Is the growth in ASX defence stocks now too explosive?

If you were starting a portfolio six months ago, a pretty good strategy (in hindsight, of course) would have been to purchase ASX-listed defence companies.

In fact, if you created an equally weighted portfolio of the largest defence stocks on the ASX, your current return would be somewhere around 171% in that short space of time.

Principal amongst these companies is Canberra-based Electro Optic Systems (ASX: EOS).

The remote weapon system and laser technology company, which flirted with bankruptcy during the pandemic, has seen its share price rise around 573.4% since early March at the time of writing.

It is currently the fastest growing defence stock in the world during that time frame.

Investing in protection

With geopolitical uncertainty and conflict existing around the world, including the ongoing war in Ukraine, it is not a surprise that capital has flowed into defence stocks.

Governments around the world have largely committed to increased defence spending.

Already the biggest spender on defence in the world, President Donald Trump is recommending a 13% increase in the American defence budget to just over US$1 trillion.

Trump has also been pressuring European nations, through the NATO partnership, to dramatically increase their defence spending to a targeted 5% of GDP (made up of a hard 3.5% spending target on defence and another 1.5% spending target on ancillary areas such as protecting critical infrastructure).

In June of this year, NATO leaders agreed to this new spending target.

Locally, Australia is also looking to increase defence spending.

The National Defence Strategy Report, released in 2024, reintroduced the measure of defence spending as a percentage of GDP and included a promise to increase defence spending to 2.4% by 2033-34, from just under 2.0% at the time.

The US has also been putting pressure on Australia to go even further and set a target of 3.5% “as soon as possible”.

Whichever way the numbers end up, the overall result is simple: around the world, far more money is likely to be spent on defence than it is now.

The world of war

But more money doesn’t necessarily mean that Australian stocks should be booming.

In fact, when you look globally, the Australian market stands out for its exuberance.

The Betashares Global Defence ETF (ASX: ARMR) tracks 52 of the world’s (not including Australia) largest defence companies. Think names like Palantir (NASDAQ: PLTR), RTX Corp or Raytheon (NASDAQ: RTX), BAE Systems (LSE:BA) and Lockheed Martin (NASDAQ: LMT), amongst many others.

Combined, they make up some of the most powerful companies in the industry. The US and its allies rely on them for everything, including fighter jets, missiles, tanks, battleships and submarines, as well as the most sophisticated weapon systems in the world.

So, what has been the investment return for the global defence sector? Based on the performance of the ETF, a solid but far less spectacular 22.4% return over six months.

Australia: controlled aggression or exuberance?

Australia should be proud of its defence businesses.

Some, like Electro Optic Systems, regarding directed energy weapons, and Droneshield (ASX: DRO), regarding non-kinetic counter drone technology, are arguably among the world leaders in their respective (but increasingly important) niches.

However, defence is not a local industry but a global one.

The same reasons that people think that Australian defence businesses are good investments also apply to those overseas. But studying the investment returns of Australian defence businesses compared to their international peers paints a different picture.

Of course, a business can have interesting products and structural themes leading to growth and still be expensive.

With the share prices of Australia’s defence companies flying higher than an F22 fighter jet in recent times, especially compared to the still strong, but more subdued performance of their global peers, perhaps it is time to start considering if the elevated valuations are more powder keg ready to explode.

If investors are looking for defence exposure, maybe it is time to start looking offshore.