Key Takeaways
- Europe defense stocks are rerating in 2026 but rearmament fundamentals remain, Morningstar equity analyst Loredana Muharremi says.
- Rheinmetall is her top pick, sitting at the center of Europe’s bumper defense spending, and positioning itself for evolving warfare.
- BAE Systems and Leonardo also rank as key picks, with core exposure to critical themes such as air defense and electronics.
Karen Gilchrist: Defense has been a dominant investing theme in Europe over recent years. But despite continued conflicts in 2026, stocks have struggled to maintain momentum. What does this mean for the sector’s outlook, and where do the biggest opportunities lie? To discuss this, where the market may be getting it wrong, and her top pick, I’m joined by Morningstar equity analyst Loredana Muharremi.
Loredana, thank you so much for joining us. Please just start by setting the scene. Why do you think it is that we’ve not seen this rally in defense stocks this year, as we have done in previous years? What more might investors be looking for?
Loredana Muharremi: What we actually saw this year was a strong pullback since the beginning of the year. But we don’t think this signals the end of the rearmament cycle. What is happening is a change in investor focus. Last year stocks rerated strongly on defense spending headlines, while now investors are moderating their expectations, and looking at the execution. They want clear evidence that these record-high backlogs can actually convert into timely revenue, margin and ultimately, cash flow. And this is important because the majority of the companies are still in the high investment phase. They are expanding capacity, they are securing supply chain, and they are hiring ahead of future demand. So while the sector remains operationally very strong, near-term cash flow is getting pressured while this ramp up is happening.
Rheinmetall the Top European Defense Pick
Karen Gilchrist: Understood. And Rheinmetall RMH, I understand, is your top pick. It’s currently trading at around EUR 1,200 a share, but you’ve actually set a fair value estimate of EUR 2,380, and that’s near a street high. Why are you so bullish on the stock?
Loredana Muharremi: Our conviction comes from a combination of structural demand, market positioning, and future earnings quality. Rheinmetall, first of all, is the lead contractor for Germany and it is positioned to benefit from the largest increase in defense spending that is going to take place in Europe over the next 10 years. Second, the company is also a leading provider in Europe for air defense ammunition and vehicles: all themes that are at the core of the long-term European rearmament, as well as NATO capability gaps. Moreover, we are seeing Rheinmetall moving outside of its core strengths toward domains that are characterized by being high margin and capacity constrained, and also toward more software and digital. So overall we see the company very strongly positioned for both the current rearmament cycle, as well as the future evolution of warfare.
Karen Gilchrist: So some strong fundamentals there. But the stock has been punished despite these record backlogs. Do you think these investor concerns are justified? And what do you see as the inflection point for the stock?
Investor Concerns Understandable but Overdone
Loredana Muharremi: Yes, investor concerns are understandable. Rheinmetall is undergoing the most aggressive expansion in the sector, and that is coupled with slow procurements, slower conversion along with high Capex and high inventories, which is pressuring working capital. However, we think that investors are over-extrapolating these short-term issues too far into the future. If we look at Rheinmetall we can see that it has already industrialized the most difficult domain, which is ammunition. And if we look at where the growth is going to be up to 2030, then we see that it’s mainly focused on ammunition and vehicles and air defense—all domains that are low risk for Rheinmetall because it already operates there at scale and with proven technology. While on the riskier domains, the company is actively derisking them through vertical integration and joint venture.
The main question remains timing, and in that sense we believe that order conversion is going to improve first—with still an acceleration toward the end of the year—which will be driven by large orders going through the approval process, and an increase in framework conversion into fixed orders. And that will already offer a big support to cash flow. However, the biggest improvement in cash flow we expect to be after 2027, when this ramp-up phase will normalize.
Rheinmetall Poised for Changing Warfare
Karen Gilchrist: Now, we’ve seen in Ukraine, and indeed in Iran, that the nature of modern warfare is changing, with more reliance on autonomy, battlefield connectivity, and software. You’ve mentioned that Rheinmetall is exploring these avenues, but do you really think it can be a leader in this field?
Loredana Muharremi: Yeah, the debate that you are mentioning is one of the central debates right now. What we have noticed is that the market expected that future warfare is going to benefit mostly electronic defense companies, drone providers, and defense tech startups. However, what the current conflict is showing is that the future warfare is becoming more network-centric, not less industrial. So drones, autonomy, sensors, and battlefield management systems are becoming increasingly important, but they still need the physical platform and the physical battlefield infrastructure in order to operate. In other words, these systems, these technologies are not going to substitute the traditional platform, but they are increasingly being layered on top of the traditional platforms.
That’s where we think that Rheinmetall has a very strong position. The company already owns a large portion of the in-fleet service that is in Europe, and is also increasingly partnering in order to lay on top of this platform more digital content. So as the procurement is going to shift from physical platforms toward more of a battlefield interconnected ecosystem, we think that Rheinmetall’s combination of industrial scale platform ownership and also increasing digital solution is going to be increasingly more relevant.
BAE Systems and Leonardo Among Other Defense Picks
Karen Gilchrist: So the leaders are very much likely to be those that can take that dual approach. And just finally, I understand you consider that the sector at large is undervalued. Are there any other top picks that you could name?
Loredana Muharremi: Yeah, at current valuations beyond Rheinmetall, we really like also BAE Systems BAE and Leonardo LDO. Both of them offer a great exposure to some of the areas that we think are going to be the most important in European rearmament, which are air defense and electronics. The conflict in Ukraine has shown the large capability gaps that Europe has in air defense, while simultaneously showing the growing importance of radars, sonars, electronic warfare, and command and control systems. Both BAE and Leonardo are very well positioned there, and we think that investors are not fully incorporating the scope and the dimension of the investment cycle that is going to follow.
Karen Gilchrist: Loredana, thank you so much for your time. For Morningstar, I’m Karen Gilchrist.
