How to Benefit from China's Preference for the Crème de la Crème

Pierre is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

China's middle class is the future. Investors that will manage to find ways to benefit from this new phenomenon will be retiring early and moving to the Bahamas.

Why am I so confident about China's middle class, you may ask? Well, there are many reasons, but I will summarize it by giving you 2 numbers: 300 million and 25%. The former is the size of the current Chinese middle class, which seems like a gigantic number, but bear in mind that it only represents 22% of the entire population of China and is estimated to double to 600 million by 2020! And the latter is what the Chinese middle class earns in annual wages in comparison to what the average OECD middle class person earns every year. You don't need to be Nostradamus to realize that the Chinese middle class has got enormous room to grow in terms of size and rising wages.

Make no mistake about it, the Chinese middle class want everything Americans have, and they're not advancing slowly anymore. Quite the contrary: young people in China are now spending more and saving less. China is entering a period of economic transition (with the occasional ups and downs) that will aim at making its people less dependent on government overinvestment and export-led growth, and move instead towards a consumption-led model. Unless a revolution or World War 3 comes along, this trend will not be reversed in the next twenty years, which means China's middle class consumption will replace the US consumer as the major engine of world growth.

This brings me to the following question: how can a smart investor benefit from these changes? In my view, luxury goods are an interesting opportunity. The Chinese love luxury goods (and that's an understatement), especially French and Italian luxury brands. To the Chinese, western luxury brands are associated with quality of life, elegance, and higher status.

Get out your wallets, it's shopping time 

Here are some luxury brands that are bound to benefit from China's obsession with luxury goods: Tiffany & Co. (NYSE: TIF) and Coach Inc. (NYSE: COH). Both brands are very popular in China and have been making a decisive push there for the past two years. Tiffany & Co. is now a major player in the Chinese luxury market, and chairman Michael Kowalski does not have any second thoughts about it. He is on the record as saying that "China will rapidly become the place where Tiffany & Co. will have the greatest number of new stores." Tiffany & Co. has trailing earnings of 17.25x, which in my view is still undervalued for such a dynamic and expansive brand. Investors are starting to hear the call: the stock is up 15% in the past four months.

The same argument can be made for Coach. It plans to make China its main market by 2014 and is already reaping the benefits. Its sales revenue in the quarter ending Sept. 29 2012 rose by 11% year over year, driven mainly by gains in the Chinese market. Unlike Tiffany, its share price took a nose dive on 2Q 2012 as China's economy cooled down significantly, losing 37% of its value. I believe the share price has bottomed and is about to turn around as the Chinese economy improves. Coach Inc. now has 15.4x trailing earnings, making it an excellent opportunity for investors who are thinking about tomorrow instead of yesterday. 

Finally, if you want a luxury brand blue chip stock with a great future, then go for Polo Ralph Lauren (NYSE: RL). Not only is it a worldwide household name, but it also has a crucial competitive advantage: it still has a lot to grow in China. Unlike many luxury brands who are relying on the booming appetite of Chinese consumers for Western prestige products to boost their profit margins, Ralph Lauren only generates 2% of its annual sales in China. This is very low compared to other household names like Louis Vuitton, which generates around 30% of its revenue from Chinese customers. Ralph Lauren do not need to depend exclusively on the Chinese market because it is already doing well worldwide. 

This is good because it means that if the company manages to establish a strong presence in the Chinese market, this will constitute a bonus for the company instead of a life saver. So the question we need to ask about Ralph Lauren is the following: is the brand planning to establish a strong position in the Chinese luxury market anytime soon? As a matter of fact it is.

In 2011, Ralph Lauren announced it was building its first company-owned store in mainland China. Last August, the CEO of the company, Roger Farah, said that Ralph Lauren would focus on building its share of sales from Chinese customers over the course of 2013. This new business strategy has created a buzz for the company's stock, which saw a 28% increase in 2011 and a 14.1% rise to date in 2012. The brand has got everything it needs in order to do very well in China: a prestigious reputation as one of the symbols of Western elegance and a strong drive to expand in the Chinese market.

Luxury goods are still very expensive in China – prices run about 70% higher than in Europe- because of the special luxury tax imposed by the Chinese government. If the government ever lowers that tax, luxury goods will probably soar. But the good news is that you don't need to wait for the Chinese goverment to make a move and lower taxes. Rising wages across China is already under way, and it will work in your favour if you're an investor in major luxury brands: as local wages continue to rise in China in the years to come (and they will), more and more Chinese will be able to travel abroad and afford to bring back gifts from their trips to Europe or the United States. Chinese demand for passports is growing at breakneck speed, and Chinese tourism is a booming industry. Added to that, Chinese citizens are not required to pay any taxes on luxury goods bought abroad. This explains why you will find more Chinese people in a luxury shop in Paris or New York than at a Chinese embassy

Change is all around us and as an investor it is wise to adapt to it as quicly as possible. The famous Chinese philosopher Laozi, founder of Taoism, said it all 25 centuries ago: "If you realize that all things change, there is nothing you will try to hold on to."

PierreDV has no positions in the stocks mentioned above. The Motley Fool owns shares of Coach and Tiffany & Co. Motley Fool newsletter services recommend Coach. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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