How to find the best defense stocks
The defense sector tends to be a stable group of companies with a few failures and a few standouts. Here are some tips for evaluating individual defense companies.
Listen to the customer
The Pentagon has an insatiable appetite for new equipment. But with aircraft carriers costing more than $10 billion and F-35 fighters priced at $100 million or more, the government can only buy so much. To figure out the likely winners and losers, pay attention to the budgeting process.
Early in the year, the Pentagon sends a funding request to Congress, which then holds hearings to discuss priorities and make final allocation choices throughout the spring and into the summer. An investor need not hang on every word. However, the budget request, available on the Pentagon's website, and commentary elsewhere can provide clues about which billion-dollar programs are administration priorities.
Follow the numbers
Companies often highlight massive contract awards in press releases without explaining that those big-dollar figures are often spread out over many years and may depend on Congress approving the funds. Pay attention to these metrics when evaluating defense stocks:
- Free cash flow: This is important for any business, but free cash flow can vary for defense contractors based on whether their projects are new or well established. Companies often spend more in the early stages of a production contract, temporarily depressing cash flow.
- Corporate backlogs: Investors should pay close attention to corporate backlogs, which are future contracts that have been awarded but not yet executed. How much of a backlog has been funded and how much must go through the congressional budgeting process can vary greatly.
- Book-to-bill ratio: This metric compares the value of orders received in a given quarter to the amount billed and indicates a company's growth potential. A growing company should have a book-to-bill ratio of at least 1.0, implying that orders for future products are being booked at a rate that equals or exceeds what is being shipped today.
Defense companies know investors are focused on these metrics and typically provide the relevant information in quarterly earnings reports or conference calls.
Benefits and risks of investing in defense stocks
There are pros and cons to investing in defense stocks. Here are some of the factors to consider before making them part of your portfolio.
Benefits
- Stable and predictable demand from a customer that invests in national security at all stages of the cycle.
- Long-term contracts give management teams strong revenue visibility, allowing for planning, and provide stability.
- High barriers to entry due to the specialized nature of the products and the difficulties of dealing with the government as a customer.
- A history of technological innovation that can translate outside of defense. From Velcro to the internet, a lot of products we take for granted today originated either within or adjacent to the aerospace sector.
Risks
- Politics can be unpredictable, and changes in government priorities or a new administration can force management teams to rethink their long-term planning.
- Cost overruns are increasingly a problem for the contractor. If a company is not well run and does not keep its costs under control, it can eat into earnings.
- Supply chain chaos can lead to program delays. Large defense platforms rely on dozens of suppliers, and those suppliers each have layers of smaller vendors below them. An issue anywhere in that chain can lead to cost overruns or delays for the entire program.
- Ethical concerns are a common reason to avoid defense stocks. These companies make lethal weapons, and not all investors want that in their portfolio.
Key trends in the defense industry
The defense industry is shaped by both age-old concerns and modern innovation.
One key theme dominating the industry is the need to restock inventory. The U.S. weapons stockpile has been worn down, and many of the new contracts issued in 2026 will be more about replenishing old weapons than focusing on the new.
At the other end of the spectrum, defense innovation is evolving from a heavy industrial model to a more high-tech focus. No longer are the massive ships and planes the focus; rather, the electronics and sensors inside them are driving profit growth.
Are defense stocks right for your portfolio?
Defense companies manufacture lethal products and can be involved in supporting operations or intelligence-gathering that some find unsettling. Some investors don't want to support those activities and may want to avoid becoming shareholders of defense stocks.
Like many industrial stocks, defense stocks tend to be more plodding than high-flying technology or biotech stocks. But that also means they are less volatile than some sectors. Defense stocks are best suited for income-oriented investors seeking steady growth and rising dividends rather than immense valuation increases.
