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China’s New Growth Driver And How To Play It

|Includes: China HGS Real Estate Inc. (HGSH)

China's 2011 fourth quarter GDP growth beat expectations, coming in at 8.9%. As reported by the Wall Street Journal, increased domestic consumption contributed to the upside surprise.

Growth in domestic consumption is being driven by China's smaller cities. "The China story is increasingly about Tier Three cities," Andy Rothman, the China macro strategist for CLSA, said to CNBC. "It's where much of the growth is coming from, and where a lot of spending on public projects and low-income housing is going."

While there is no specific definition of what is a third-tier city, it's generally accepted that first-tier cities are represented by Shanghai, Beijing, Shenzhen, and Guangzhou. According to international property brokerage Knight Frank, China's second-tier cities have populations greater than three million and minimum per-capita GDPs of $2,000 (NYSEARCA:USD). By this definition, there would be some 60 second-tier cities. With more than 650 cities across China, this means nearly 600 would fall into the categories of third- and fourth-tier cities.

China's ongoing urbanization trend continues to fuel growth in its third- and fourth-tier cities, and in central and western provinces, China's "Go West" policy continues to gain traction. The confluence of these trends is resulting in substantial growth amongst China's middle class, creating strong demand for affordable housing options in these regions.

One way to play this new growth driver is through leading third-tier and fourth-tier city property developer China HGS Real Estate, Inc. (NASDAQ: HGSH). The dominant player in its home market of Hanzhong, HGSH attained National Grade-I certification in October 2011, allowing it to expand into lucrative markets in other central and western provinces in China.

HGSH has completed and fully sold seven projects totaling an aggregate gross floor area (GFA) of 6.7 million square feet. Its completed projects have included low-rise, mid-rise, and high-rise residential offerings.

The Company maintains a robust project pipeline, currently totaling an aggregate GFA of 6.4 million square feet across four projects. While past projects have included small-scale integrated commercial developments, such as retail offerings in lower levels of high-rise buildings, HGSH is now moving toward larger-scale mixed-use developments that will combine hotels, restaurants, and expanded shopping into its residential communities.

While inflated property prices in China's top-tier cities grab regular headlines, housing remains substantially more affordable in the third-tier and fourth-tier cities of the country's central and western provinces. A driver behind this variance is the heavy use of mortgage financing in the mega-cities versus the more typical high down payment or all-cash purchases in smaller cities. Approximately 70% of HGSH property buyers complete all-cash transactions, reducing sales volatility from policy changes impacting the mortgage market.

There is no question the next wave of China's growth will be fueled by rising standards of living in third-tier and fourth-tier cities, and much of this growth will take place in the country's central and western provinces. In fact, per capita GDP in the Company's home province of Shaanxi is forecasted to increase more than 100% by 2020.

HGSH provides a great way to play this monster trend. With a price-to-earnings ratio of less than two, a nearly 35% operating margin, and a robust pipeline of projects to fuel growth, the Company's shares represent a tremendous opportunity for investors who act fast. Moreover, as a NASDAQ-listed company, HGSH must take action to regain a share price of $1 to maintain its listing. With the effort the Company has expended to get listed in the first place, we believe HGSH has every reason to make sure this happens very soon. This alone represents nearly 50% upside, and even then, HGSH shares will remain dramatically undervalued by any typical measure.

Disclosure: The subject security is a client of RedChip Companies, Inc. RedChip Companies, Inc., employees and affiliates may have positions and affect transactions in the securities or options of the issuers mentioned herein. For full financial disclosures for all RedChip clients, please visit http://www.redchip.com/disclosures.asp?src=rcv.