Nine U.S. defence stocks with attractive valuations

U.S. FY2026 defense budget proposed at >$1 trillion, a 13.4% increase year-over-year, and NATO commitments to lift defense spending expand addressable demand for U.S. contractors. Lockheed Martin: P/E 21.9 vs group avg 45.5, FY2025 sales $75B (+6% YoY), free cash flow $6.9B, backlog $194B (~2.5x sales), accelerating F-35 and PAC-3 production and 23 consecutive years of dividend increases. Honeywell: P/E 22.2, forecast one-year sales growth 5.7%, orders +23% in the most recent quarter, backlog $37B, and an aerospace division spin-off planned for Q3 2026.

Analysis

A sustained rise in defence spending is a multi-year demand shock concentrated into a capital-intensive supply chain; primes with scale and stable FCF can convert backlog into free cash disproportionately faster than smaller suppliers, which will face multi-quarter lead times for tooling, specialty alloys, and avionics components. Expect upward pressure on input costs (titanium, high-grade electronics, test facilities) that will compress margins for mid-tier contractors and system integrators before capacity additions normalize pricing.

Geopolitical tail-risks create asymmetric timing: in the next 3–9 months funding votes and appropriation language (procurement vs R&D vs O&M) are the primary catalysts; over 12–36 months, production cadence and supplier capacity ramping determine earnings realization. A reversal can be triggered quickly by a fiscal compromise that prioritizes domestic spending cuts or by a short-term de-escalation that slows alliance-driven procurement commitments — either would rapidly re-rate forward multiples.

Consensus is underweight the operational execution risk and overweights headline budget growth as a near-term earnings accelerator. That gap creates a two-pronged opportunity set: (1) high-conviction exposure to large primes for a multi-year structural play and (2) tactical, event-driven hedges/shorts on suppliers whose margins and delivery timelines are most sensitive to raw-material inflation and factory bottlenecks. Position sizing should reflect a binary political/capex-risk profile — smaller, hedgeable sizes into the near-term budget cadence and larger, duration-weighted allocations for the multi-year procurement runway.

Key Decisions for Investors

• Long LMT (core holding): Buy equity for a 12–36 month hold targeting +20–30% total return if procurement funding converts to sustained order flow; size 4–6% NAV with a 12% stop-loss or hedge via buying 12–18 month puts at ~10–15% OTM to cap downside.
• Relative-value pair (directional): Long LMT / short a mid-cap defence supplier lacking vertical integration (size ratio 1:0.6) over 6–12 months to capture re-rating of primes versus margin compression at suppliers; expect asymmetric payoff if procurement drives prime margins while suppliers face cost push — target +15% pair return, max loss 12%.
• Event/options play on Honeywell exposure: Purchase 12–24 month LEAP calls on HON (~25–35% OTM) sized 1–2% NAV as convex upside to corporate redeployment or asset re-pricing; hedge by selling near-term covered calls representing ~30–40% of position to monetize premium and reduce carry if catalyst slips.
• Risk hedge: Buy protection on the sector via puts on a defense/small-cap supplier ETF or a short-dated put spread on a defense basket to hedge a short-term political or de-escalation shock (3–6 month horizon), allocating ~0.5–1% NAV to cost-effective downside insurance.