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Small U.S. defense stocks surge as demand rises for next-gen battlefield tech

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Smaller U.S. defense companies are delivering standout gains on Wall Street this year, driven by surging demand for low-cost, next-generation military technology designed for modern combat. Global conflicts in Ukraine and Gaza have fueled higher military spending, boosting stocks tied to AI-powered drones, unmanned vehicles, and software-enabled systems that reduce reliance on traditional ground troops.

“The winners in this new market will be those companies leaning into change and investing in low-cost, upgradable, and software-enabled weapon systems,” said Jon Siegmann, managing director for aerospace and defense at Stifel.

The NYSE Arca Defense Index (.DFII) has climbed about 34% in 2025, far ahead of the S&P 500’s (.SPX) 12% gain. Mid- and small-cap firms lead the rally, including drone makers Kratos Defense (KTOS.O) and AeroVironment (AVAV.O), components supplier Astronics (ATRO.O), and Mercury Systems (MRCY.O). Larger players such as RTX (RTX.N) and Northrop Grumman have also advanced, gaining 37% and 23% respectively.

Policy signals from Washington are shaping the surge. President Donald Trump has proposed renaming the Pentagon to the “Department of War,” while requesting $892.6 billion for fiscal 2026 defense spending, with nearly $6 billion earmarked for unmanned aircraft and counter-drone systems—a 78% jump from last year.

AeroVironment’s growth chief Church Hutton noted the administration’s push to get equipment to U.S. forces faster, a priority echoed by Defense Secretary Pete Hegseth.

Mergers and acquisitions in aerospace and defense are also climbing, though deal values remain modest. Lockheed Martin’s $360 million purchase of Amentum’s Rapid Solutions unit, aimed at expanding radar capabilities, is one recent example. Venture capital has followed suit, with startup funding in the sector hitting $14.17 billion by August, the highest in a decade.

“The demand signal we’re seeing is for tens of thousands of lower-cost munitions systems and unmanned systems,” said Lukas Czinger, CEO of Divergent Technologies, which 3D-prints parts for Lockheed, Raytheon, and others.

The Evolving Role of Defense Stocks in ESG Portfolios Amidst Geopolitical Shifts

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The ongoing conflict between Russia and Ukraine has sparked a significant transformation in the way defense stocks are regarded within the realm of environmental, social, and governance (ESG) investing. Traditionally, defense stocks have been excluded from ESG portfolios due to their connection with military activities and warfare, which raised ethical concerns among mission-driven investors. However, in recent months, there has been a growing willingness among ESG fund managers to incorporate defense companies, especially as the geopolitical landscape intensifies and military spending soars.

This shift, though still contentious, represents a profound change in ESG investing dynamics. The CEO of Saab, a Swedish defense and security company, highlighted this evolving trend, noting a remarkable increase in shareholders since the war began. While some institutional investors, such as pension funds, remain hesitant to include defense companies in their portfolios, others are recognizing the importance of national security and the deterrent capabilities provided by such firms. This has led to a reevaluation of whether defense companies, which contribute to societal resilience, should be considered within the scope of ESG.

Saab, which produces advanced military equipment such as missiles and fighter jets, has seen its stock price surge by around 330% since the onset of the war in Ukraine. This performance underscores the growing interest in the defense sector, even among investors traditionally focused on ethical concerns. Yet, skepticism persists, particularly from retail investors and fund managers wary of aligning with companies associated with warfare. For many, the ethical implications of investing in companies that manufacture weapons remain a critical issue.

The debate extends beyond Europe, with ESG investments becoming a politically charged topic in the U.S. In recent years, Republican lawmakers have criticized ESG investing as a form of “woke capitalism,” accusing it of prioritizing social goals over financial returns. On the other hand, Democrats have defended ESG principles, framing them as part of a broader effort to promote responsible business practices. This divide is likely to be further shaped by the outcome of the upcoming U.S. presidential election, which could have significant implications for the future of ESG investing in the defense sector.

Despite the controversies, some industry leaders believe that the role of defense companies in protecting free societies is gaining broader acceptance. Brad Greve, CFO of BAE Systems, remarked that discussions about the positive role of defense firms were almost impossible before the war in Ukraine. The conflict has reshaped public perception, allowing for more open conversations about how defense companies contribute to societal stability and security. BAE Systems, another major defense player, has also seen its stock rise significantly, driven by increased demand for its military products.

As geopolitical tensions remain high and military spending continues to grow, the inclusion of defense stocks in ESG portfolios is likely to be an ongoing topic of debate. Fund managers are divided on whether these companies should be classified as villains or essential components of national security. Ultimately, the future of defense stocks within ESG portfolios will depend on how investors reconcile the need for security with the ethical considerations that have long defined sustainable investing.