Could ASX shares in this sector be set 'for runaway growth'?

Rising interest rates and geopolitical tensions are shaking up tomorrow's potential stock winners.

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Key points

  • ASX shares with exposure to the defence industry are in the spotlight 
  • Newton Investment Management says the defence sector is one to watch “for runaway growth” 
  • There are no large-cap ASX defence shares, but plenty of smaller companies with a footprint in the sector 

ASX shares with exposure to the defence industry may be set for "runaway growth".

That's according to Aron Pataki, global portfolio manager at Newton Investment Management.

As the Australian Financial Review reported, Pataki says the defence sector is a key area he's keeping an eye on in his hunt for growth stocks amid today's rising geopolitical turmoil and environment of fast rising interest rates.

Which could throw up some welcome tailwind for ASX shares with exposure to defence spending.

Russia's war in Ukraine sparks defence spending growth

With inflation rocketing after a decade of 'stubborn absence' and interest rates rising fast following 11 years of stable or falling rates, Pataki sees the advantage returning to active investors over passive investors.

According to Pataki (quoted by the AFR):

For decades, passive investing worked very well. It didn't really matter what you invested in, everything went up, and the mantra was whenever you have a dip, it's a brilliant buying opportunity. But I suspect the world might be more complicated than that going forward. Active investors like us will benefit where you need to be far more selective.

Russia's invasion of Ukraine has spurred governments the world over to rethink their defence spending, with further growth in defence budgets widely forecast over the coming years.

Having invested in global defence giants Lockheed Martin Corporation (NYSE: LMT) and BAE Systems plc (LON: BA), Pataki said defence is among the key sectors to watch "for runaway growth".

Which ASX shares have exposure to the defence sector?

Now, there are no ASX shares that can rival Lockheed Martin or BAE Systems for their sheer size.

At least, not yet!

But a number of small-cap shares trading on the ASX do have significant exposure to increased global defence spending. Though that's largely yet to filter down to their share price performance this year.

Electro Optic Systems Holdings Ltd (ASX: EOS), for example, develops electro-optic technologies for the aerospace market. The company's biggest revenue earner is its defence segment, which manufactures advanced fire control, surveillance, and weapon systems. Despite running sharply higher in the weeks following Russia's invasion of Ukraine, the Electro Optic share price is down 79% in 2022 amid slumping revenue figures.

DroneShield Ltd (ASX: DRO) is another ASX share that stands to benefit from increasing geopolitical tensions. DroneShield provides drone detection and disruption solutions to the defence sectors as well as commercial airports, prisons, and other critical infrastructure. The DroneShield share price is down 3% year-to-date, beating the benchmark performance.

Then there's Codan Limited (ASX: CDA). Codan develops electronics solutions with a strong focus on metal detectors. Codan sells its equipment to both private and government customers. The Codan share price is down 33% this calendar year despite reporting strong FY22 results. Those results included a 16% year-on-year increase in sales and a record underlying net profit after tax (NPAT) of $100.5 million.

Other ASX shares with a footprint in the defence sector worth exploring include Bisalloy Steel Group Ltd (ASX: BIS), Austal Ltd (ASX: ASB), and Quickstep Holdings Limited (ASX: QHL).

Motley Fool contributor Bernd Struben has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has positions in and has recommended Austal Limited, DroneShield Ltd, and Electro Optic Systems Holdings Limited. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has recommended Lockheed Martin. The Motley Fool Australia has recommended DroneShield Ltd. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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