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Digging Moats in China

Foreign firms that have established competitive advantages in China are well-positioned to profit from consumption growth.

Sumit Desai, CFA, 11/30/2011

If China is to sustain growth rates anywhere close to those achieved in the past decade, consumption will need to play a significantly greater role in China's economy. At this juncture, Morningstar's equity analysts are finding more investment opportunities in consumption-related companies than in fixed-asset plays. Here is a look at firms based outside of China that are well-positioned to benefit from consumption growth there. We'll also identify some firms currently benefiting from growth in China that we think investors should avoid in the face of lower fixed-asset-investment growth in the future.

Consumer: Focus on Middle Class

The road map of transition from a fixed-investment- based economy to a more consumption-based one is visible in the government's new five-year economic plan. The Chinese will see more investments in education, health care, and other social programs to give people a better sense of security. The lack of a meaningful social safety net has been the major factor behind the high savings rate of Chinese households, in our view, and we expect that Chinese consumers will be more willing to open up their purses when they can have reasonable assurance from the government that they have some support to fall back on in times of difficulty. As part of the economic rebalancing plan, we also expect China to allow gradual currency appreciation and wage increases to continue, which will boost Chinese consumers' purchasing power.

Consumer brands such as Yum Brands YUM, McDonald's MCD, Starbucks SBUX, Nike NKE, and adidas ADS, which sell products to China's middle class, are appropriate investment options for investors looking to participate in China's growth. Yum is the leading restaurant owner in China, with 3,400 KFC units and 500 Pizza Hut restaurants. We think those numbers could expand to 15,000 KFC locations, 5,000 Pizza Hut units, and several thousand units apiece from emergent restaurant concepts. McDonald's is a distant second in China with about 1,300 locations, but management has a realistic plan to have more than 2,000 locations by 2013. China also is a key component of our valuation assumptions for Starbucks; the firm has set an achievable goal of more than 1,500 locations by 2015. Nike has considerable opportunities for expansion in China, where the brand is already the leading player with more than $2.3 billion in annual sales projected in fiscal year 2012 and $2.5 billion in fiscal year 2013. Number-two player adidas also has ample growth opportunities.

We think that companies targeting the middle class are more likely than those targeting the wealthy to become ubiquitous over the long run because of economies of scale and other economic forces. Consumer companies that focus on broad sections of the Chinese populations are trading closer to our fair value estimates, versus the shares of luxury-goods makers, such as Tiffany TIF and LVMH MC, which have valuations that could take away the appreciation potential.

Basic Material Firms Will Feed Expansion

A shift toward consumption in China's economy would play to the strengths of a few basic-materials industries, such as agriculture, thermal coal, and paper and packaging. Chinese retail gold demand also could begin to take off. Meanwhile, a reduction in fixed-asset investment growth rates is a major threat to many metals, metallurgical coal, and building materials companies. A rebalancing of the Chinese economy would have a mixed effect on chemical companies, as their products make their way into a vast array of end markets.

Fertilizer and seed companies stand ready to feed a hungry China. Rising incomes in China should allow people to consume more calories and, more importantly, more meat, fruits, and vegetables. Expanding meat production has a multiplier effect on crop demand. It takes more grain to feed the animals that provide sustenance for humans than it takes to feed humans directly. Plus, nutrient-intensive fruit and vegetable crops require greater fertilizer applications. Therefore, producers of potash fertilizer stand to benefit, and global production is highly concentrated in the hands of a few players. Further, China has to import a significant portion of its potash requirements because of its lack of high-quality domestic deposits. On this basis, and in combination with its lower-cost resources, we believe Potash Corp. POT has a wide economic moat. Potash also owns a 22% stake in Sinofert, China's largest fertilizer importer and distributor. Meanwhile, Monsanto MON will benefit indirectly from China's supportive influence on global crop prices, although the firm's direct involvement in China is only a small part of its overall business (in the form of vegetable seed sales).

Sumit Desai, CFA is a senior stock analyst with Morningstar.

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