China is expanding its armed forces – investors, pay attention

There's a massive Chinese naval base hidden under the island of Hainan, off the coast of Vietnam. It's cut right into the cliff face, just like in a James Bond movie. You can see it here on Google Maps.

The base was completed in 2009, and it reportedly has the capacity for 20 nuclear submarines. At the moment, China only has five type 094 nuclear subs. But as the huge new base shows, that number is probably going to grow.

China is growing more than twice as fast as the US and the EU, and it's already the second-biggest economy in the world. It doesn't yet have the armed forces to match, but that's all starting to change. It increased military spending by 9.9% between 2008 and 2012. And the Institute for Strategic Studies predicts that China will spend more on defence than any other country by 2025.

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Sounds scary, right? Well, oddly enough, I think this is good news for investors.

Military spending is huge business

The first is increased private sector involvement. More and more private companies are claiming a piece of China's military spending. Since 2005, the government has actively encouraged private companies to participate in the arms industry.

Second, it means less dependence on unproductive assets in China. China's economy has been heavily based on the housing sector and on infrastructure investment. This has resulted in a misuse of capital. Look no further than the world's largest mall, the new and deserted South China Mall in Guangdong, for example.

Third, military spending boosts innovation & research. Important technology and great companies are often a by-product of military research. Silicon Valley was partly built on military contracts, for example.

Take Fairchild Semiconductor, one of Silicon Valley's first start-ups. The American company has a lot to thank the Cold War for. It developed in the 1960s through military partnerships, building chips for space exploration and missiles for the US. In 1999, the CIA started its own non-profit corporation, In-Q-Tel, which now backs 59 IT companies. One-third of these companies are based in Silicon Valley and focus on areas such as image analysis and data-centre efficiency. If China decides to back military research, the next Silicon Valley could be Chinese. And investors can keep an eye out for the next Fairchild.

Fourth, local development around military bases. When the US built bases around the world, it stimulated local economies and drove asset prices (particularly property) higher. I think the same could happen with China and investors could be part of this chain of interest' in various places in the region.

Investors are starting to take notice of this story. BoA Merrill Lynch identified 17 companies listed on the Shanghai Stock Exchange with over 50% of revenues linked to military use. Since 2000, these companies have outperformed the index by just under 300%, on average. Increased geopolitical tensions were responsible for 200% in the last year alone.

It's hard to ignore returns like that, and China is a lock' to increase its military spending further in the next few years. Let's keep a close eye on this story.