Over the last six months, we have skewed our portfolio more towards defense companies. We have done this intentionally. The world appears less safe today than at any time since the Berlin Wall came down. After 9/11 the world was united to fight terrorists. Even Russia – our Cold War foe – reached out to help the US fight the terrorists who attacked us.

Fast-forward two decades. We live in a drastically different world.

The resurgence of nationalism had started to create cracks in attitudes about global trade, especially in the US, before the pandemic. The pandemic has just widened those cracks as it exposed fragilities in global just-in-time supply chains and unearthed a helpless feeling of discomfort when we realized that we rely on the kindness of strangers to manufacture such simple items as face masks. Bringing manufacturing back to the US (or at least diversifying it away from China) is now about a lot more than jobs; it is an issue of national security.

Globalization led to shared interests; localization leads to us vs. them mentality.

China’s economic ascent, though based on a shaky foundation of debt and the biggest real estate bubble the world has ever seen, nevertheless presents a fresh challenge to US global dominance. That ascent has continued much longer any rational person could have imagined. That is what you can get when you have an authoritarian regime controlling the economy, with the ability to borrow in its own currency. At some point, this will not end well, but that is a topic for another time.

Graham Allison, an American political scientist, wrote the book Destined for War: Can America and China Escape Thucydides’s Trap? Thucydides was the Greek general and historian who chronicled the Peloponnesian War in 400 BC. He wrote, “It was the rise of Athens and the fear that this instilled in Sparta that made war inevitable.”

Allison draws a parallel between the rise of Chinese global power and the rise of Athens that Sparta perceived as a threat to its power, leading to war. The Thucydides trap leads to conflict because of a change in the status quo: There is an established, dominant nation, confronted by a new contender to its dominance.

The dominant nation got used to spreading its values and writing the rules for the rest of the world. The contender believes it can write its own rules and doesn’t need to follow by the rules of the old “has been” power. The dominant nation perceives this change as a threat. Any gain in strength of the contender nation is at the expense of the dominant nation.

The US (maybe naively) thought that as China developed, an infusion of market-based economics would lead to the democratization of the country and an inevitable embrace of Western values. However, the opposite happened: It led to a stronger China, which doubled down on authoritarianism. China has five times the population of the United States, and today it is the largest economy in the world (measured by purchasing power parity, adjusted by cost of living).

Allison chronicled sixteen situations that involved Thucydides traps. Twelve spilled over into war.

In the past, it required far more imagination to see the conflict between the US and China turning into war. However, today we find ourselves already in the middle of a technological cold war with China. And it is a war, not a friendly competition of tech companies battling for market share. It is a zero-sum game, us vs. them, where governments are putting a lot more than their thumbs on the scale of competition; they are removing the scale completely. They are doing whatever they deem is in their nations’ best interests.

Robert Spaulding, retired US Air Force brigadier general, served as US Defense Attaché to China and is the author of Stealth War: How China Took Over While America’s Elite Slept. He says, “What oil is for Saudi Arabia, data is to China.” The Chinese government uses data to exert control over its citizens and may use it to impact other nations – the US perceives it as an existential threat. Cloud computing, 5G, and the amassing of data through the deployment of these technologies is at the core of this fight.

Let’s zero in on 5G for a minute. The transition from 4th-generation (4G) wireless to 5th-generation (5G) is about a lot more than just the ability to download Netflix movies in seconds rather than minutes. 5G is a transformational technology that in coming years may turn our global society into either a utopian or a dystopian sci-fi movie. 5G uses a much wider wireless spectrum, drains a fraction of the battery power, and has lower latency. The combination of these factors will result in a hundred- if not thousand-fold increase in internet-connected devices. Streetlights, trash cans, cars, cameras… cows; all will be connected through the wireless grid.

Here is one example from 2020 that popped up as I was writing this. Amazon has announced that you’ll be able to pay for goods at its Amazon Go stores by scanning your hand. In other words, you’ll no longer need your smartphone. Your personal data will change its main residence from the personal comfort zone of your smartphone to the cloud.

We are a few years away from it, but the amount of data created by the 5G network will increase exponentially. It will transform the internet of smartphones to the internet of things, where smartphones are just a small fraction of those things. And the potential for abuse of this power to monitor and control people will grow exponentially, too. We know that China is already the world leader in the antidemocratic applications of technology.

