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Investing.com -- Barclays (LON:BARC) strategists warn that the strong rally in European defense stocks could trigger profit-taking, particularly if a Ukraine cease-fire materializes, but see any pullback as a buying opportunity amid an accelerating earnings supercycle.
Defense stocks have significantly outperformed the MSCI Europe index, with a year-to-date increase of around 60%. This surge has led to debates about whether valuations are reaching bubble-like levels.
“Positioning looks quite extended and the re-rating suggests a lot of expected good news on defence spend is likely priced in now,” strategists led by Emmanuel Cau said in a note.
“While we would not chase all defense stocks at current levels, we would use potential dips as buying opportunities given defense’s strong structural growth outlook.”
The recent spike in aerospace and defense (A&D) stocks was initially justified by a rise in earnings per share (EPS) growth since the Ukraine conflict began.
The valuation of the sector, when compared to the expected compound annual growth rate (CAGR) of EPS over three years, does not seem overly expensive.
Furthermore, consensus estimates do not yet account for the increased fiscal and defense spending announced by Germany and the European Union (EU). Barclays sees the current momentum as a potential driver for greater EU cohesion in defense matters.
The investment bank estimates that increasing European NATO defense spending from 2% to 3.5% of GDP, with a corresponding rise in equipment spending, could lead to an additional $140 billion in equipment expenditure. This marks a significant increase over current levels.
The strategists see European defense companies like Hensoldt Ag (ETR:HAGG), Rheinmetall (ETR:RHMG), and SAAB AB ser. B (ST:SAABb) as well-positioned to benefit from this uptick.
Based on a 15x through-cycle multiple, defense companies are currently reflecting about 60% EPS growth on average, while consensus expectations are for a 30% EPS CAGR through 2026-2028.
On that basis, share price levels for the aforementioned three companies “appear to be reasonable,” strategists said.
The defense industry might also see a shift in investment from ESG funds, which have traditionally excluded weapons-related companies.
With European policymakers committing more public funds to defense, private financing is expected to increase. Barclays notes early signs of ESG funds adopting a different stance toward the defense sector, which could lead to more investment in these companies.