Why the market is rethinking defense valuations

The rapidly evolving nature of warfare and modern military requirements should prompt investors to rethink valuations in the defense sector, according to Panmure Liberum strategist Joachim Klement.

An increasingly fragile geopolitical environment continues to support the long-term bullish trend for the defense sector, Klement told CNBC’s “Squawk Box Europe” on Monday, as acquisition risk, financial pressure and artificial intelligence trading begin to separate the winners from the losers.

Investors are becoming more selective, he said, evaluating not only how much governments are promising to spend but also whether that money is flowing into legacy platforms or AI-powered systems, drones and electronic warfare.

The next generation of defense winners may increasingly look like software and artificial intelligence companies rather than traditional weapons manufacturers, Klement said.

“Electronic warfare is a technology phenomenon,” he added. “These companies need to be traded like technology companies.”

This means some stocks in the sector could deserve a “much, much higher valuation” than traditional warfighting companies, according to Klement.

European defense stocks have been one of the clear winners of the continent’s rearmament drive.

But the recent pressure from some of the sector’s biggest winners points to a new phase in Europe’s defense trade in which investors no longer view rearmament as a general buying signal.

Klement argued that Germany’s cancellation of the F126 program showed that even in a world of rising defense budgets, big-ticket legacy programs can be vulnerable if they are slow, expensive or not compatible with changing military needs.

“Often generals are fighting the previous war, not the next war, and the problem is that the military-industrial complex in Europe is dominated by manufacturers of conventional weapons, whether we are talking about tanks or artillery,” Klement said.

“What the German government did not do and where Rheinmetall it also lags behind, focusing on AI-enhanced weapon systems [and] “Weapon systems developed with drones,” he said, and companies like Italy Leonardo and England BAE Systems We are building systems that use artificial intelligence and drone technology to fight war.

European defense spending occurs “across the full spectrum,” including traditional land equipment such as main battle tanks and munitions, as well as naval platforms including aircraft carriers and frigates, McKinsey senior partner Hugues Lavandier told CNBC last month.

He also pointed out that with the increasing understanding of the importance of deep attack capabilities, anti-drone and unmanned systems, more investments are being made in new areas.

Defense stocks have made big gains over the last five years. Klement suggested that the recent weakness was due to investors turning to AI trading rather than deteriorating defensive fundamentals.

“For us it’s a matter of flows rather than fundamentals; many fund managers are strapped for cash,” he said, pointing to companies such as: Alphabet And SpaceX I have recently raised large amounts of money.