Smaller defense companies have seen their stock prices decline sharply in recent months despite growing geopolitical tensions that are driving demand for military innovation and restocking depleted weapons inventories. This trend presents a potential buying opportunity for investors, according to industry analysts.

Since the onset of the conflict in Iran earlier this year, small- and mid-cap defense stocks have underperformed larger defense contractors. The State Street SPDR S&P Aerospace & Defense ETF, which has a greater weighting toward smaller defense firms, has fallen approximately 21%, compared with a 15% drop in the iShares U.S. Aerospace & Defense ETF, which focuses more on established companies like RTX and Boeing. Valuations for smaller defense firms, as reflected in forward earnings multiples, have contracted from averages of 44 times during the Trump administration to around 36 times currently.

Several factors are contributing to the downward pressure on these stocks. A wave of initial public offerings this year—six in the U.S. and five in Europe—has expanded the supply of publicly traded smaller defense firms, many of which have seen their share prices weaken since debuting. Additionally, uncertainty ahead of the U.S. midterm elections, where the Democratic Party’s prospects for sweeping Congress have increased, is dampening investor enthusiasm for defense stocks. Concerns over rising government deficits, expected to exceed 6% of gross domestic product this year, along with elevated interest rates, have also fueled worries about potential cuts to defense budgets.

A key area of uncertainty involves part of the $1.5 trillion Trump administration defense budget proposal for the current fiscal year. Around $350 billion of that request must pass through budget reconciliation, which includes $54 billion allocated for drones and $49 billion targeted for artificial intelligence initiatives. While such proposals might face scaling back, analysts expect final defense spending to fall between last year’s $1 trillion budget and the higher $1.5 trillion target.

Industry experts stress that even a tighter budget could benefit smaller, agile companies if the military increasingly seeks cost-effective solutions. The use of expensive interceptors to counter cheap drones is raising questions about the sustainability of current defense strategies. “If the military cannot acquire as many F-35 fighter jets or Patriot interceptors as planned, it may turn to purchasing more unmanned aerial vehicles and robotics,” said Byron Callan, an analyst from Capital Alpha Partners.

This shift toward autonomous systems is underlined by recent Pentagon initiatives. Defense Secretary Pete Hegseth announced plans to establish a four-star command dedicated to autonomous warfare, emphasizing the rapid development of affordable, American-made drones and robotic platforms. Notably, a panel led by SpaceX founder Elon Musk, Anduril CEO Palmer Luckey, and former House Speaker Newt Gingrich will study the future of warfare.

Historical patterns provide some optimism for investors. Defense stocks have typically outperformed the broader market in the year following midterm elections, particularly when the president loses control of at least one chamber of Congress. A report from RBC Capital Markets found that in such scenarios, defense stocks have exceeded market returns by an average of 13.6% since 1986.

Analysts recommend selective exposure to smaller firms with diversified technological capabilities across platforms such as missiles, drones, and space systems. Companies like Karman and Mercury Systems stand out due to their broad product offerings and strong growth prospects. Karman specializes in components for missiles, interceptors, drones, and space, with expected revenue growth around 22% annually over the next four years. Mercury Systems focuses on computing and electronics for air, ground, and missile platforms, positioning itself well amid the increasing demand for battlefield technology.

Both companies currently trade at forward price-to-earnings ratios near 40 times, lower than their previous multiples during the Trump administration, which were as high as 100 times for Karman and 60 times for Mercury Systems.

While short-term concerns about political developments and interest rates cloud the defense sector’s outlook, the sustained need to replenish armaments and adapt to evolving warfare technologies suggests that smaller defense companies could attract investor interest in the near term.