A Drone Bubble? For Defense Stocks, the Answer Had Better Be No.

The Black Widow drone, manufactured by Red Cat Holdings. (David Paul Morris/Bloomberg)

Key Points

• The drone industry is experiencing high demand, with AeroVironment and Kratos Defense & Security Solutions shares up 145% and 244% year to date.
• Analysts are assessing whether the rapid growth in drone technology constitutes a market bubble and identifying leading innovators.
• Defense contractors’ shares are up an average of 28% year to date, outperforming the S&P 500 by 14 percentage points.

Defense drones are becoming ubiquitous, with the industry racing to meet seemingly endless demand for unmanned technologies. Unchecked investment, however, runs the risk of a dreaded word on Wall Street: Bubble.

Both factors have put the focus on an industry showcase hosted by the Association of the United States Army in Washington. D.C., last week. Some 750 companies and 44,000 people took part, including a number of Wall Street analysts searching for clues about the direction of defense technology.

“The dominating theme of this year’s AUSA conference was the proliferation of drones for defense applications,” wrote KeyBanc analyst Michael Leshock on Monday.

Drones, of course, have been in the news for months. Ukraine has weaponized large numbers of low-cost drones in its war with Russia. And Defense Secretary Pete Hegseth recently implemented measures to boost American drone production, as well as drone training for senior military officers.

That has shown up in stock prices. Shares of AeroVironment and Kratos Defense & Security Solutions, providers of unmanned-systems technology, were up 145% and 244% year to date, respectively, entering Wednesday trading.

Those spectacular numbers have generated some anxiety for investors. Leshock went to the conference to find out if there was a “drone bubble,” with the market rapidly becoming “oversaturated.” He also wanted to find out who has the leading drone technology, and if there is any threat or opportunity for the large contractors in the new drone-dominant world.

The good news: Drones are here to stay. “We came away with incremental confidence that the proliferation of drones in combat is a critical theme that must be supported by the U.S. government and our allies to not fall behind our adversaries,” wrote Leshock.

Drone and counter-drone technologies are expected to expand for the foreseeable future. What is more, there will be many types of drones, from low-cost, human-directed weapons, to complex multimillion-dollar systems capable of operating autonomously for lengthy periods. Development can be expensive, too, which also gives an edge to well-capitalized large contractors.

“Drones and counter-unmanned aircraft systems were everywhere at the show,” wrote Jefferies analyst Sheila Kahyaoglu. Many companies were showing off products, including Textron, Lockheed Martin , Honeywell, Booz Allen, privately held Anduril, and others.

For now, there is business for everyone. “Drones won’t replace large, manned platforms,” wrote Capital Alpha Partners analyst Byron Callan in a report following the gathering. “They will compete for funding, [offering] lower-cost weapons systems for offense and defense.”

One plan for drone defense—using laser beams to melt the electronics of drones more than a mile away—shows how war is a crucible for technology advancement as adversaries endlessly act and react to gain an edge. That alone is why drone technology will continue to proliferate.

Coming into Wednesday trading, shares of major defense contractors were up an average of 28% year to date, about 14 percentage points better than the S&P 500 . Rising military spending and a need for new technologies have boosted the stocks.

Write to Al Root at allen.root@dowjones.com