Al Root

Investors in defense stocks will have to brace for volatility as domestic policy throws curveballs to the industry, wars continue, and the NATO alliance comes under strain.

On balance, higher growth should offset headwinds from the forced elimination of dividends, if that comes to pass.

By now, investors are aware that President Donald Trump is both unhappy with the pace of change in the defense business and wants a much bigger military. He recently signed an executive order restricting dividends, stock buybacks, and executive compensation at underperforming defense contractors while almost simultaneously pushing for a $1.5 trillion defense budget for fiscal 2027. That would be up from about $1 trillion expected for fiscal 2026.

Expectations for dividend cuts are typically a death knell for stocks. They generally signal distress in a business, when cash flow and earnings can't cover payouts.

While that isn't the case in the defense industry -- sales growth is solid and earnings are fine -- stocks that cease to pay dividends, or reduce them, generally lose some buyers. Mutual funds that focus on dividend-paying stocks sell those shares, putting downward pressure on stock prices.

Still, in this case, the shift from a sector valued for its returns of capital to shareholders to one where growth brings higher stock prices might go more smoothly than some defense investors may fear.

Citi analyst John Godyn pointed out in a recent report that valuations for defense stocks have risen in line with growth in earnings and sales. When sales growth was stagnating in the middle of the past decade, Lockheed Martin and Northrop Grumman shares traded for about 10 times expected earnings.

But now, both growth and the companies' valuation ratios have risen. And a $1.5 trillion defense budget would lead to higher growth.

A problem with Godyn's analysis is that no one has seen a rapid 50% defense spending increase since the Korean War. Exactly where the stocks will trade, and how valuations might react, is unclear.

It might not happen. Vertical Partners Research analyst Rob Stallard pointed out in a Monday report that both the capital-control and spending ideas are facing congressional pushback. "Ranking member of the Senate Armed Services Committee, [Rhode Island Democratic] Senator [Jack] Reed noted that any change of this magnitude would need to be legislated," he wrote.

Things will continue to change and more news will emerge.

So far, the stocks are fine. Through early trading on Monday, Lockheed and Northrop shares were up about 5% and 3%, respectively, since Trump weighed in on dividends and defense spending. The iShares Aerospace & Defense ETF was up about 1% while the S&P 500 was roughly flat.

Writing clauses governing returns of capital into defense contracts is certainly an option, but having the government set companies' capital-return policies by fiat isn't a good idea. Over many, many years, markets have proven more effective at allocating capital than governments.

The U.S., as the largest customer of many defense companies, could do other things to effect change.

Write to Al Root at allen.root@dowjones.com

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January 12, 2026 11:19 ET (16:19 GMT)

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