08 Sept 2026
Defence has been one of the best-performing sectors in recent years. The catalyst for this is obvious. When Russia invaded Ukraine, governments across Europe realised they would need to buy every bullet, tank and drone they could lay their hands on.
But this catalyst was only obvious in hindsight. You could have bought (and done very well from doing so) on the day the conflict began, but that decision could have swiftly looked foolish if the war had proved to be short lived.
Perhaps the true catalyst was not the invasion itself, but the gradual realisation that this would evolve into a multi-year war, triggering rising defence budgets across Europe. But what’s the use of that? As an investor you would have always been behind the market if you had waited for evidence of the conflict’s ongoing nature.
This raises the question of how investors can hope to get ahead of such a catalyst. Our strategy is not to look for them at all. This is a very different approach to that taken by many of our peers (our sense is that in a momentum-driven market, most investors are clamouring for the next ‘catalyst’).
We owned defence stocks before February 2022 but not because we had any foresight about the upcoming conflict. What interested us was that many investors had shunned the sector: the ESG movement was at its peak and defence companies were seen as unpalatable. There was no obvious catalyst to turn this sector around.
But what was obvious was its attractive valuation. Lowly share prices created an appealing risk/return profile: defence companies looked likely to deliver reasonable (if unspectacular) gains during peacetime, with the potential for very strong returns should war break out.
This is similar to how we approached beaten-up businesses during the pandemic. We had no way of knowing a vaccine would be successful or how quickly it would make its way through clinical trials. But we were confident that, five years after the first lockdown, people would be free to leave their homes. Once we had identified the companies with enough cash to survive such a period, we found the most attractively valued were those where there was no evident catalyst for recovery.
We owned defence stocks before February 2022 but not because we had any foresight about the upcoming conflict. What interested us was that many investors had shunned the sector
It is easier to sing about our successes than to highlight our failures, but it is even more important to acknowledge (and seek to learn from) these too. The Iran conflict has harmed our holdings exposed to the UK consumer.
Equally, we did not foresee the impact that fears about potential disruption from AI would have on our investments in media companies. As is evident in our recent performance, investing in out-of-favour companies without catalysts is no guarantee of success. However, for those investors with a long enough time horizon, we do believe it increases our chances.
So which area of the market currently offers this sort of asymmetric risk?
As managers of a UK small-cap fund, you may be a touch cynical when we point out UK small caps fit the bill.
Yet we would note the UK market trades at a discount to the rest of the world and UK small caps trade at a discount to their larger counterparts. Meanwhile, our portfolio trades at a discount to small caps as a whole (and our investment trust is on a double-digit discount to the value of its own NAV).
UK small caps are being shunned (and hence are trading at such lowly valuations) because there is no obvious catalyst. But this valuation creates exactly the asymmetry that we like to see
The lowly valuations in UK small caps (our fund trades on 10x P/E for double-digit forecast EPS growth and a free cashflow yield of 9%1) are at odds with an economic picture that is much better than commonly reported: household debts are at an 18-year low2, while the household savings rate is at 10% (about double its historic level)3. A fall of 1% in this figure would be equivalent to an extra £20bn of consumer spending4. A return to pre-Covid levels would result in quite the boost to the economy.
Source: Lazarus Economics, ONS
If you are asking what could cause the consumer to spend more, or investors to return to UK small caps en masse, that is precisely the point that has brought about the opportunity.
UK small caps are being shunned (and hence trading at such lowly valuations) because there is no obvious catalyst. If nothing changes, we believe we can still expect respectable returns from the operating performance of our companies, supplemented by takeovers and share buybacks.
And yet… this is what defence stocks looked like before 2022. If you can afford to take a long-term view on an asset class, sector or stock where a lot of bad news is factored in, even a slight improvement in the outlook could be the catalyst for a rapid reappraisal from investors.
1 Artemis as at 30 June 2026
2, 3 & 4 Lazarus Economics, ONS
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CAPITAL AT RISK. All financial investments involve taking risk and the value of your investment may go down as well as up. This means your investment is not guaranteed and you may not get back as much as you put in. Any income from the investment is also likely to vary and cannot be guaranteed.
This is a marketing communication. Before making any final investment decisions, and to understand the investment risks involved, refer to the fund prospectus (or in the case of investment trusts, Investor Disclosure Document and Articles of Association), available in English, and KIID/KID, available in English and in your local language depending on local country registration, available in the literature library.