The Surge in Defense Tech Small Caps: Geopolitical Tensions and AI Fuel a New Era of Military Modernization

The defense technology sector is undergoing a seismic shift, driven by escalating geopolitical tensions and the urgent need for AI-driven military modernization. Small-cap defense firms, once overshadowed by industry giants, are now capturing a disproportionate share of investor attention and government contracts. This transformation reflects a broader realignment of global defense priorities, with Europe and the U.S. accelerating spending on next-generation capabilities amid rising threats from Russia, China, and regional instabilities.

Geopolitical Risks as a Catalyst for Defense Spending

According to a Morningstar report, Europe's defense budgets are projected to grow at an annual rate of 6.8% from 2024 to 2035, outpacing the U.S. and other major spenders. This surge follows the Russia-Ukraine war and intensifying Indo-Pacific tensions, which have exposed vulnerabilities in legacy systems and spurred a race to adopt advanced technologies. The U.S. Department of Defense (DoD) has similarly prioritized modernization, with a 2025 budget request of $1.8 billion for AI programs alone, according to a Sheridan Tech analysis. These investments are not merely reactive but strategic, aimed at countering adversaries who are themselves rapidly militarizing AI and unmanned systems.

The shift in spending is reshaping procurement dynamics. As noted by Forbes, the DoD is actively diversifying its supplier base to reduce reliance on the top four defense contractors, opening doors for smaller firms with niche expertise in areas like autonomous systems and cyber warfare. This trend is particularly evident in the drone and AI sectors, where companies such as Kratos Defense (KTOS.O) and AeroVironment (AVAV.O) have seen their stock prices soar in 2025. Kratos, for instance, has capitalized on demand for its low-cost Valkyrie drones, which align with the Pentagon's push for rapid, scalable solutions, according to an InvestorPlace piece.

AI as the New Frontier in Military Innovation

Artificial intelligence is no longer a futuristic concept but a core component of modern warfare. The DoD's establishment of the Chief Digital and Artificial Intelligence Office (CDAO) underscores its commitment to integrating AI into everything from logistics to combat operations. Small-cap firms are playing a pivotal role in this transition. As of fiscal 2024, small businesses secured 35% of federal AI obligations-a 34% increase since 2022. This reflects a deliberate effort to harness innovation from non-traditional defense players, many of whom are commercial tech firms with expertise in machine learning and data analytics.

Palantir Technologies (PLTR), for example, has seen its stock surge by 395% year-to-date, driven by contracts with the DoD and intelligence agencies. Its AI platforms are being used to analyze battlefield data and optimize decision-making, a capability that becomes increasingly critical as conflicts grow more complex. Meanwhile, the DoD's $10 billion investment in cloud infrastructure-awarded to tech giants like Amazon and Microsoft-has created a ripple effect, enabling smaller firms to access the computational power needed to develop advanced algorithms.

Market Performance and Investment Implications

The financial performance of defense tech small caps in 2025 has been nothing short of remarkable. As reported by Reuters, companies like Kratos and AeroVironment have outperformed broader market indices, driven by robust demand for unmanned systems and cyber capabilities. This trend is likely to continue as governments face mounting pressure to modernize. However, investors must remain mindful of risks, including potential tariffs on AI hardware and fiscal constraints that could slow spending in the medium term.

A would illustrate the divergent trajectories, highlighting Europe's accelerated pace. Similarly, a would underscore the sector's democratization.

Conclusion

The confluence of geopolitical risk and AI innovation is creating a fertile ground for defense tech small caps. While large primes will remain dominant in traditional domains like aircraft carriers and tanks, the future of warfare-and the profits it generates-is increasingly software-driven and decentralized. For investors, this means opportunities lie not just in well-known names but in agile firms that can pivot quickly to meet the DoD's evolving needs. As the Trump Administration's focus on commercial technologies reshapes procurement, the defense sector is becoming a proving ground for the next generation of tech-driven disruptors.