War Is Changing. These Stocks Can Win.

War is changing. Investors need to understand what that means for defense contractors. (Kyle Grillot/Bloomberg)

Everyone knows that the way wars are being fought is changing, and will change even more soon. It’s the job of investors to understand what that means for today’s defense contractors.

Modern electronics and artificial intelligence have essentially made low-cost drones into long-range strike weapons. The implications have been, well, world-changing.

The deployment of drones in the Russia-Ukraine war has changed the role of army infantry in modern warfare and helped Ukraine stall the advances of a larger military. The conflict between Israel and Iran has seen drones and ballistic missiles “used on an unprecedented scale,” wrote Capital Alpha Partners analyst Byron Callan in a Thursday report, adding that Houthi forces have been able to shut down commercial ship traffic in the Red Sea. “The Houthis don’t have an air force or a navy,” he notes. “Ukraine doesn’t have long-range combat aircraft, and it doesn’t have a Navy.”

For Callan, it means that while global defense spending is on an upswing, the beneficiaries of that spending won’t necessarily be the old guard.

“Prior [spending] cycles saw the replacement of older platforms with newer, improved ones, though there were some new segments (e.g., missiles, satellites),” wrote Callan. “The 2025 to 2030 cycle will see increased demand for autonomous, lower-cost weapons and systems to counter them. This is opening up new markets with new and different competitors.”

To be sure, large contractors such as Lockheed Martin, Northrop Grumman, L3Harris Technologies, and RTX believe they will get their fair share of spending. All four have recently used the Wall Street jargon “well-positioned” to describe their competitive standing.

That may well be the case. Still, Callan recommends understanding how global threats and the defense industry are evolving to help pick new defense winners. For starters, the cost of waging war is dropping. Militarized drones aren’t all that expensive, relatively speaking. That makes drone production important, but also raises the need to counter unmanned vehicles with detection and jamming technology.

Collective behavior is also waning. “The United States and the USSR had a degree of control over how and when their allies chose to wage war,” wrote Callan. Obviously, the USSR of the 1980s is no more. While the U.N. hasn’t been able to end conflicts, countries including Turkey, the U.A.E., Israel, and South Korea “have emerged as countries that can supply and support proxy forces and regional allies with advisors and with direct sales of defense equipment.”

All that means investors should expect three things. First, non-U.S. defense spending will rise, benefiting European contractors. Funding for manned systems will also flatten out, with unmanned technology taking the lion’s share of growth. And newer firms, such as Palantir Technologies, will benefit more than existing players from the growth in AI.

None of that is a shock to investors. Palantir has a market value of some $425 billion and trades for 220 times estimated 2026 earnings, according to FactSet. Lockheed’s market value is closer to $125 billion and trades for about 15 times estimated 2026 earnings.

Callan doesn’t cover stocks specifically. But his observations correlate closely with current Wall Street sentiment. About 38% of analysts covering Lockheed stock rate the shares a Buy. The average Buy-rating ratio for stocks in the S&P 500 is about 55%, according to FactSet. Only 28% of analysts rate Palantir stock a Buy. Valuation may be the primary concern. (Different sets of analysts cover Lockheed and Palantir.)

Among the traditional defense contractors, RTX and L3Harris have the highest Buy-rating ratios at 62% and 68%, respectively.

Companies specializing in unmanned systems have strong support on Wall Street. For Kratos Defense & Security Solutions, 81% of analysts covering its stock rate the shares a Buy. AeroVironment scores a rare 100% on its Buy-rating ratio. Eleven of 11 analysts rate the shares a Buy. AIRO also has a 100% Buy-rating ratio, but only three analysts cover the stock. Its IPO was completed in June. (Through midday trading Thursday, shares were up about 100% from the $10 IPO price.)

For European contractors, Germany’s Rheinmetall has the strongest analyst support, with 89% of analysts rating the shares a Buy.

The Buy-rating ratios don’t guarantee stock market success, but they are a good place for investors to start when thinking about the changing defense landscape.

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