There’s never been a better time to invest in China’s military

From 7-25 October, Chinese, American and Australian troops are taking part in Kowari 14, a historic land exercise in Australia's Northern Territory.

Ten soldiers from the Australian army, ten from China's People's Liberation Army, five from the US army and five from the US Marine Corps are taking part, with a further 100 military personnel providing support in roles including liaison and logistics.

Few people have heard about this development as it is receiving minimal news coverage. Pity. It could change our world.

"The troops will have to depend on each other absolutely in order to succeed", according to the commander of the exercise, Brigadier Peter Clay.

The aim of the project is to strengthen cooperation between the three countries. And it's not the first of its kind.

In July of this year, the Chinese navy made its debut at the US-led Rim of The Pacific' naval exercise off Hawaii. It contributed the second largest force after the US: four navy ships, two helicopters and 1,100 personnel including divers.

It is no exaggeration to say that the Chinese armed forces are making an entrance on the global scene. As that happens, expect China to spend even more on its aerospace and defence programmes.

As investors, we need to watch this closely.

Three reasons for a rise in China's defence spending

China's defence and aerospace spending grew at a compounded annual growth rate of 15% over the last decade, hitting $189bn in 2013, the second largest in the world after the US at $640bn. It is about 2% of GDP below the world's average level of 2.9% and the US ratio of 3.8%.

We think it is fair to assume that China will not lag behind for much longer, setting the stage for an increase in spending in absolute as well as relative terms.

Here are three reasons why:

1. Geopolitical tensions between China and its neighbours

This is particularly true along the maritime sea-lane which runs from Japan/Korea in the north to Philippines, Vietnam and other countries in Southeast Asia (and, to a certain degree, India).

In military terms, it means China will have to create anti-access/area denial cordons to discourage potential adversaries, counter third-party intervention, and reduce island disputes with neighbouring countries.

2. The Chinese leadership has put security high on the political agenda

This is evident by the establishment of the National Security Commission in November 2013, and domestic security issues in 2014.

3. There is a need to upgrade equipment and materiel

Most Chinese weaponry, except for indigenously-produced nuclear submarines and missiles, is based on obsolete Soviet designs of the 1950s and the 1960s.

For example, Morgan Stanley predicts that for the period 2014-20, China needs to build 1,549 military helicopters, 656 new jet fighters, 294 advanced trainers, 70 strategic bombers and 236 heavy transporters.

In aggregate, that's worth over $60bn.

And now's the time to invest.

Military spending and the economy have a long history

The line between defence and civil market is blurring, paving the way for more commercially-driven military spending, allowing higher profitability, better incentives and further R&D spending to boost innovation and technology developments.

In June, the integration of market and military began in China as the government started increasing the securitisation of military assets. It was quickly followed in July when China's State-Owned Assets and Supervision and Administration Commission (SASAC) implemented four reforms in state-owned enterprises, including promoting growth in key economic sectors.

This sort of thing is a well-trodden path. In the US, for example, a lot of Silicon Valley companies can trace their origins to military links, something we have highlighted before.

In fact there is a historical relationship between military spending and the economy.

In the book The Cash Nexus: Money and Power in the Modern World: 1700-2000, historian Niall Ferguson argues that Western political economic institutions are intricately linked with military campaigns.

For instance, the UK Parliament emerged out of the monarchy's realisation that it could amass more funds for military campaigns through an elaborate system of taxation and representation than through plundering state assets. Similarly, central banks, tax bureaucracies and stock markets flourished as part of the modern warfare state. It also created some great opportunities.

In China, one such opportunity lies in the liberalisation of the country's air space

Starting in 2015, regulations are set to relax for low-altitude flying (below 1,000m) in a handful of provinces, followed by further reforms and improved infrastructure between 2016-20. The aim is to support growth in China's general aviation markets. At the end of last year, China's total fleet size for civil helicopters and fixed-wing aircraft was 385 and 1,239 respectively equivalent to 4% and 1% of the US levels.

But these relaxed regulations are set to accelerate demand for both helicopters and fixed-wing aircraft.

So what's the best way to play this theme?

Mark this day in your calendar

Alluring investment ideas rarely translate into simple stock ideas. This is particularly true for China, where almost 99% of aerospace and defence-related stocks were initially listed on the domestic A-share market.

For a long time, international investors have had great difficulty investing in China. But that is on course to change with the start of the Shanghai/Hong Kong Stock Connect through train' the direct share-trading platform between Shanghai and Hong Kong.

On 27 October, the most likely starting day, the floodgates will open to international investors.

With a total quota of RMB550bn ($90bn), international investors can buy shares in Shanghai up to RMB13bn ($2.1bn) a day. And mainland investors will be able to trade up to RMB10.5bn ($1.7bn) of Hong Kong-listed shares.

We expect international funds to hoover up the A-share market for defence-related stocks. As far as we know, there are some 50 listed subsidiaries of state-owned-enterprises defence industrials to choose from.

Many of these defence-related stocks are likely to end up in pan-Asian portfolios and hedge funds, allowing foreign investors to benefit from China's military spending boom.

The influx of foreign investors will also help to make the A-share market more professional. Individual investors account for 81% of A-share turnover. Institutional investors dominate Hong Kong, accounting for 61%. Institutional investors from the UK and US alone account for 25% of this.

All well and good for the long term, you may say, but is there is anything to do now?

Our answer is have a look at AviChina Industry & Technology (HK: 2357), China's largest contract supplier of helicopters and avionics system.

As investors pour in, prices will soar

AviChina acts as the international platform for financing and acquisition of its parent group, Aviation Industry Corporation of China (AVIC), which holds a 54.6% stake. Interestingly, Airbus Group NV (Paris: AIR) is a strategic partner and holds 5.0%.

We acknowledge that we are not the first to realise the potential. This year the stock has gained 35% and is trading at a PE of 28.4x FY15.

But there is an alternative way to value the stock.

AviChina controls four A-share listed subsidiaries which offers direct access to helicopter manufacturing and avionics: Hafei (600038.SS), Hongdu (600316.SS), Avionics (600372.SS) and CAOT (002179.SZ).

Based on a marked-to-market valuation of these A-share assets, the stock is trading at a discount to its sum-of-the-parts valuation. In mid-September, it was estimated to exceed HK9.00 equivalent to a 30% discount according to Morgan Stanley.

The valuation gap is too wide. It should mean that this entry ticket to China's defence boom can get even more pricey...

This is a theme that I think could go for a long time. In the meantime, I'll be watching this stock closely.