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Three Things You Must Know to Invest in China

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This article is by Shaun Rein, whose book The End of Cheap China: Economic and Cultural Trends That Will Disrupt the World was just published. He is the founder and managing director of the China Market Research Group.

Chinese consumers wait to buy iPads. (Image credit: Getty Images via @daylife)

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 (see my new book with that title here).  There are three key trends that I told them investors need to remember when investing in China now.

Lesson 1: Don’t invest in labor-intensive industries.

China's combination of rising wages and an aging population will make it harder 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 by an average of 22%. Also the government is forcing companies to obey laws requiring them to provide medical care and pensions to employees, regulations that many simply ignored until the last two years.

Rising total compensation costs are squeezing the profit margins at labor-intensive businesses like Foxconn, which produces products for Apple and Dell. Meg Whitman, the chief executive of Hewlett-Packard, announced recently that rising labors costs in China might force HP to raise its prices in the U.S.

Key takeaway: Be cautious of investing in companies that rely heavily on labor unless they can transfer their higher costs to their customers or can relocate to places where manufacturing is cheaper, such as Vietnam and Indonesia. However, except for companies in light industry, like Nike, moving production will be difficult, because labor productivity and infrastructure are weaker elsewhere. For products like personal computers and original equipment bearing non-Chinese brands, profit margins will continue to deteriorate.

Lesson 2: Invest in premium goods.

China has been emerging as a market to sell into, not just produce in. Despite the slowing Chinese economy, Chinese consumers remain confident, and they will drive 15% retail sales growth in 2012. However, they are changing their spending habits. They are increasingly seeking to upgrade in categories like food, handbags, cosmetics, and travel. No longer do they only buy what is cheap, as they did 15 years ago, when most Chinese struggled to put food on the table. Now more are searching out brands that have cachet and are perceived to be safe and nontoxic.

Key takeaway: Look at brands that command great loyalty and that can transfer higher costs to their end consumers without losing them. Chinese have reported very high loyalty to Apple, Estee Lauder, and Starbucks, despite their relatively high prices. A 26-year-old women from Jiangsu province who makes $250 a month as a clothing vendor told me, “I skipped lunch for six months to buy an iPad 2.”

Lesson 3: Beware of middling brands.

The brands that will get hurt in this shift by Chinese consumers towards higher-priced goods are those that position themselves as middling. They are neither aspirational nor are they cheap. Consumers will either save up to buy higher-priced brands or trade down. If these middling brands try to raise their prices to offset soaring costs, consumers will stop buying them.

Brands like Gap and American Eagle 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 and Best Buy did before them. Gap has jeans selling for $50 to $200. For people who make $1,000 a month, a pair of Gap jeans costs a considerable part of a month's discretionary income. Our research suggests that such consumers are more likely to buy more affordable jeans from a brand like Uniqlo, at a fraction of the cost, or save to buy something from Gucci or Coach that they deem a better value because it gives them more prestige. Wealthier consumers will simply forgo buying Gap altogether for more expensive brands, like Tiffany & Co. or Louis Vuitton.

Key takeaway: Consumers shop for either premium or cheap brands. Companies in the middle are in no man’s land and will have a hard time growing their bottom lines without destroying their margins.

China’s economy has changed much faster than many economists realize. It is no longer a cheap place to do business, and consumers there are no longer guided only by price. Savvy investors will track the consumer's evolution and realize that the end of cheap China has arrived—and adjust investing portfolios accordingly.