If there is one clear investment opportunity that is shaping up out of the two biggest surprises of last year -- the Brexit vote and Donald Trump's election victory -- it is the one I highlighted even before the U.K.'s referendum: defense stocks.
U.K. Prime Minister Theresa May, in her Brexit speech earlier this week, made a veiled threat that Brexit also could mean a reduction by Britain in its defense efforts in Europe. Donald Trump already has called the North Atlantic Treaty Alliance (NATO) "obsolete," although he later toned down that remark by saying it's still important to him.
Investors should know by now that Germany's Chancellor Angela Merkel is an extremely pragmatic political leader. So, it should come as no surprise that she called for more spending on defense in Europe following Trump's remarks.
Germany's own defense minister, Ursula von der Leyen, yesterday followed that up by saying the eurozone's biggest country is boosting its own spending on defense. This year, the country's military spending will increase by almost 2.0 billion euros ($2.12 billion) to 37 billion euros, or around 1.22% of the country's GDP, and it should reach 39.2 billion euros by 2020.
However, this year's spending is still below the 2% of GDP recommended in NATO's guidelines. If European states want to take a bigger responsibility for their own defense, they will need to allocate more money to the sector.
According to NATO data, only five countries spend above that threshold on defense. They are the United States, Greece, United Kingdom, Estonia and Poland.
In terms of the equipment's share of expenditure, NATO recommends that 20% of defense spending should go toward that category. Here again, wealthy countries in the European Union are below that threshold, suggesting good growth potential.
Among these, Germany allocates only 13.7% of total defense spending to equipment, the Netherlands 14.4%, Denmark 12.4%, Belgium 2.17% and Spain 15.2%.
Taking a look at investors' appetite, money has been returning to European equities. A recent survey of fund managers by Bank of America Merrill Lynch showed that investors are buying eurozone stocks in January.
Cyclically, a survey of 176 global fund managers with $455 billion in assets under management showed rotation away from industrials and into technology, REITs, telecoms and energy. So, from this survey it looks like defense stocks, a sub-sector of industrials, may be falling out of favor.
However, a survey among European fund managers only -- to which 102 participants with $212 billion in assets under management responded -- indicated that European asset managers are still overweight industrials. Indeed, positioning in the sector was at its most crowded since August 2013.
Looking strictly at countries in Europe, European fund managers' sentiment has improved the most toward Italy, Spain and Germany in January versus December last year.
To take advantage of these trends, investors could start their research with defense companies based in these countries or that have these countries high on their list of clients. Looking at European companies also makes sense because the strength of the U.S. dollar gives U.S.-based investors additional firepower when it comes to buying international stocks.
The biggest company by sales is France's Airbus (EADSY) . However, it is also the most expensive, trading at a trailing 12-month price/earnings multiple of 20.5 versus the European aerospace and defense industry's 18.9x P/E average. Still, momentum favors the French firm. Year to date, the ADR price of Airbus is up 4.8% versus the European sector's relatively meager 1.8%.Safran ( SAFRY) , which just bought Zodiac Aerospace ( ZODFF) , is another French company in the area of defense, and it is trading on a relatively cheaper P/E ratio of around 17.4. For those looking at Italy, Leonardo ( FINMY) could be a good company to research further, as it is at a P/E of just 14.4, and for those who want to look at a German company, MTU Aero Engines ( MTUAY) is trading at a 17.7 P/E.