China is upping its military spending – this company could benefit hugely

Over the weekend, a very special meeting took place in Singapore – the Shangri-La Dialogue security conference.

Initiated in 2002, the Shangri-La Dialogue is a pow wow for Asia-Pacific defence ministers to “engage in dialogue aimed at building confidence and fostering practical security cooperation”.

The conference attendees included the US Defence Secretary, Ash Carter, and China’s Admiral Sun Jianguo, deputy chief of the People’s Liberation Army general staff, as well as many top military brass from Asia.

The attendees had a lot of things to discuss – as Asia has accumulated trillions of dollars in new wealth, the need to safeguard th region’s various interests has increased. Or, as my former boss was fond of saying, “more wealth brings more concerns”.

It goes without saying that China is the key player. It is home to the second-biggest global economy (or biggest if using purchasing parity power); it’s also the factory floor of the world, and a major importer of commodities and intermediate goods from faraway places.

So last Tuesday when the State Council – China’s cabinet – issued its first defence white paper focused on strategy, the rest of the world took notice.

The new strategy dictates “active defence”. That means that China will not attack unless it is attacked – but if it is, it will certainly counterattack.

If that sounds wishy-washy, the paper is clear about two main changes: the navy will widen its scope from offshore areas to the open seas; and the air force will focus on offensive operations as well as defence of China’s territory.

All well and good, but what does this new strategy really mean?

Nobody really knows. I think the quest to answer it is the most daring question for Asia in the near-term given its profound impact on politics, economics and stockmarkets.

I call this quest the ‘China equilibrium’.

Lessons from the Cold War

In 1950, John Nash, a 22-year-old student published a 32-page doctoral thesis in mathematics with a focus in game theory.

You might remember this story from the Hollywood film A Beautiful Mind.

Nash, who tragically passed away in a traffic accident recently, formulated the ‘Nash equilibrium’, defined as “a configuration of strategies, such that no player acting on his own can change his strategy to achieve a better outcome for himself”.

Basically, it offers a way to analyse situations of conflict and co-operation and produce predictions of how people will behave.

It was widely deployed during the Cold War, arguably helping to create the right environment to support trade, economic growth and less military conflicts.

I think a similar equilibrium will be reached in Asia. Of course, it will probably require some time and a lot of posturing, but I believe it can be reached – and the benefits for investors could be huge.

The Chinese defence sector offers huge opportunities

In the short term, the easiest way to play this theme is through the defence sector. I have favoured Chinese defence sector stocks since October. To recap, in contrast to received wisdom, increased defence spending should have a positive effect on China’s economy and companies.

The nexus between defence spending and business goes back centuries. In modern times, the best example offered is Silicon Valley, where many technology stars were incubated, supported by generous American military research and development spending.

I fail to see why China should be much different.

According to the Stockholm International Peace Research Institute (SIPRI), China increased military spending by 9.7% to an estimated $216bn in 2014. In comparison, global military spending dropped by 0.4% last year, down for the third consecutive year.

SIPRI found that China has gradually cut its weapons imports to support the domestic arms industry. China’s defence import fell by 58% between 2007 and 2011.

The combination of rising military spending and falling imports means that Chinese arms-related companies will face a lucrative future.

AviChina gains 78%, but I think it has more to give

In the past I singled out AviChina Industry & Technology (HK: 2357), China’s largest contract supplier of helicopters and avionics system, as a particularly interesting opportunity.

Since October, the stock has surged nearly 78%, outshining the H-shares index (37%) and Hang Seng index (18%).

AviChina’s gain is linked to the commencement of the Shanghai/Hong Kong Stock Connect through train – the direct share-trading platform between Shanghai and Hong Kong.

I had flagged up the opportunity previously and urged investors to mark the launch date in their calendars (admittedly, I was off about the launch date: the through train commenced operations on 17 November instead of the expected 27 October).

AviChina has done well in the interim, but I think it still has more to offer.

Five reasons to buy AviChina

1. Defence in Asia is a hot topic

China’s defence budget is set to increase by 10% in 2015, so there could be a lot of opportunities for AviChina. Similarly, the US is currently preparing to shift 60% of its navy fleet to the Pacific by 2020.

2. Its parent company is going on a spending spree

Secondly, the market is speculating that AviChina’s parent company, AVIC, will inject assets into AviChina’s subsidiaries over the next couple of years.

3. It’s looking to buy foreign companies

AviChina is eyeing overseas acquisitions in the aviation parts and components markets. Since AviChina is trading at a steep multiple (a forward price/earnings (p/e) of 39.6 for 2016, according to Bloomberg), and any acquisition is set to grow earnings.

4. It’s trading at a 50% discount to its NAV

The net asset value (NAV) of AviChina’s A-share-listed subsidiaries is estimated to be HK$15.50, according to BoA Merrill-Lynch. It implies that the Hong Kong-listed stock is trading at about a 50% discount to its NAV.

5. It’s one of the few Chinese arms companies available to buy

There is a dearth of Chinese defence-related stocks available to foreign investors, which could trigger a narrowing of the hefty discount to NAV.

As for the general Chinese market, I think the stupendous gains in Chinese stocks look a bit overdone in the short term, warranting a pull back. I can’t estimate how extreme this will be or how long it will last for it, but it could have a large impact on AviChina.

There’s also nothing to say that China’s defence spending plans won’t change in the future.

Regardless, for now at least, AviChina is definitely worth a look.