Last month Mizuho Securities engaged me to travel to Tokyo, Singapore, and Hong Kong to advise their top hedge fund clients how investors need to adjust their investing strategies to handle the dawn of "The End of Cheap China." There are three key trends that investors need to remember when investing in China now.
Lesson #1: Don't Invest in Labor Intensive Industries
The mix of rising wages and an aging population will make it difficult for labor intensive industries to turn a profit as they will face severe human resource problems in the next three years. In 2011, 21 of China's 31 provinces raised the minimum wage on average by 22%. The government is also forcing companies to adhere to laws on the books to provide medical care and pensions to employees, regulations many companies simply ignored until the last two years.
Rising total compensation costs is causing profit margins for labor intensive companies like Foxconn (OTCPK:FXCNF), which produces products for Apple (NASDAQ:AAPL) and Dell (NASDAQ:DELL) to get squeezed. Meg Whitman, the CEO of Hewlett-Packard (NYSE:HPQ) announced recently that rising labors costs in China might force HP to raise prices in the U.S. or it will face squeezed margins.
Key takeaway: Investors need to be cautious of investing in companies that rely heavily on labor unless brands can transfer higher costs to end consumers and customers or relocate to cheaper manufacturing areas like Vietnam and Indonesia. However, aside from companies in light industry like Nike (NYSE:NKE), it's unlikely they will be able to shift production out of China because labor productivity and infrastructure is weak. For categories like personal computers or OEM manufacturers, profit margins will continue to deteriorate.
Lesson #2: Invest in Value Plays
China has emerged as the market to sell into rather than produce in. Despite the slowing Chinese economy, Chinese consumers remain confident and will drive 15% retail sales growth in 2012. However, they are changing their spending habits - they are increasingly seeking value in a number of categories like food, handbags, cosmetics and travel. No longer do they only buy what is cheap like 15 years ago when most struggled to put food on the table. Now more are searching out for brands with the lifestyle image they aspire to, and which are perceived to be safe and non-toxic.
Key Takeaway: Investors should look at brands that command so much loyalty and are positioned as value plays because they can transfer higher costs to end consumers without losing customers. Respondents reported very high loyalty to Apple, Estee Lauder (NYSE:EL), Starbucks (NASDAQ:SBUX) despite being relatively high priced. As one 26-year-old woman from Jiangsu province who makes $250 a month as a clothing vendor told me, "I skipped lunch for six months to buy an iPad2."
Lesson #3: Beware of Middling Brands
Brands that will get hurt in this shift by Chinese consumers towards value and higher priced commodities and input prices are ones that position themselves as middling - they are neither aspiration plays nor are they cheap alternatives. Consumers will either save money to buy higher priced brands or trade down. If these middling brands try to raise prices to offset soaring costs, consumers will stop buying them.
Brands like Gap (NYSE:GPS) and American Eagle (NYSE:AEO) fall into this category and are in danger of failing to live up to analysts' expectations or even retreating from the China market altogether as Home Depot (NYSE:HD) and Best Buy (NYSE:BBY) did before. Take for instance Gap, which has jeans selling for $50 to $200. For people who make $1000 USD a month, a pair of Gap jeans takes up a considerable part of their monthly discretionary income. Our research suggests consumers are more likely to buy more affordable jeans from a brand like Uniqlo which is a fraction of the cost, or save up and buy something from Gucci or Coach (COH) that they deem as better value because it gives them more prestige. Wealthier consumers will simply forgo buying Gap for more expensive brands altogether like Tiffany & Co. (NYSE:TIF) or Louis Vuitton (OTCPK:MAGOF).
Key takeaway: Consumers either shop for value or cheap brands. Companies in the middle are in no-man's land and will have a hard time growing bottom-lines without destroying margins.
China's economy has changed much faster than many economists realize. It is no longer a cheap place to do business and consumers are no longer driven only by price. Savvy investors will track the evolving consumer and realize that the "End of Cheap China" has arrived and adjust investing portfolios accordingly.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.