2026 has brought more wars and political instability. Despite this, valuations in the defence sector have pulled back so far this year.
The key thing to keep in mind is that new conflicts and political instability aren’t the main drivers of defence companies’ valuations. Rather, it’s the outlook for military budgets which is the better indicator.
On that front, we think the long-term trajectory of defence budgets is still underappreciated by the market. Even if there is durable peace in Ukraine or Iran, the current rearming cycle is expected to continue until the end of the decade, at least. That means there’s a long potential runway of growth ahead for companies that can scale to meet demand.
Warfare is also evolving, with AI, drones, missiles and space tech looking set to play an increasingly important role. As a result, we see these as higher-growth areas of the sector, and ones that investors should pay particular attention to.
With that said, here are three share ideas that look well-positioned for the future of the defence industry.
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L3Harris Technologies
L3Harris Technologies is a US-based defence contractor with exposure to key strategic priorities for the US Government, like missile defence and next-gen space capabilities.
The group operates through three divisions.
The first, Missile Solutions (MSL), has market-leading positions in missile components, munitions and space propulsion. It’s currently the smallest segment, accounting for around 15% of group revenue. But it also has the greatest growth potential, with revenues expected to grow in the high teens for the foreseeable future.
To help deliver this growth, L3Harris plans to spin out MSL in an Initial Public Offering (IPO) during the second half of 2026, while maintaining a majority stake in the business. The current management team will stay in place, so nothing will change from a day-to-day perspective. But it will bring in more cash, including a $1bn investment from the US government, to help fund the division’s ambitious expansion plans as it races to meet growing demand.
The other two divisions are Communications & Spectrum Dominance and Space & Mission Systems, which currently account for around 85% of the group’s revenue and profits. Their arsenals include electronic warfare, secure communication systems and space-based missile warning and defence systems, among others. The group has a strong foothold in these areas, and multi-year contracts provide good revenue visibility.
All in, this is expected to see L3Harris’ revenues and operating profits grow at annual rates of 8% and 9%, respectively, over the next three years. Demand is strong, with its order backlog growing around 7% over the first quarter to a record $40.7bn – equivalent to nearly twice last year’s sales. Alongside impressive cash conversion and a robust balance sheet, we don’t have any concerns about the group’s financial health.
Increased investment to expand production capacity is weighing on cash flows. We’re cautiously optimistic that this will reverse later in the year as production ramps up. However, any delays or missteps in execution could weigh on the growth outlook and investor sentiment.
The group’s valuation sits towards the top end of its peer group, reflecting its stronger margins and exposure to high-growth areas. Despite this, we think there’s still upside on offer if the group delivers its expansion plans as promised. But that’s not guaranteed, and the upcoming IPO could distract management in the near term.
Kratos Defense & Security Solutions
Kratos Defense & Securities Solutions is another US-based company, focussing on cutting-edge, innovative areas of defence.
It’s particularly known for its unmanned systems (drones), propulsion, space and hypersonic capabilities – positioning itself as a disruptor in the sector.
All of these categories are taking an increased share of growing defence budgets, highlighting their role in future warfare. Drones particularly are reshaping the battlefield, allowing military chiefs to deliver precise strikes at far lower cost than missiles, as seen recently in Ukraine and Iran.
With a market value of around $10.5bn, it’s considerably smaller than the other names on this list. On one hand, its small size allows it to respond quickly to emerging trends and technological breakthroughs. These can often be overlooked by larger contractors, who tend to be more focussed on multi-billion-dollar contracts using older, proven tech.
This also makes it an attractive partner for larger companies looking to tap into its niche expertise, without the time and cost of developing it in-house. Kratos has already teamed up with industry giants like GE Aerospace and Northrop Grumman, and the US government, highlighting its credibility.
Kratos got off to a flying start this year, beating first-quarter expectations and prompting an upgrade to full-year guidance. Revenues are now expected to grow by 30% to around $1.7bn, with underlying cash profit (EBITDA) rising even faster, up 45% to $173mn, helped by the group's growing scale and a favourable product mix.
But the group’s relatively small size also brings risks. Kratos spends a significant portion of its net revenue on research and development. While this is necessary for innovation and growth, it puts pressure on cash flows and margins. It’s also spending heavily on building out its production capacity to meet future demand. If current and future programmes fail to bring in the expected benefits, the group could find itself in trouble.
Kratos’ valuation is significantly higher than the sector average, reflecting its innovative focus and exciting growth potential. If earnings growth comes through as forecast, we think there’s significant upside on offer. But there’s a lot that has to go right for that to happen, and any missteps will likely see the valuation punished harshly. Potential investors need to focus on the long term and be willing to stomach volatility along the way.
Rheinmetall
Rheinmetall is a defence powerhouse, with strong positions in weapons, ammunition, military vehicles, naval and digital systems.
As Germany’s largest contractor, it has great exposure to one of Europe’s biggest and fastest-growing defence markets. The country’s spending is set to increase from around €87bn in 2025 to at least €180bn in 2030, meaning there’s a long runway of growth if it executes its planned capacity expansions effectively.
This strong demand outlook gave Rheinmetall the confidence to lay out its ambitious long-term growth plan back in November. The group’s now aiming to drive its sales from €9.9bn in 2025 to around €50bn by 2030, implying annual revenue growth of nearly 40%. Alongside this, the group aims to increase its operating margins to over 20% by the end of this period, supported by efficiency and procurement benefits that its growing scale should bring.
Since then, however, Rheinmetall’s had a disappointing couple of quarters with sales falling short of market expectations and near-term orders getting pushed further into the future. As a result, we see scope for near-term growth to fall short of the group’s target levels.
These recent disappointments have seen Rheinmetall’s valuation fall around 25% so far this year, which now sits just ahead of its peer group. This means a great deal of scepticism is already baked into the valuation, and the group has a relatively low bar to jump over to revive investor sentiment.
We remain more positive on the longer-term picture. That’s because, rather than being cancelled, expected orders have been delayed until later in the year. The group’s order intake is still expected to reach around €76bn in 2026, which more than covers its 2030 sales targets, so our focus is firmly on execution and delivery.
The balance sheet is in great shape, sporting a small net debt position. Despite the group’s plans to expand production facilities, that’s expected to flip to a net cash position by year-end, helped by cash advances on long-term contracts and improving sales momentum.
All in, Rheinmetall benefits from exposure to a strong German defence market and is expected to grow much faster than its peers. We don’t think these strengths are fully reflected in the valuation, which could offer significant upside potential if the group follows through on its growth plans. However, expanding capacity at this scale and pace won’t be easy, and there’s potential for disappointments in the near term.
This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. It was correct as at the date of publication, and our views may have changed since then. Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by LSEG. These estimates are not a reliable indicator of future performance. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss. Yields are variable and not guaranteed.
This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment.