Equipment stays put—testing comes first: 2021 Insights into the Military Industry Testing Sector

Since the outbreak of the COVID-19 pandemic, multiple industries—both domestically and internationally—have been impacted, leading to a downturn in various segments of the testing sector. According to relevant data, the defense industry, driven by the certainty of national defense development, exhibits certain counter-cyclical characteristics. Overall, military product packaging testing has remained relatively less affected by the pandemic. Given the high qualification barriers that military testing imposes on inspection agencies, this niche area has become a premium growth opportunity for a select few testing firms, attracting significant market attention. Below, we’ll share insights into the military testing industry from the perspective of our center, which has been deeply involved in military product packaging testing for many years.

1. The defense industry is entering a golden age, truly showcasing its growth potential.

    Over the past two decades, China has invested heavily in its military equipment, with key weapon systems gradually being finalized and integrated into service in recent years. Building on this solid foundation, the next decade is poised to become a period of significant achievements and explosive growth for China’s defense industry. 2020 marked the final year of the 13th Five-Year Plan, coinciding with the nearing completion of military reforms—and setting the stage for a golden age in the defense sector. Among these developments, the military aircraft industry, symbolized by the three "20s," continues to thrive, with several key models entering mass production. This trend is expected to drive a turning point in the performance of related companies. Meanwhile, major aerospace projects—most notably the BeiDou-3 satellite system—are either nearing completion or officially launching, positioning China’s space program at an unprecedentedly bright moment. On the naval front, China has entered the era of having two aircraft carriers, signaling a new phase in the modernization of its maritime forces. Simultaneously, domestic ground-based military equipment is undergoing rapid upgrades, while exports of defense products remain robust. Additionally, all branches of the armed forces are aggressively advancing the integration of information technology into their defense strategies.

In recent years, due to the impact of military reforms, some projects and models have been delayed in terms of verification, production, or delivery, resulting in certain products being unable to secure contracts, meet delivery deadlines, or recognize revenue on schedule. This has caused significant challenges for the relevant defense industry enterprises. Military Product Packaging Inspection As a result, it has also been affected. While downward pressure on the macroeconomy continues to grow, the defense industry remains highly robust and on an upward trajectory, giving it a growing comparative advantage over other sectors.

II. The China-U.S. trade friction is accelerating the push for self-reliance and controllability, and the defense industry naturally possesses the inherent "attribute" of being self-sufficient and controllable.

    The China-U.S. trade friction is likely to persist and recur intermittently, making self-reliance and controllability the main investment theme for the medium to long term. While the logic behind self-reliance and controllability may not fully translate into immediate financial performance in the short term, China's vast domestic market provides ample room for absorbing even high valuations. Currently, China's defense industry is prioritizing self-reliance and controllability by focusing on areas where the country faces significant gaps—specifically, the upstream foundational sectors and the downstream critical systems. In the upstream foundational segment, the emphasis is on achieving "controllability," shifting from "cannot" to "can," such as core electronic components, advanced materials, and essential software. Meanwhile, the downstream critical systems focus on fostering "self-sufficiency," moving from "non-existent" to "available"—for instance, in large aircraft, aero-engines, and the BeiDou satellite navigation system.

III. Reform of state-owned defense enterprises accelerates implementation, focusing on "high-quality development."

    In the new era, China's state-owned defense enterprises are pursuing "high-quality" development, which will unlock fresh vitality. As a result, these companies have seen significant improvements in asset quality, profitability, and corporate governance standards. On the corporate level, 2020 will see the implementation of new performance evaluation metrics for central enterprises, providing strong guidance toward high-quality growth. Meanwhile, at the business level, the State-owned Assets Supervision and Administration Commission (SASAC) will redefine the core responsibilities and primary businesses of defense-related central enterprises in 2020, fostering innovation and technological advancements within listed companies tied to these enterprises' core industries. From a management perspective, the deepening and wider adoption of the "capital-based management" model, coupled with equity incentive programs introduced by publicly listed companies, will further energize internal growth drivers. Finally, on the front of market-oriented transformation, SASAC’s three-year action plan for state-owned enterprise reform, launched in 2020, is expected to accelerate the restructuring of research institutes under major defense groups, expand the scope and intensity of mixed-ownership reforms across defense enterprises, and ultimately pave the way for broader, more strategic asset securitization initiatives involving top-tier research institutions and high-quality enterprise assets.

