Michael Patchen, global equity research analyst, William Blair Investment Management writes that the European Union (EU) has a problem.
For decades, member states enjoyed the benefit of the peace dividend under the shade of the US security umbrella. That era, under the current U.S, administration, has ended. The EU’s defence spending is now poised to rise sharply, creating challenges for policymakers but also opportunities for investors. But after a strong rally in European defence equities, investors must now weigh long-term structural growth against the risk of near-term overvaluation.
A changing landscape
America’s willingness to provide security guarantees to Europe is waning just as Russia’s war machine threatens to make devastating progress in Ukraine. If Ukraine falls, the EU faces a grim reality: a fully mobilised Russian combat force could outnumber the EU’s by two to one, reshaping the politics of Europe around Putin’s vision – a vision fundamentally opposed to everything the EU stands for.
Problems like these bring change, and change brings opportunity. The future of Europe now depends on the EU building up a credible defence deterrent to Russia. As António Costa, the European Council president, recently said, “Peace without defence is an illusion.”
We believe Europe’s private sector will play a critical role in this rearmament. EU nations have already committed to increasing defence spending rapidly, but three major challenges remain: understocked arsenals, lack of interoperability, and the need for innovation.
Three challenges, three opportunities
First, militaries are understocked. Germany’s Parliamentary Commissioner for the Armed Forces warned that the country’s ammunition stocks would last only one to two days in a conflict. Poland, Bulgaria, and Romania still rely partly on Soviet-era weaponry. According to Goldman Sachs, the EU has underspent on defence by about USD1 trillion since 2006.
Second, there is a lack of interoperability. The EU is stronger together, but unity requires compromise. While America and Russia each have one main tank family, EU countries operate 19 different tank models – each with its own supply chain, logistics, and communications systems. This fragmentation makes coordination difficult and wastes precious R&D resources. What’s true for tanks is also true for jets, air defence, and ships. To take advantage of its scale, EU member countries must standardise and centralise procurement.
The third challenge is innovation. Technology is changing warfare. More than 70 per cent of casualties in Ukraine have been caused by drones – an unthinkable figure a decade ago. Artificial intelligence, robotics, space technology, and microelectronics are transforming battlefields, and Europe must keep pace.
Private-sector solutions
Governments generally do not manufacture weaponry, so restocking will rely on corporate partners, particularly those with industrial scale and established credibility. The private sector has also engineered a solution to interoperability through joint ventures. For example, Italy and Germany’s leading defence firms have partnered to produce vehicles locally in Italy that use the same operating systems as those in Germany, maintaining jobs and ensuring compatibility. Since 2022, more than 30 such joint ventures have been announced across Europe.
Both trends – scaled industrial producers and cross-border partnerships – signal the emergence of national champions, European equivalents of US “prime” contractors. Governments increasingly rely on these leaders to coordinate resources and align international efforts.
At the same time, small-cap innovators are addressing NATO’s most pressing capability gaps: drone and anti-drone systems, quantum-safe encryption, autonomous vehicles, and improved satellite surveillance. These agile firms are driving technological progress across the defence value chain.
Our investment approach focuses on identifying both emerging national champions and defence innovators poised to benefit from Europe’s rearmament.
Policy support and earnings potential
European policymakers now recognise that the private sector must be incentivised to meet these challenges. Germany’s finance minister recently said defence companies “need private investments and financing,” calling for new “framework conditions” that allow stronger profitability. Likewise, the European Council has endorsed industry consolidation and urged competition authorities not to hinder cross-border cooperation.
Such statements would have been surprising a decade ago. Yet today, they signal a broad political consensus: private enterprise must help deliver Europe’s security, and it should be rewarded for doing so.
While European defence stocks have already rerated sharply since 2022, we believe the next phase will be defined by selectivity. Much of the early performance reflected a broad repricing of the sector as budgets rose, but future returns will hinge on execution. The task for investors now is to identify the long-term winners – companies that can convert record order books into sustainable earnings growth.
Execution will separate structural leaders from short-term beneficiaries. For emerging national champions and innovators that can deliver on orders, manage supply chains, and scale efficiently, the best opportunities still lie ahead.
Importantly, this investment case does not depend on a prolonged conflict. Europe must rebuild its defences regardless of Ukraine’s outcome. Peace, we believe, will be sustained through deterrence – through a stronger, more capable Europe. In that process, select European defence companies will act as problem solvers, creating value for both shareholders and EU stakeholders alike.
