With many countries in Europe facing domestic challenges and geopolitical hot spots both around the world and at their doorstep, it has become clear to Fidelity Portfolio Manager Clayton Pfannenstiel that years of underinvestment in defense capabilities have left gaps that are now commanding their attention, and funding.
“Amid the seismic pressures of conflict in Ukraine and the Middle East, U.S. efforts to get the rest of the world to share more of the cost of defending democracy on a global scale have seemingly come up short of expectations,” says Pfannenstiel, who co-manages Fidelity® Select Defense and Aerospace Portfolio (FSDAX) with Todd Haggerty. “As such, I believe the scope of the rearmament effort in Europe is vast and multiyear in nature, setting the stage for potential investment opportunities.”
In helming the industry-based equity strategy, he favors companies with a strong business model, balanced capital allocation and high recurring free cash flow, trading at a reasonable valuation.
In a segment of the market characterized by lengthy business cycles, Pfannenstiel took note early in the year when the U.S. – long the dominant player in defense spending – signaled budget cuts. Around the same time, he notes, European nations ramped up investments in their own military capabilities, a historical divergence that he believes could help provide unique investment prospects aligned to this long-term growth trajectory.
As the U.S. Department of Defense announced a reduction in spending initiatives, the U.K. took a different stance, revealing plans to increase its long-term defense budget to 3% of gross domestic product by 2027, a level not seen since the end of the Cold War in 1991.
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Elsewhere in Europe, PfannenstieI points out that Germany, too, is making bold moves by aiming to boost its defense spending from 1.5% to 2.5% of GDP, as the country redefines its security priorities.
“In fact,” he adds, “this singular shift could expand the addressable defense market by a staggering $44 billion. Moreover, it remains to be seen whether these current spending targets will even be sufficient in the years to come.”
For context, PfannenstieI notes that German armed forces shrank by roughly 60% since the end of the Cold War, according to the CIA World Factbook, including a 90% reduction in the size of its tank fleet.
On the other hand, though the United States spends more on defense than any other country in the world, the Congressional Budget Office is forecasting a different trend. Specifically, projections indicate that U.S. spending as a share of gross domestic product could decline in the coming years, from 2.9% in 2024 to 2.5% by 2034.
Accordingly, Pfannenstiel has positioned the portfolio based on his thesis that European defense budgets likely will grow materially faster than their U.S. counterparts in the next three to five years. Consequently, the fund has favored U.K. defense contractor BAE (BAESF) and French defense electronics provider Thales (THLEF), two companies PfannenstieI thinks are well-positioned amid this potential spending surge.
Additionally, he highlights that General Dynamics (GD), a U.S.-based firm and top fund holding as of June 30, enjoys a solid position in Europe through its European Land Systems business, headquartered in Madrid, Spain.
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Clayton Pfannenstiel is a sector leader and portfolio manager in the Equity division at Fidelity Investments.
In this role, Mr. Pfannenstiel is the global industrials sector leader and portfolio manager on Fidelity Select Industrials Portfolio, Fidelity Advisor Industrials Fund, VIP Industrials Portfolio, Fidelity Disruptive Automative ETF, and Fidelity Select Aerospace and Defense Portfolio. Additionally, he covers the global multi-industrials companies within the industrials sectors along with aerospace and defense industries.
Prior to assuming his current position in 2021, Mr. Pfannenstiel was a research analyst in Fidelity’s High Income and Alternatives division covering the airline, aerospace and defense, ground transports, maritime shipping, and packaging industries.
Before joining Fidelity in 2018, Mr. Pfannenstiel was a research associate at Sirios Capital Management. Prior to that, he held equity research roles at Credit Suisse and Bank of America/Merrill Lynch. He has been in the financial industry since 2009.
Mr. Pfannenstiel earned his Bachelor of Arts in economics and Asian studies from the University of North Carolina – Chapel Hill and his Master of Business Administration from the Massachusetts Institute of Technology – Sloan School of Management. He is also a CFA® charterholder.