4. The downturn in the defense industry's participation by civilian companies has passed, and with performance improving and fundamentals returning to normal, the sector may resume mergers and acquisitions—but this time, with a more rational approach.

    Civilian-to-military enterprises have faced mounting risks over the past two years, influenced by declining defense reform-related orders, reckless mergers and acquisitions, and excessive collateralization. However, at this particular juncture, the industry’s fundamental outlook remains positive. With the impact of military reforms expected to gradually diminish and the resolution of previously exposed issues well underway, market fundamentals are poised to stabilize—and as they do, valuations are also likely to return to more reasonable levels. Moreover, backed by supportive policies aimed at fostering innovation, private-sector firms, with their agile market mechanisms, may once again drive consolidation within the defense industry.

5. Investment Recommendations

    The defense industry is trading at historically low valuations, with its core assets significantly undervalued. The sector’s P/E ratio sits at the 2.49th percentile of its valuation range since 2014, while its P/B ratio is at the 7.98th percentile. Compared to the ChiNext Index, as well as the computer and electronics sectors, the defense industry’s P/E ratio ranks at the 7.22nd, 1.62nd, and 13.68th percentiles, respectively. From an absolute valuation perspective, core assets—particularly those represented by major OEMs—are clearly undervalued.

    Publicly offered mutual funds hold military-industry stocks at historically low levels, while foreign investors continue to increase their positions in the defense sector. Fund holdings in military-related companies are at their lowest point in five years. Meanwhile, Northbound Trading (via Stock Connect) has significantly boosted its stakes in defense firms. As MSCI expanded its coverage at the end of 2019, it continued to attract incremental capital. By year-end 2019, the proportion of shares held via Northbound Trading relative to free-float market capitalization had reached as high as 14.65% for AVIC Optoelectronics, 7.36% for Great Wall Technology, and 4.73% for Zhongzhi Shares—levels that underscore the growing interest from institutional investors.

    Specific sectors and individual stocks to watch:

  ① Military aircraft industry chain (including complete aircraft, materials, airborne systems, engines, etc.), Aeroengine Corporation of China, Hangxin Technology, AndaVil, Aeroda, Emerging Equipment, and others (the military aircraft sector is experiencing strong growth with relatively assured expansion).

  ② China's satellite, aerospace electronics, aerospace connectors, Tianao Electronics, and Haige Communication—(the downstream application market of the satellite industry chain will continue to expand rapidly)

  ③ Weihai Guangtai (All three business segments—airport, firefighting, and drones—showing significant improvement)

  ④ Guangwei Composite Materials, Polytter (leading companies in the military-grade new materials sector)

  ⑤ Yaguang Technology, Hongda Electronics, Guorui Technology, Sichuang Electronics, and Zhenhua Technology (military-industrial informatization is accelerating construction, while self-reliance and controllability are driving growth in military electronics demand)

  ⑥ China State Shipbuilding Corporation, China National Defense Technology Industry Corporation, and China National Machinery Industry Corporation (The merger of the two shipbuilding firms could lead to specialized integration and capital restructuring among listed shipbuilding companies)

    Risk Warning

Military reform is progressing slower than expected; state-owned enterprise reform is lagging behind expectations; program development is falling short of targets; and order fulfillment is moving more slowly than anticipated.

With the strengthening of national defense, the continuous upgrading and modernization of equipment, Military Product Packaging Inspection The gradual liberalization of business to third parties and the market, Military Product Packaging Inspection Business demands in this area will continue to grow, driving the market size to expand steadily as well. Throughout this process, testing and inspection organizations that are fully qualified, enjoy long-term, stable partnerships with the military, offer a diverse range of testing services, maintain high levels of expertise, and deliver exceptional service quality will gain a competitive edge in the market.

Note: Some of the information is sourced from "In-Depth Analysis Report on the Testing Industry: Military Testing—Equipment Remains Stationary, Testing Takes the Lead."