NATO's Defense Surge: Spotting the Undervalued Winners in the Geopolitical Arms Race

The escalating geopolitical tensions since Russia's invasion of Ukraine have transformed NATO's defense spending landscape, with member states collectively committing to a historic escalation in military budgets. While giants like Lockheed Martin and Boeing dominate headlines, a subtler opportunity lies in undervalued defense contractors positioned to benefit from NATO's 5% GDP spending target, critical minerals supply chains, and cutting-edge projects like the Eurodrone initiative. Here's how to navigate this emerging opportunity.

NATO's Spending Surge: A Blueprint for Contractors

NATO's 2025 summit marked a pivotal shift: member states agreed to raise defense spending to 5% of GDP by 2035, with 3.5% allocated to core military capabilities (e.g., aircraft, armor) and 1.5% to security infrastructure (cybersecurity, intelligence). This creates a €500 billion market opportunity for firms capable of delivering interoperable systems and critical materials.

Key priorities include:
- Aggregating Demand: Multinational procurement contracts (e.g., Eurodrone programs) to reduce reliance on U.S. tech.
- Critical Minerals: Securing supply chains for lithium, cobalt, and rare earth elements to power drones, missiles, and AI systems.
- Cyber Resilience: Protecting networks from hybrid threats, a cornerstone of NATO's 1.5% “security infrastructure” allocation.

The Undervalued Contenders to Watch

While major defense stocks like Lockheed Martin (LMT) and Airbus (AIR) are well-covered, three undervalued players stand out for their niche expertise and underappreciated contracts:

1. Saab (ST: SAAB – Sweden)

Why it matters: Sweden's 2032 defense plan includes €27 billion for modernization, with Saab as the primary supplier of Gripen fighter jets and eLynx drone swarms—critical for NATO interoperability.
- Growth Catalyst: Sweden's borrowing of €1.8 billion in 2025 to boost air defense systems directly funds Saab's projects.
- Risk: Supply chain bottlenecks (e.g., 18-month drone delivery delays) could pressure execution.
- Investment Case: A P/E ratio of 14.5 (vs. 22 for LMT) reflects undervaluation, but monitor cash flow against ambitious targets.

2. Thales (EPA: HO – France)

Why it matters: Thales supplies NATO-standardized cybersecurity systems and avionics, with a €2.8 billion 2024 order for drones tied to the Eurodrone project.
- Diversified Portfolio: Strengths in radar systems (e.g., France's FREMM frigates) and secure data centers align with NATO's 1.5% infrastructure sub-target.
- Risk: Italy's minimal defense spending (1.5% GDP) pressures Leonardo's (its competitor), but Thales's broader European footprint mitigates this.
- Investment Case: A P/B ratio of 1.8 (vs. 2.5 for Leonardo) suggests undervaluation, but track its ability to convert orders into cash.

3. Rheinmetall (ETR: RHM – Germany)

Why it matters: Germany's €100 billion “special defense fund” funds Rheinmetall's upgrades to Leopard tanks and hypersonic missile systems.
- Geopolitical Tailwinds: U.S. orders for Stryker vehicles and collaboration with Raytheon (missile tech) expand its global reach.
- Risk: Labor shortages in Germany could delay production, but its vertical integration (from engines to armor) buffers supply chain risks.
- Investment Case: A 518% stock return since 2020 (vs. 200% for Airbus) hints at underappreciated momentum.

The Stealth Opportunities: Nondefense Firms in the Crosshairs

Beyond traditional defense names, nondefense companies are quietly pivoting to capitalize on NATO's needs:
- Cybersecurity Firms: F-Secure (HEL: FSECU) and Bouygues (EPA: BUGE) are securing contracts for NATO's hardened data centers and AI-driven surveillance.
- Critical Minerals Suppliers: Lynas Corporation (ASX: LYC) (rare earths) and SQM (NYSE: SQM) (lithium) supply materials for drones and missiles, with minimal defense exposure in their valuations.
- Logistics & Telcos: Firms like AAR Corp (NYSE: AIR) (aircraft maintenance) and Telefónica (NYSE: TEF) (secure comms) are partnering with NATO members to build resilient supply chains.

Risks and Execution Hurdles

While the long-term trend favors defense contractors, risks abound:
- Fiscal Sustainability: Spain's refusal to meet the 5% target and Italy's debt concerns could drag on regional spending.
- Supply Chain Bottlenecks: Global shortages of skilled labor and critical materials (e.g., gallium for semiconductors) may delay projects.
- Overvaluation Traps: Avoid companies with stretched valuations (e.g., Raytheon (RTX) at 25x P/E) unless their order books justify it.

Investment Strategy: Play the Undervalued, Play the Gaps

For investors, a diversified approach is key:
1. Core Positions: Allocate to Saab and Thales for their niche contracts and underappreciated growth.
2. Satellite Plays: Use ETFs like SPDR S&P Aerospace & Defense (XAR) to hedge against execution risks.
3. Critical Minerals: Pair defense stocks with LYC and SQM to capture raw material demand.

Conclusion: The Geopolitical Arms Race is Here to Stay

NATO's spending surge is a multi-decade trend, and undervalued contractors like Saab and Thales are positioned to thrive. While risks remain, the combination of fiscal flexibility (EU's Readiness 2030 package) and strategic priorities (Eurodrones, cybersecurity) creates a fertile landscape for investors willing to look beyond the obvious names.

Actionable Takeaway: Build a portfolio anchored in niche players with visible contracts, geographic diversification, and exposure to critical minerals—and stay vigilant on execution risks. The defense sector's next wave of winners is already in motion.

Mohammed El-Erian's analytical style emphasizes macroeconomic forces, geopolitical dynamics, and overlooked value creation. This article mirrors his focus on structural trends and asymmetric opportunities in global markets.