What to buy as China flexes its muscles

In the East China Sea, northeast of Taiwan and southwest of Okinawa (Japan's most southerly prefecture), lie eight uninhabited rocks. The Japanese, who control the islands, know them as Senkaku. The Chinese, who claim the islands for Taiwan, call them Diaoyu. The rocks themselves are of little interest. But they are surrounded by rich fishing grounds and potentially huge gas and oil deposits. That's why Japan and China are at loggerheads over them.

The dispute stretches back at least four decades, but this week took a potentially dangerous turn. Japan paid $26.1m to buy three of the islands, which it had been renting from the Japanese family that has owned them since the 1970s. This enraged China: its main military newspaper, the People's Liberation Army Daily, called the move "the most serious provocation against China's territorial sovereignty since the end of the second world war", reports the Financial Times.

Whatever the rights and wrongs of this dispute, it won't be the last. China is going through a tough phase in its development. Its economy is slowing sharply. Its workers are demanding double-digit pay rises, even as corporate cash flow dries up. The government is in flux too. It is meant to be gearing up for a handover of power, yet this week press reports noted that the man expected to be China's next president Xi Jinping hadn't been seen in public for at least 11 days.

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Under this pressure, will China be more or less inclined to pick fights that appeal to nationalist sentiment? We suspect the former. As Sun Cheng, a professor at Beijing's China University of Political Science and Law, told Reuters: "Chinese people won't disregard territorial disputes just because of the economy and the Party Congress. And if China is too soft on this issue, I don't think the Chinese people will abide by that."

Against this backdrop, it's perhaps no surprise that 2012 marks the first time in 500 years that Asian countries will have spent more on their military forces than their European peers. This is a major shift in the global power balance. Even if China fails to overtake America as the world's biggest economy, Asia is undoubtedly becoming wealthier.

Moreover, unlike Europe, where most conflicts and territorial issues have been resolved albeit very bloodily for now, the geopolitical status quo in Asia is far more fragile. If history is any guide, the newly rich countries will continue to increase military spending to defend lucrative trade routes and protect or enforce their interests. That creates opportunities for the companies that supply these countries and those who invest in them.

Islands are common flashpoints

To see the potential for friction, you only have to look to the South China Sea. This small, resource-rich stretch of water lies just below the Chinese mainland and is surrounded by ten densely populated countries, each with rival claims on overlapping sections.

Settling maritime boundaries is usually relatively easy. UN convention says that a country's exclusive economic zone (EEZ) extends to 200 nautical miles from its coast. If the EEZs of two nations overlap, the border should run in an equidistant line between the two. But islands complicate matters, as a country can claim a 200 nautical mile zone around one. In effect, ownership of a distant island allows countries to control a much greater chunk of the sea.

The South China Sea contains hundreds of tiny islands. Indonesia, the Philippines, Malaysia, Vietnam, Brunei, Taiwan, Singapore and China all have competing claims on various lumps of rock, meaning the sovereignty of large swathes of the sea is disputed (see map). Until recently these disputes were largely academic. Few of the islands are inhabitable and none of these countries had the naval power to enforce far-flung claims. But in the last decade that's changed.

One reason is population growth. Around 270 million people live in the coastal regions around the South China Sea and that number is growing fast. More people means more pressure on the sea's resources. One commodity up for grabs for local consumption and export is fish. A potentially more lucrative resource is energy.

Estimates of the amount of oil in the region vary widely, from 28 billion barrels roughly the amount left in Britain's share of the North Sea to 213 billion barrels almost as much as Saudi Arabia. There's also an estimated 900 trillion cubic feet of natural gas, which would be more than 12% of the world's total current reserves. Given the economic bounty at stake, governments have been quick to use force to defend their interests.

The common trend to all these disputes is China's increased assertiveness. In recent years the country has pursued a more aggressive foreign policy, matched by a huge increase in defence spending. According to Japanese investment bank Nomura, China's military spending increased at a compound annual growth rate of 16% between 2005 and 2010.

