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U.S.-China cold war over technology has this investing pro buying up defense stocks

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The U.S. underestimated China for a long time, but no more. Now it’s war — a technology cold war, to be specific.

The U.S. has put restrictions on U.S. 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 allocated $200 billion to achieve parity with the U.S. in semiconductors. I used to think 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 know-how 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 the U.S. cut off the supply of chips to Huawei — one of China’s most important technology companies.

Today China looks at the chip issue as an existential threat; and so it will do whatever it must to survive. China will steal intellectual property from other chip companies to catch up. Here is one example. Chinese engineers were found guilty of stealing secrets from Micron. This is not good news for American tech companies that are accustomed to exporting to China.

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

This is not the behavior of friends. We are on a trajectory that if left unchanged could lead to greater conflict.

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

The U.S. government gave an ultimatum to TikTok get out of the country or be sold to a U.S.-based company. Then President Donald Trump demanded that whoever buys TikTok must pay the U.S. government “key money” (a commission).

This is extortion. Mobsters do this, not the U.S. government. Actually, other countries, including China, do this too. Apparently, it is done in commercial real estate, as well. But the U.S. is supposed to be a shining beacon of democracy. The U.S. should be doing the opposite; we should make sure that this sale process is fair and above board.

The U.S. government’s treatment of TikTok only escalated the U.S.-China conflict. So you can be less outraged when China does something similar to a U.S. company (Apple or Qualcomm). Being a global technology company and doing business in China will come with a new set of risks.

It is difficult at the moment to see U.S.-China relations improving. U.S. and Chinese interests are becoming less aligned, and I’m not sure if the occupant of the White House will really make a difference at this point. Yet the fact is that China and the U.S. are still deeply integrated. The two are like a couple stuck in a bitter marriage, waiting for the children to leave the house before divorcing.

But the divorce will come, and both sides are preparing for it. The U.S. and China will have to gain more economic independence from each other. For example, while China is beefing up its semiconductor industry, the U.S. is figuring out how to bring factories back home.

Defense stocks are a good offense

This brings us to defense-industry companies — the lawyers in the U.S.-China divorce. They will be the primary beneficiary of any split, and the greater the tension, the more money they make.

The U.S. spends $750 billion a year on national defense. China is second at $250 billion. China’s defense spending has almost doubled over the past decade and is unlikely to slow anytime soon. It’s difficult to envision defense spending declining; instead it will likely continue to march higher. When you look at U.S. defense spending data over the past 70 years, despite the public perception that Republicans love defense and Democrats not so much, defense spending has actually been quite apolitical — the external environment (self-preservation) has determined our spending on defense.

The U.S. and Europe are likely going to continue to boost defense spending, preparing not for the war tomorrow but decades from now. Moreover, European nations will likely feel that they need to be more self-reliant on defending themselves.

My firm has created a basket of U.S. and European defense stocks. On a valuation basis, these companies are so cheap that we should make money with them even if the China–U.S. relationship normalizes. If tensions escalate, they’ll skyrocket. We are not hoping for that scenario, of course, but we are prepared for it.

Defense companies needed to adjust and they did. Their contracts with governments are usually structured as percentage of completion. To put it simply, they finish 20% of a submarine and the government sends them a check for 20% of the agreed price. These milestones got pushed by the coronavirus a few quarters into the future. So the defense 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 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 U.S., Huntington Ingalls Industries
HII,
+6.58%

 and General Dynamics
GD,
+6.76%

 make submarines, with each taking a 50% market share.  Barriers to entry and switching costs are enormous and further complicated by security clearance required for employees, which are extremely difficult to obtain. 

The market today is going bananas for subscription as a service businesses; defense companies truly are subscription as a service businesses. They are building, servicing and upgrading aircraft careers, ships, submarines and planes, and training armed forces for a customer whose check will never bounce. In addition, long-term contracts ensure that revenues will flow. These businesses have a good return on capital, stable margins and usually conservative balance sheets. And all because they got inconvenienced by the virus, these stocks can be had at bargain basement prices.   

How does one invest in this overvalued market? Our strategy is spelled out in this fairly lengthy article.     

