Stocks To Own And Stocks To Avoid To Profit From China's Growth - An Interview With China Expert Shaun Rein, Part 1

by: David Jackson

Shaun Rein is the Managing Director of the China Market Research Group and a long-time contributor to Seeking Alpha. I interviewed him ahead of the publication of his new book, The End of Cheap China: Economic and Cultural Trends that will Disrupt the World.

David Jackson: What's the most important China trend that investors should be aware of?

Shaun Rein: The key trend for investors is China's shift from an export-oriented economy to a consumption-oriented economy. That shift has accelerated much faster than many investors realize in the past three years as labor and real estate costs have soared. Wages are increasing 20% a year in the main manufacturing hubs and office space in Shanghai is more expensive than in many Western capitals. To deal with rising costs, firms like Nike (NYSE:NKE) have had to move manufacturing to lower-cost places like Vietnam, while at the same time China has become the market for Nike. They are now selling over $2 billion a year into the country and have 30% margins, the fattest they have anywhere in the world. China has become the market to sell into rather than produce in.

DJ: Are there accompanying changes in Chinese society that investors should be watching?

SR: Many investors underestimate the increasing purchasing power of Chinese women. They hear stories about female infanticide and have an outdated image of Chinese women as living downtrodden lives. That stereotype just is not true anymore. In the 1950s, Chinese women accounted for 20% of household income. They now have reached parity, and are the segment driving retail sales and big ticket purchases, like homes and autos.

My book includes a whole chapter that delves into what Chinese women want, their hopes and aspirations. For instance, I found one of Chinese mothers' biggest concerns in life is adequate education for their children. They feel China's education system is terrible, relying too much on test taking and rote memory, so they spend serious money on training and enrichment programs. One mother in Beijing told me she spent $40,000 USD a year on after-school training for her 5-year-old daughter. Investors should be looking at companies like New Oriental Education & Technology Group (NYSE:EDU) and Xueda Education Group (NYSE:XUE) to capture this trend.

DJ: What's the best way to invest in rising Chinese consumption - buy Chinese stocks, or the stocks of Western companies that export to China?

SR: There are some real risks to investing in China. Fraud and lack of transparency are rampant, as we have seen in the past year with Longtop (NYSE:LFT) and Sino-Forest (OTC:SNOFF). One of my mottos is that if you cannot do serious due diligence or stomach volatility, you should not be investing in China.

That said, there has been far too much fear and over-selling, and now might a good time to add exposure to domestic Chinese firms. Muddy Waters and Citron are trying to trade off their reports, so investors should be very cautious about investing based on their word; they lack transparency as much as the Chinese firms. For instance, we did due diligence for a hedge fund on a company that had been accused of being fraudulent. My firm travelled all over the country for months, to the mountains of Sichuan Province even, and found that the company was 100% legitimate and the numbers correct. There are some great Chinese firms out there that are worth investing in if you do serious due diligence or can stomach volatility.

For more cautious investors, owning the stocks of Western firms like Apple (NASDAQ:AAPL), YUM! Brands (NYSE:YUM), Rio Tinto (NYSE:RIO), Prada (OTCPK:PRDSY), and L'Occitane might be a good way to get exposure to the China growth story without all the risk.

DJ: Of the Western stocks you mentioned, many play in the luxury market. Should that be the focus for investors who want to buy U.S. stocks?

SR: The luxury sector is soaring right now in China as wealth creation, perhaps counter-intuitively, is being accelerated by the financial crisis. Well-capitalized entrepreneurs are consolidating market share so they are getting wealthier. The number of millionaires in assets available for investment hit one million this year, and they are driving a luxury boom.

Chinese consumers will buy about $15.6 billion USD of luxury products this year, 20% growth from last year. That said, there will probably be more losers than winners, and Chinese are still gravitating towards the same brands, so investors need to be careful who they back. Louis Vuitton (OTCPK:LVMHF) will remain dominant in the mass luxury sector for handbags, as will Mercedes and BMW in the auto sector. But the exciting part is that there is an emergence of the very high end consumer - they are buying watches from Van Cleef & Arpels and handbags from Bottega Venneta.

Companies that are making great strides are Tiffany & Co. (NYSE:TIF) and Coach (NYSE:COH). They were slow at developing smart plans for China at first, but they have hit their stride in the last year. Ralph Lauren (NYSE:RL) and Brooks Brothers are still struggling with a confusing brand image and store roll-out plan. Chinese don't really aspire to the preppy, summering-in-the-Hamptons lifestyle that Ralph Lauren represents.

DJ: In the book you discuss brands. Is Chinese growth a pure positive for Western brands, or are there also U.S. and European companies that will be negatively impacted?

SR: The growth of China's domestic consumption is only a positive for those brands that understand what Chinese consumers want, and can cater to those needs. Many Western brands will ultimately fail in China, as Best Buy (NYSE:BBY) and Home Depot (NYSE:HD) did, because they not only did not cater enough to local consumer tastes, but were unable to compete against well-capitalized, aggressive Chinese brands. In many ways, they underestimated the competition, which is never a smart thing to do.

In the first chapter of my book, I interview Chinese billionaires and other trailblazing Chinese entrepreneurs. Some of these folks are super impressive, and many are beating Western brands in China, and I predict will become global players. Investors should keep their eyes on brands like Ctrip (NASDAQ:CTRP) and Mindray (NYSE:MR) that are competing head-to-head and beating foreign players like Expedia (NASDAQ:EXPE) and GE (NYSE:GE).

DJ: When I worked as an analyst covering the telecom equipment sector, I watched Huawei take market share from, and pressure the margins of, companies like Lucent, Nortel, Alcatel and Cisco. Are there other Western companies or sectors you think are particularly at risk?

SR: I would be nervous if I were sitting in the board rooms of construction equipment makers like Terex (NYSE:TEX) and Caterpillar (NYSE:CAT). They need to develop better strategies to deal with rising Chinese competition. China's richest man is the head of SANY Heavy Equipment. SANY and brands like Xugong are more than good enough and cheaper than their Western counterparts. They have products that better fit local conditions and are starting to export around the world. Construction equipment, and heavy machinery, is an area that investors should keep an eye on.

Read part II of the interview »

Shaun Rein's articles can be found here. His new book is available for order on Amazon: The End of Cheap China: Economic and Cultural Trends that will Disrupt the World