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The outlook for the defence sector is arguably brighter now than at any point since the credit crunch. Following years of austerity across the developed world, defence spending is set to increase. Donald Trump has repeatedly stated that the US defence budget will rise, while increasing demands on NATO members could signal a period of improved performance for defence stocks. Here are two companies which could benefit from an improving external environment, while also effecting turnaround programmes of their own.

An improving business

As well as the potential growth opportunities resulting from higher spending in the defence sector, Rolls-Royce (LSE: RR) could be positively catalysed by a new strategy. It is focused on reducing costs over the medium term, which should create a more efficient and profitable business.

In fact, the company’s bottom line is expected to increase by 7% in the current year and by a further 17% next year. Beyond 2018, faster growth could be achieved due to the impact of additional cost cutting as well as rising demand for the company’s products.

In addition to reducing costs, Rolls-Royce is also investing in new products. For example, its aerospace division’s performance could gain a boost from the introduction of new Trent engines, while higher production volumes could mean sales growth moves higher. As such, its turnaround programme appears to be far from complete.

Trading on a price-to-earnings growth (PEG) ratio of 1.1, Rolls-Royce appears to have a relatively wide margin of safety. Certainly, there is scope for more disappointment if demand growth fails to reach expected levels, or if its transformation programme stalls. However, in the long run the company’s outlook and valuation suggest it could be a strong performer.

Strong momentum

Another defence stock with turnaround potential is Chemring (LSE: CHG). It reported upbeat results on Friday which showed that the momentum from the second half of the prior year has continued into the current year. Order intake in the first four months of the year was in line with the company’s expectations.

This is excellent news for the company’s investors, since Chemring has endured an exceptionally difficult period which has seen several profit warnings released. Its outlook for the next two years is relatively positive, with earnings growth of 11% and 8% forecast for 2017 and 2018 respectively. And since debt levels are now stabilising and its trading is more consistent than in recent years, it would be unsurprising for investor sentiment to improve over the medium term.

Chemring trades on a PEG ratio of 1.5. While significantly higher than that of Rolls-Royce, Chemring arguably has more turnaround potential than its sector peer. Therefore, while its shares may be a relatively risky proposition, they could also record higher levels of growth. That’s especially the case if currency translation continues to be positive during the remainder of the year. An increase to the company’s guidance could be on the horizon if sterling moves lower as Brexit talks commence.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Peter Stephens has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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