated and brilliant people. When they come up with startup ideas, they move to the U.S.
It is politically hard to allocate money to defense spending when economies are stagnating. Since the euro does not enjoy reserve currency status and the EU cannot issue “euro bonds” (though this may change), higher defense expenditures cause interest rates to go up. This is exactly what happened in March, when European countries announced that they’d be spending more on defense — their long-term rates jumped.
This defense-spending money could have come from cutting other expenses (i.e., social programs), running larger deficits, or raising taxes. Of course, Europe had another choice — doing what seems to be the impossible: cutting regulations (maybe even taxes), loosening restrictive labor laws, and growing the economy by making their environment business-friendly.
Over the last quarter of a century, Europe has underinvested in defense by several trillion dollars. According to the NATO charter, Europe was supposed to spend 2% of GDP on defense, but it has spent about 1.4% — a gap of about $120 billion a year (in today’s dollars).
After the Cold War
Most importantly, there seemed to be little need or urgency. The Cold War was over. The Soviet Union had fallen. Russia was in shambles, and Eastern and Western Europe were forging economic and political ties. There were no immediate threats. Consequently, Europe cut defense spending and went about collecting its peace dividend. And, of course, it was protected by its most powerful friend and NATO partner, the United States of America, which spent more on defense than the rest of the world combined.
Then, in 2022, the unthinkable happened: a territorial war in Europe. Russia invaded Ukraine, and Europe found itself in an uncomfortable situation: It wanted to help Ukraine but could not.
This excerpt from an interview with Ukraine’s ex-foreign minister Dmytro Kuleba captures this harsh reality perfectly:
When the war started and I realized that the best way I can help my country as foreign minister is not to negotiate with the enemy, because it didn’t make sense to negotiate with them, but to negotiate weapons for Ukraine….
It got really scary when I realized that there is very little to negotiate because Europe has proudly positioned itself as the state of the art, of cutting-edge military technologies. The problem is that these technologies existed in the quantities necessary for arms exhibitions taking place simultaneously in different parts of the world. That was it. That was the scariest moment – when you realized how quickly warehouses will run out of reserves because they were not replenished for decades.
Europe had armies but only showroom weapons. Germany quite literally did not have a rifle and ammunition for each of its soldiers. In other words, it was going to defend itself with bow and arrows against Russia — whose army was the largest in Europe.
(Side note: Think about this next time you hear Putin claim that the invasion of Ukraine was to stop a NATO invasion. Europe simply did not have the weapons to pose a threat to Russia).
Russia invading Ukraine was a wake-up call for Europe (sort of). European governments increased their defense spending in large part to help Ukraine. However, the increase came from a very small base. While the U.S. was spending 3% of GDP on defense, Germany went from 1.2% to 1.9%, and the U.K. went from 2.2% to a whopping 2.3%. Most of Europe clearly was not concerned about defending itself against the still-low probability of a Russian invasion. After all, it was protected by the U.S.
On the other side of the pond, the U.S. found itself in its own pickle. It had run up $36 trillion of debt, with interest payments that became larger than its defense spending. Russia is far and away a bigger threat to Europe than to the U.S. — we are protected by two huge oceans.
Also, the U.S. had a new and, in many ways, a stronger rival — China. Over the last three decades, the U.S. industrial base has been shipped to China. The Chinese shipbuilding industry has a 200 times greater production capacity than the U.S. China’s navy surpasses ours in ship count, though not yet in overall capability — but while theirs grows in strength and number, ours continues to shrink.
The essence of the NATO alliance was that all partners would protect each other. In reality, Europe had demilitarized itself over the last three decades. From the U.S. perspective, the issue is not just about money. If Europe has no military force, then it will be young American men and women who will be dying protecting Parisians from speaking Russian if Putin’s tanks roll in. Meanwhile, the war in Ukraine has shown that our European allies don’t have the means to come to our rescue if we are attacked.
During his first term, President Trump raised the issue of the Europeans not holding up their part of the NATO bargain. In his second term, unencumbered by reelection concerns and emboldened by America’s economic dominance over other major powers, his self-described transactional approach led him to question both NATO’s value to the U.S. and America’s commitment to defend Europe if attacked.
An Evolving Relationship
The U.S. and Europe are “the West” — we share similar values and have strong economic ties. However, over the last few months there was a significant shift in this multigenerational relationship. Europeans felt that the U.S. suddenly switched sides and aligned with the enemy when the United States joined Moscow to vote against a UN General Assembly resolution condemning Russia’s war against Ukraine. Trump then bypassed European allies and Ukraine by negotiating peace with Russia directly, excluding Europe from the conversation altogether.
Armin Papperger, CEO of Rheinmetall — the largest defense company in Germany and one in which IMA is a shareholder — aptly described the American perspective: “If parents have dinner, the kids sit at another table. Right now, the U.S. is negotiating with Russia, and no Europeans are at the table. It has become clear that Europeans are being treated like kids. If you don’t invest, if you aren’t strong, you end up being treated accordingly.”
This stunned Europeans.
The trust that was built over almost 80 years, while not quite shattered yet, has been significantly cracked in a span of just a few weeks. Whether your friend will come to your defense is not something you want to discover at the last minute. Europe therefore suddenly found itself in an existential need to rearm.
This is a difficult but not insurmountable task. Europe has a population of 400 million people, while Russia’s is only 140 million. The European economy is $20 trillion — ten times larger than Russia’s $2 trillion. To be sure, Russia has certain advantages — it has been at war for three years, which has weakened its economy but made its military stronger and battle-tested. Russia is also ruled by a dictator who can make decisions fast. Europe, by contrast, is a collection of several dozen democratic countries, each with their own internal politics. Consequently, reaching consensus is a painstakingly slow and difficult process.
