* Big contractors seen as first to benefit from morespending
* Smaller firms' shares seen having potential for big gains
By Danilo Masoni and Atul Prakash
MILAN/LONDON, Dec 4 (Reuters) - The stepping up of airstrikes in Syria following the attacks in Paris this month hasalerted investors to the prospect of increased spending ondefence, putting European firms in the sector back on theirradar screens.
Defence-related stocks have outperformed the market sincethe Nov. 13 attacks but investors and analysts say there couldbe further gains to come, not only for prime contractors likeBAE Systems and Finmeccanica but also smallercompanies further down the supply chain.
IHS Jane's estimates that over 2015-2019 an extra $50billion will be added to Western European defence spending as aresult of budget changes already implemented this year byFrance, Germany and Britain.
In addition eastern European countries are looking tostrengthen their defences following Russia's annexation ofCrimea and the conflict in eastern Ukraine.
"We are turning the corner now," said Nick Cunningham,managing partner at institutional stockbroker Agency Partners."It's very early days. Budgets have just stopped falling butonce the cycle reverses it carries on going up for 10 years."
The Stoxx Europe aerospace and defence index hasrisen more than 4 percent since the Paris attacks, while themain Stoxx Europe 600 market index < .STOXX> has fallen backthis week.
"Stay long on Finmeccanica, Thales,Safran and BAE Systems," said Gary Paulin,founding partner at equity brokerage Aviate Global.
Meanwhile on Friday Deutsche Bank lifted target prices forseven stocks - Thales, BAE Systems, Dassault Aviation,Airbus, Meggitt, Finmeccanica and MTU AeroEngines - saying the defence outlook was muchimproved and geopolitics had removed downside risk to Europeandefence budgets.
In terms of share price performance Europe's big primedefence contractors have already advanced but are still seen bysome analysts as having some way to go to catch up with U.S.peers like Lockheed Martin and Northrop Grumman because of an earlier improvement in the outlook for U.S.defence spending.
Moreover, according to Cunningham, peak spending in pastcycles has lifted U.S. defence stocks to a premium rating interms of price-earnings multiples of 115-120 percent ofindustrial sector PEs.
They are now trading at a differential of just 75-80 percentbut have recovered from 50 percent in 2010-11, he said.
But the biggest gains could eventually be made by the sharesof the smaller, lower-tier supplier firms who have sufferedbadly during the years of cutbacks, but investors and analystssay it will still take some time before increased defencebudgets convert to increased spending.
"The really interesting argument here is that we shouldstart looking at the mid-caps," said Cunningham, citing firmssuch as Rheinmetall, Cobham and UltraElectronics.
According to Liberum analysts the 2015 PE for Rheinmetallstands at 15.5, Cobham at 14.7 and Ultra Electronics at 15.8.That compares with 20.2 and 19.3 for Lockheed and Northroprespectively.
Either way, the defence sector is back in focus forinvestors.
"Recent events have made people realise that defencespending has to continue," said David Battersby, investmentmanager at Redmayne-Bentley. (1 euro = $1.0886) (Editing by Greg Mahlich)