Vitaliy Katsenelson is chief investment officer at Investment Management Associates in Denver, which holds positions in Huntington Ingalls Industries and General Dynamics.

Read: U.S. faces a potential ‘secession crisis’ at home and ‘open conflict’ with China in the coming decade, says author who predicted 2020 unrest

More: Why this frustrated value stock pro sees shades of 1999 in the market now — and bargains in the future

 



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My husband doesn’t get along with my son. I brought most of the wealth into our marriage. How do I split my estate?

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Dear Quentin,

How do couples typically handle their estates in a second marriage? My husband and I have been married for seven years, and it is the second marriage for both of us. I have one adult child from my previous marriage; he has no children.

I brought the majority of our wealth to our marriage, including almost $1 million in my 401(k) and a nice home that is almost paid off; otherwise, we have no debt. My husband and I bought a second home together. We work hard to fund our new 401(k)s, and own a successful business together.

I am turning 65 this year, so estate planning is long overdue. My husband is five years younger than me, and we are both in very good health. We have two issues facing us: I see our retirement as living very comfortably on the monthly income generated by our 401(k)s, pension, Social Security, etc., and leaving whatever may be left to my son.


‘The other issue is that my husband no longer gets along with my dear son at all, and feels no obligation to get along with him.’

I am not interested in scrimping, but I want to be able to have enough money to last us until age 90 (or beyond) by not touching the principal. My husband is more interested in dipping deep into our savings, and living it up in retirement while we are young enough to enjoy it.

The other issue is that my husband no longer gets along with my dear son at all, and feels no obligation to get along with him, to the point that neither one wants anything to do with the other. As far as he is concerned, my son doesn’t meet his expectations, and so deserves nothing from me and certainly nothing from him.

I want my estate planning to be fair to both my new husband and my son. How do people typically handle this type of quandary? I think that I need to create some type of trust to pass on my share of our estate to my son. My pre-marriage assets involved my son as I pursued my graduate degree through night school and worked long hours throughout his childhood.

Second Wife

You can email The Moneyist with any financial and ethical questions related to coronavirus at qfottrell@marketwatch.com.

Dear Second Wife,

Don’t allow your husband’s feelings toward your son to influence your estate planning.

Your relationships with your husband and your son and your own plans for retirement are all fair game when making decisions about your estate, but your husband and son’s fractured relationship is their business, not yours. You worked hard for this money, and your son is your legal heir. Any effort by your husband to spend all of your savings and fritter away any inheritance that you intended to leave to your son should be resisted at all costs.

You have worked too hard your entire life to compromise your plans for a comfortable retirement where you have money set aside for long-term medical care insurance, unforeseen emergencies and/or your son. If you jointly own your home, you can leave your half to your son in your will, and specify it can only be sold after your husband passes away.

If you own the home, you can give your husband a life estate. Your son would pay capital-gains tax on the value of your home when he sells it, and not when you bought it. You could also make your son the beneficiary on your life-insurance policy, and/or gift him a certain amount of money per year to see how he manages and spends that money.

Figure out what is fair to yourself first before moving on to what is fair to your husband and your son. It’s OK to put your needs first. I caution against your dipping into savings at a rate that is beyond your own risk tolerance.

Ultimately, you are entitled to leave all other separate property to your son when you die — and, along with a financial adviser, set up a trust with that in mind for you, your husband and your son. Not necessarily in that order.

The Moneyist: ‘I cut his hair because he won’t pay for a haircut’: My multimillionaire husband is 90. I’ve looked after him for 41 years, but he won’t help my son

Hello there, MarketWatchers. Check out the Moneyist private Facebook
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 group, where we look for answers to life’s thorniest money issues. Readers write in to me with all sorts of dilemmas. Post your questions, tell me what you want to know more about, or weigh in on the latest Moneyist columns.

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These money and investing tips can help you make a place for crypto in your portfolio

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Don’t miss these top money and investing features:

These money and investing stories, popular with MarketWatch readers over the past week, can give you a better understanding of bitcoin and other cyrptocurrency, and help you figure out if digital currency has a place in your portfolio alongside stocks, bonds and other traditional assets.

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