Defence specialists Jane's expect it to more than double between 2011 and 2015, reaching $238bn. "This would not only make it larger than the defence budgets of all other major Asian nations combined, but also places tremendous pressure on China's regional neighbours to increase their own military expenditure," says Nomura's Michael Kurtz.

A new Cold War?

China's defence splurge is about more than dominating its neighbours. Last year Barack Obama announced a historic shift in America's military and foreign policy. He made it clear that the future belonged to the Pacific powers, and that America would "pivot" towards Asia.

In practice, that means strengthening alliances with Asian-Pacific countries and redeploying military resources. The pivot has already begun. For example, 2,500 US marines have set up base in Australia, and the military has carried out joint exercises with China's rivals. By 2020, 60% of the US navy's assets will focus on the Asia-Pacific region, compared to 50% today.

Some in China complain that America is trying to contain' China, as it did the USSR in the Cold War era. That may be true. But America also needs to maintain its influence in this economically vital region. The South China Sea alone is the world's second-busiest sea lane. One third of global shipping passes through it. In total, more than half the world's merchant shipping tonnage goes through the south-east corner of the Asian-Pacific. If China gains naval dominance there, it would effectively control the world economy.

America is also pushing other countries to improve their military. Fearing a newly assertive China, smaller nations are doing just that. "All major Asia-Pacific countries except Japan have increased their military spending from five years ago most notably in India, Australia and Korea a pattern that would appear likely to [continue] in the years ahead," says Kurtz. Between 2000 and 2010, arms imports to Indonesia, Singapore and Malaysia rose by 84%, 146% and 722% respectively. Vietnam recently spent $2bn on six state-of-the-art Russian submarines and $1bn on Russian fighter jets, while Malaysia just opened a submarine base in Borneo.

"The acquisition of sophisticated weapons indicates two things," says Andrew Marshall in Time. "First, that southeast Asian nations are more wary of eachother than fraternal declarations at the Association of South East Asian Nations [ASEAN] meetings suggest. Second, that a region that publicly welcomes China's soft power is also quietly tooling up for the hard version." Even Japan has made significant changes to its defence policy.

Japan's post-World War II constitution was pacifist. It effectively outsourced much of its defence to America, whom it compensates with payments. Its own army was limited to defence and peacekeeping. However, in 2008, legislators overruled an old law that said Japan's space programme could only be used for peaceful needs. It promptly pumped $600m for space development' into the 2009 defence budget. Then last year, Japan changed the law on foreign arms sales. Its leading arms firms had been restricted to supplying America or Japan. Now it can sell to Asian neighbours.

It's been shy about spelling out its motives. But its most recent defence white paper says: "China has been expanding and intensifying its activities in waters close to Japan. These moves, together with the lack of transparency in its military and security affairs, are a matter of concern for the region and the international community, including Japan." With China's military spending rising, pressure on Japan and others to respond will grow.

We realise that investing in defence companies is not for everyone. To be clear, we do not anticipate, much less hope for, conflict in the Asia-Pacific region, although clearly it's a risk. Our investment case instead rests on the observation that increased military spending is simply a natural result of the region becoming wealthier.

Defence budgets are always among the biggest items on any government's spending priorities list, and Asia will be no different to America or Europe in this respect. So as nations have more money to spend and more valuable resources to protect we can expect more of this money to be diverted towards defence spending. We look at the companies most likely to benefit below.

The military build-up on India's border

The Asian arms race isn't just about the navy. Another major military build up is taking place along the land border with India. Historically, the Chinese and Indian empires have been kept apart by the Himalayas, says Frank Jack Daniel in Reuters. But "after years of fast economic growth, the rivals now have the resources to consolidate and patrol their most distant regions".

The two Asian super powers fought a brief war in 1962 over their disputed Himalayan border. Since then the two sides had been content to leave an untouched no man's land' between them, but now both are ramping up military forces in the area.