The US underestimated China for a long time, but no more.

So back to the tech cold war.

The US fired the first shot when it went after one of the most important technology companies in China – Huawei (one of the largest contributors of technology to 5G). At the US’s request, the Canadian government arrested the company’s CFO (daughter of the founder) in Vancouver, and she is potentially facing 30 years in prison for selling equipment to Iran. (You don’t have to be a disgruntled cynic to see that the Iran sanction violation was used as an excuse here.)

Then the US put restrictions on the US companies providing chips and chip-making equipment to Chinese tech companies. This action alone is like shutting off the oxygen to the Chinese tech economy, and thus the Chinese economy as a whole. China will not sit by idly. It will retaliate. In the meantime, this was another reminder to China that it cannot rely on the continuity of American technology, so it is going to be spending as much as it needs to become self-sufficient in semiconductors and software.

In 2014 China announced its own version of the Manhattan Project: It allocated $200 billion to achieve parity with the US in semiconductors. (Actually, the cost of the Manhattan Project in today’s dollars was about $20 billion.) I used to think that it would be impossible for China to catch up in semiconductors, no matter how much money it had to lose because it doesn’t have the knowhow that the global leaders (Samsung, Intel, Nvidia, Qualcomm, Micron) have accumulated over the decades of research. I am no longer sure that is true, especially after we cut off the supply of chips to Huawei.

Today China looks at this issue as an existential threat; and therefore, as a powerful but wounded animal, it will do whatever it must to survive. This is war. China never valued the intellectual property of others; it will steal intellectual property from other chip companies to catch up. Here is one example. Chinese engineers (plural!) were found guilty of stealing secrets from Micron. This is not good news for American tech companies that have gotten used to exporting to China (the understatement of the century).

Just as the Cold War of the 20th century had two gravitational poles, with satellite countries revolving around each pole, we’ll likely see US/Western Europe/Japan and China gravitational technological poles. The UK has already followed the US’s lead and banned Huawei equipment from its communications network.

This is not the behavior of friends. Henry Kissinger said that “We are in the foothills of a Cold War.” We are on a trajectory that if left unchanged could lead to greater conflict. The US government closed the Chinese consulate in Houston, claiming China had violated the Espionage Act. China retaliated by closing the US consulate in Chengdu.

Then there is the TikTok fiasco, which is still unraveling. The US government fears TikTok’s unchecked presence in the US, the data it may collect about US consumers, and what it will do with it. This is understandable. However, the way the US has dealt with the issue will be perceived as unconscionable by both China and, more importantly, the rest of the world.

The US government gave an ultimatum to TikTok get out of the US or be sold to a US-based company. But then President Trump demanded that whoever buys TikTok must pay the US government “key money” (a commission). In other words, since this “key money” will lower TikTok’s purchase price, TikTok is basically paying the US government for… I’m not sure what. This is extortion. Mobsters do this, not the US government.

Actually, other countries, including China, do this. Apparently, it is done in commercial real estate, as well. But we are the shining beacon of democracy; we are the United States of America. We should be doing the opposite; we should make sure that this sale process is fair and above board.

Anyway, our treatment of TikTok will only escalate the US-China conflict. We just lowered the bar, which was already incredibly low. Be less outraged when China does something similar to a US company (Apple or Qualcomm). Being a global technology company and doing business in China will come with a new set of risks.

It is hard to imagine a “hot” war between two nuclear nations. But though the US and Soviet Cold War did not result in direct confrontations, there was plenty of fighting through proxies (Vietnam and Afghanistan immediately come to mind).

From today’s perspective, it is difficult to see the US and China relationship getting better. US and Chinese interests are becoming less aligned, and from today’s perch nothing short of an alien invasion seems likely to align them). I’m not sure if the occupant of the White House will really make a difference at this point. He/she may avoid escalation, or increase it. JFK’s genius during the Cuban Missile Crisis was that though he listened to his advisors, he did not let the crisis escalate into a war by making a lot of what might have seemed to be small, incremental decisions that, independently, were relatively benign but that taken together would have led irreversibly to a nuclear shooting war.

There is an interesting dichotomy between the hawkishness of what I wrote above and the fact that China and the US are still deeply integrated. This buys us time for the relationship to improve.

