Defense Sector Valuations Need Rethink Amid AI and Evolving Warfare, Says Strategist

The rapidly evolving nature of warfare and modern military requirements should prompt investors to rethink valuations in the defense sector, according to Panmure Liberum strategist Joachim Klement.

While an increasingly fractious geopolitical environment continues to support the long-term bull case for the defense sector, Klement told CNBC's "Squawk Box Europe" on Monday, procurement risk, fiscal pressure and the AI trade are starting to separate winners from losers.

Investors are becoming more selective, he said, weighing not just how much governments promise to spend, but whether that money flows into legacy platforms, or AI-enabled systems, drones and electronic warfare.

The next generation of defense winners could increasingly resemble software and AI companies instead of conventional arms manufacturers, Klement said.

"Electronic warfare is a tech phenomenon," he added. "These companies need to be traded like tech companies."

It means that some stocks in the sector could deserve a "much, much higher valuation" than conventional warfare companies, according to Klement.

European defense stocks have been one of the clearest winners of the continent's rearmament push.

However, some of the sector's biggest winners have come under pressure more recently, suggesting a new phase for Europe's defense trade, where investors are no longer treating rearmament as a blanket buy signal.

Klement argued that Germany's cancellation of the F126 program showed that even in a world of rising defense budgets, big-ticket legacy programs can be vulnerable if they are slow, expensive or not aligned with changing military needs.

"So often generals are fighting the previous war, not the next war, and the problem is that the military-industrial complex in Europe is dominated by conventional weapons manufacturers, whether we're talking tanks, artillery, etcetera," Klement said.

"What the German government has not done, and where Rheinmetall is also lagging, is focusing on AI-enhanced weapons systems [and] drone-enhanced weapons systems," he said, noting that companies like Italy's Leonardo and the U.K.'s BAE Systems are building systems that use AI and drone technology to fight.

McKinsey senior partner Hugues Lavandier told CNBC last month that European defense spending is occurring "across the full gamut," including conventional land equipment such as main battle tanks and ammunition, as well as naval platforms, including aircraft carriers and frigates.

He also pointed to higher investment in newer areas, with growing recognition of the importance of deep strike capabilities, anti-drone and unmanned systems.

Defense stocks have enjoyed massive gains over the past five years. Klement suggested that recent weakness reflects investors rotating into AI trades rather than deteriorating defense fundamentals.

"To us, it's a question of flow rather than fundamentals – a lot of fund managers are starved for cash," he said, pointing to companies like Alphabet and SpaceX raising large amounts of money recently.

"When we look at the fundamentals, the European rearmament drive continues unabated, especially Germany and Poland are spending more and more money on defense."