But nothing unites these countries and expedites decision-making like the threat of learning Russian — it is a very difficult language.
I know this sounds over the top. I’m sure you’re thinking that Russia is not about to invade France. I would have said (and did say) the same thing about Russia invading Ukraine. But Finland, Lithuania, Latvia, Estonia, Poland, Czechoslovakia, and Ukraine have been invaded by Russia (or the Soviet Union) over the last 100 years.
Abraham Maslow, American psychologist, described food, shelter, and safety as fundamental human needs; we cannot focus on anything else unless these needs are satisfied.
Europe no longer feels safe.
Today Europe has the will and the urgency to act. It now needs to find the money. Two-thirds of Germans support increased defense spending — an astonishing figure. Badly scared by hyperinflation a century ago, Germany today is no longer concerned about increasing its debt for defense spending. This point is very important, as Germany previously was the spending hawk in the EU. Germany’s new chancellor is working on passing $800 billion in spending on infrastructure and defense, increasing the country’s defense budget to 3.5% of GDP (tellingly, German and EU governments want to exclude defense spending in fiscal deficit calculations).
Other European countries are trying to figure out how to raise money. There will be a lot of social programs that will get cut.
We are at the beginning of a significant European defense spending supercycle. It is payback time after decades of underspending. European defense spending is going up — and will go up a lot.
What is even more important is that revenues of European defense companies — for several reasons — will likely outpace headline increases in GDP.
Not all defense spending in the past went for weapons. In fact, the bulk of European defense spending went for paying soldiers, pensions, etc. — pretty much anything other than weapons.
Here is one way to understand the difference in priorities between European and American defense spending. In 2010, Germany spent $43 billion on defense; only $6 billion of that was on weapons. The same year, the U.S. spent $786 billion on defense, out of which $235 billion went for weapons. Even when adjusted for population (the U.S. is four times larger than Germany), Germany would still have spent only one-tenth as much as the U.S. on weapons.
Changes for the Global Defense Industry
European defense spending went up sharply in 2022, but these countries had to make up for at least a quarter-century of underinvestment. A much greater proportion of new defense spending will go to weapons, outpacing the growth of total defense spending. Additionally, a much greater portion of that spending will go to European companies, at the expense of American defense firms. Let me explain why.
My friend Ben says, “Sometimes little things tell us a lot about big things.”
The U.S. co-developed the Trident nuclear weapon with the U.K. Lockheed Martin developed the missile, while the U.K. developed the nuclear warhead. The Trident missiles are not owned outright by the U.K. but are leased from the U.S. The U.S. maintains the missiles and stores them in King Bay in Georgia. But now the U.K. is considering alternative plans, uncertain whether the U.S. is going to honor its lease agreement. It is talking to France about potentially providing a nuclear shield for the U.K. This tells you the level of trust America’s closest ally has in us.
We think of countries as monoliths, but they are run by people, and when countries have a relationship, these people may experience emotions similar to those of a married couple. When your partner breaks your trust, you start questioning all aspects of the relationship that were based on that trust.
Let me give you another example. In March 2025, at President Trump’s direction, the U.S. stopped intelligence sharing with Ukraine. The U.S. also halted software support for the electronic warfare systems of the F-16s operated by Ukrainians. This removed radar jamming capabilities, making F-16s nakedly vulnerable to Russian anti-aircraft missiles.
A good chunk of Lockheed Martin’s revenue comes from sales of F-35 planes to European countries. The F-35 is the best plane made today. However, if the U.S. stops software and parts support, it becomes an expensive brick. It is costly to cancel orders that have already been placed, but we have already seen other nations decide not to order F-35s — Portugal was very vocal about it.
We estimate that EU spending on weapons over the next five years (from 2026 to 2030) will exceed $1.4 trillion, which is 130% more than over the previous five years. This estimate is based on defense spending that is 3.0–3.5% of GDP. I can see this figure going to 5%. Historically, about 20% of weapons spending has gone to U.S. contractors, but this percentage will decline significantly in the future.
What Is Next?
Defense stocks represent a significant part of our portfolio — firmwide about 35% (this percentage is somewhat inflated because of recent price appreciation). We have been adding to our defense stocks opportunistically over the last few years and increased our position as recently as early February.
Now comes the hardest part — sitting on our hands. There is going to be a lot of news flow impacting the price of these companies, driving them up and down. Most defense companies in our portfolio today — with maybe the exception of Huntington Ingalls (HII) and Babcock (BAB in London) — don’t look in-your-face cheap. However, this apparent lack of cheapness is a bit deceiving.
Their current and near-term earnings reflect a different geopolitical environment than the one that is emerging. It will take time — a few years — for this process to unfold. Legislation must be passed, social programs cut, funds raised, plans formulated, and orders placed before these changes translate into sales. When this happens, profits will rise, and rise substantially.
The potential end of the war in Ukraine is mixed news for European defense companies. On one hand, they’ll need to send fewer weapons and ammunition to Ukraine. On the other hand, a not-at-war Russia will rearm and become a more dangerous Russia, thus increasing the urgency for Europe to rearm.
We want to prepare you that fluctuations on this side of the portfolio are likely to increase — but please, don’t confuse them for increased risk. Our patience is likely to be rewarded in the long term.
Vitaliy Katsenelson is the CEO at IMA, a value investing firm in Denver. He has written two books on investing, which were published by John Wiley & Sons and have been translated into eight languages. Soul in the Game: The Art of a Meaningful Life (Harriman House, 2022) is his first non-investing book. You can get unpublished bonus chapters by forwarding your purchase receipt to [email protected].
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.