Here is an unpleasant but accurate analogy: The US-China relationship is like a very bitter marriage with a lot of young children. The parties are skirmishing, but they are waiting for the kids to get out of the house before they go to “war” with each other.

But the divorce will come, and both sides are preparing for it. The kids-going-off–to-college moment for the US and China will have to mean economic independence from each other. While China is beefing up its semiconductor industry, the US is noodling on how to bring factories back to the US.

President Trump recently signed an executive order making it a strategic priority for the US to mine rare earth minerals. Despite their somewhat deceptive name, these not-so-rare minerals are crucial to the production of electronics. Today, however, 80% of them are imported from China. Rare earth minerals are another kid that has to go to college before the parents split up.

This brings us to defense stocks – they are the “lawyers” in our divorce analogy. They will be the primary beneficiary of any divorce, and the greater the tension between the couple, the more money they make.

The US spends $750 billion a year on defense. China is a not-so-distant second at $250 billion. Its defense spending almost doubled over the past ten years and is unlikely to slow down anytime soon. It is difficult for us to see defense spending declining; it will likely continue to march higher. When you look at US defense spending data over the last 70 years, despite the public perception that Republicans love defense and Democrats, well, not so much, defense spending has actually been quite apolitical – the external environment (self-preservation) has determined our spending on defense.

The US and Europe are likely going to continue to beef up their spending preparing not for the war that may come tomorrow, but the one decades into the future. Also, irrespective of who wins the November election, the European allies will likely feel that they need to be more self-reliant on defending themselves. They’ll be likely increasing their defense spending no matter what their underlying economy is doing.

Our portfolio of defense stocks

We have assembled a global (US and European) basket of defense stocks. They have less sex appeal than the internet-connected bike or the latest software-as-a-service darling, but we believe the virus provided us an opportunity to pick up these companies on the cheap. We were offered a welcome asymmetry of outcome. These companies are so cheap that we should make money with them if the China-US relationship normalizes. If, god forbid, tensions escalate, they’ll skyrocket. We are not hoping for that scenario, but we’re preparing for it.

Some of their stock charts look like these companies are about to have a date with their maker. Don’t believe those charts. They are a perfect example of how the virus has inconvenienced businesses but not really changed them. These companies make stuff – be it fighter planes, submarines, aircraft carriers, or tanks. Social distancing does not remove the demand for their products but makes producing them temporarily harder.

These companies needed to adjust. They did. They went to multiple production shifts. Their efficiency temporarily decreased. Their contracts with their respective governments are usually structured as percent of completion. They finish 20% of the submarine and the government sends them a check for 20% of the agreed price. We are oversimplifying but hope you get the point. These milestones got pushed up by the virus a few quarters into the future. The companies will incur some extra short-term costs, but their long-term fundamentals are not impacted by the virus. Also, the virus does not make their business path-dependent – they are still very profitable and cash flow-generative businesses that can honor all of their obligations from their cash flows.

Defense companies have another thing in common – they are terrific businesses.  They are either monopolies or operate in a cozy competitive (oligopolistic) environment.  For instance, in the US – Huntington Ingalls and General Dynamics make submarines, each has 50% market share.  Barriers to entry and switching costs are enormous, they are further complicated by security clearance required for their employees which are extremely difficult to obtain. 

The market today is going bananas for subscription as a service businesses; well, these are truly subscription as service businesses – they are building, servicing, and upgrading aircraft careers, ships, submarines, planes, and training armed forces for a customer whose check will never bounce.  In addition to that, they have long-term contracts and thus revenues flow till the end of times. These businesses have a good return on capital, very stable margins and usually very conservative balance sheets.  And finally, today, because they got inconvenienced by the virus, we are buying them at bargain-basement valuations. 

And one more thing…

I am not a journalist or reporter; I am an investor who thinks through writing. This and other investment articles are just my thinking at the point they were written. However, investment research is not static, it is fluid. New information comes our way and we continue to do research, which may lead us to tweak and modify assumptions and thus to change our minds.

We are long-term investors and often hold stocks for years, but as luck may or may not have it, by the time you read this article we may have already sold the stock. I may or may not write about this company ever again. Think of this and other articles as learning and thinking frameworks. But they are not investment recommendations. The bottom line is this. If this article piques your interest in the company I’ve mentioned, great. This should be the beginning, not the end, of your research.