"China has vastly improved roads and is building or extending airports on its side of the border in Tibet. It has placed nuclear-capable intermediate missiles in the area and deployed around 300,000 troops across the Tibetan plateau," says Daniel. Meanwhile India, which has already spent $8bn on US weapons, is planning to spend a further $100bn over the next ten years.

India has also just hiked its defence budget up 17% this year to $40bn. For the Indians the dispute is about pride, sovereignty and defence. For China a tight grip on the region is necessary to keep control of restive Tibet. The Himalayas are also home to one of the world's largest sources of fresh water a resource that could prove vitally important to both water-scarce state.

The best stocks to buy now

Political restrictions prevent most Western firms from selling military equipment to China. Several Russian firms have secured large deals with China, but none are appealing investments. So the firms we prefer sell to America, and to China's neighbours.

Singapore Technologies Engineering (SP: STE; US: SGGKY) is a defence and engineering conglomerate and the only southeast Asian firm (excluding China) to make it into the world's 100 top-selling arms producers. It was formed from the 1997 merger of four military suppliers and its land, aerospace, electronics and marine units now supply both governments and private companies.

STE provides just about everything a modern army would need. The electronics unit provides satellite communications, rail communications systems and command and control centres. The land systems division makes armoured carriers, weapons systems and surveillance equipment. Its marine business provides ship design, building, conversion and repair for naval customers. This division is expected to do particularly well as China's neighbours upgrade their navies. Finally, STE's aerospace unit provides maintenance to Singapore's Air Force.

Defence accounts for 40% of sales directly, but much of the rest of its business is also linked to military spending. For example, it makes construction equipment that will be used as countries bulk up support infrastructure. Its marine unit also caters for offshore energy projects, which would see it benefit from any energy boom in the South China Sea. On a price-to-earnings (p/e) ratio of 18.6, it's not cheap. But it's the best South East Asian defence firm.

The best pure play' on the naval build-up in the region is Australian shipbuilder Austal (ASX: ASB; US: AUTLF). The firm specialises in littoral combat ships fast, lightweight vessels that are ideal for coastal and island warfare. These ships were designed with the Asia Pacific in mind, and the US Navy commissioned the first one in 2003.

They use aluminium frames instead of traditional metals and an unconventional hull design. Their roles range from minesweeping to carrying special forces and, thanks to their modular design, can be refitted for a new mission within hours.

Austal is also building the Joint High Speed Vessel for America. This is an aluminium catamaran supply ship, designed to shuttle equipment and personnel quickly around the Pacific. Last year the firm's sales rose 30%, thanks to new orders from the US Navy and a contract to supply patrol boats to the Australian coast guard.

Its order book is now worth $2.6bn, enough to keep its three shipyards in America, the Philippines and Australia busy for at least four years. Yet the share price has fallen 55% since last July and it now trades on a forward p/e of 8.5, far cheaper than its peers.

This is partly due to technical problems with some of the new ships, and worries about a slowdown in US military spending. But the sell off is misjudged. Hiccups are to be expected with new designs. More importantly, US policymakers have made it clear that, even as army budgets are cut, the navy will continue to receive funding. It's a buy.

Japan's biggest arms maker is Mitsubishi Heavy Industries (JP: 7011; US: MHVYF). Until now its arms business has been restricted by Japan's stagnant defence budget and legislation. Indeed, defence only contributes 15% to group profits at present. But in its 2012 plan, the firm was restructured to increase its focus on defence.

Nomura's Kurtz says it will now benefit from militarisation in the region. The firm makes destroyers, submarines, aircraft, missiles, spaces systems and tanks for the Japanese government. It will now branch out into sales to friendly governments, working with its international peers to lower costs.

Another factor in the company's favour is that, like many Japanese companies, it's cheap. Its price-to-book value is 0.8, a 17% discount to its peers. Meanwhile, the other parts of the business its power generation, machinery and transport units should also benefit from a general increase in spending on the military and military infrastructure.