Foreign firms that have established competitive advantages in China are well-positioned to profit from consumption growth.
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
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
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.
Growing electricity needs to power consumption would bode well for low-cost thermal coal producers. We expect China's voracious and increasing appetite for thermal coal imports to be a secular trend. More consumption means more lighting, appliances, air conditioning, and space heating, and China's electricity generation capacity would have to follow suit. While coal-fired generation will likely lose share to sources such as nuclear and gas-fired generation, expected strong growth in overall generation demand means coal plants will still need to be added.
Moreover, rising domestic costs and internal infrastructure, transportation, and political issues are making it more difficult for China to be self sufficient in thermal coal. Infrastructure constraints in Australia, South Africa, and Indonesia are restricting these traditional exporters' ability to meet that demand. The Powder River Basin of Wyoming has ample low-cost thermal coal reserves, but until recently, this coal had not found its way to Asia because of the huge shipping distances involved. However, thanks to the rise in Asian coal prices in recent years, the Powder River Basin has the potential to be a major player in the Pacific Basin as a critical "pressure release valve" swing producer. Cloud Peak
As a nation's middle class grows in size, the convenience and need for paper products likewise expands. Toilet paper, tissues, and paper towels are parts of consumers' daily lives that are unlikely to be significantly curtailed by a slowdown in fixed-asset investment. Global demand for tissue should steadily increase for many years to come, thanks in no small part to growing consumption in China. Fibria
More wealth would mean more gold jewelry and investments. The growing middle class in China is spending some of its newfound wealth on gold. Many factors influence gold prices, so a rebalancing of the Chinese economy would have an indeterminate effect on gold prices, in our view. However, to the extent that other forces in gold markets remain generally favorable in the long term, additional demand from Chinese consumers can only help. Eldorado Gold
Rebalancing "losers" include metals, metallurgical coal, building materials, and, to some extent, chemicals. In 2010, China consumed more than 35% of the world's aluminum, copper, steel, and zinc. Much of this metal finds its way into electrical wiring, pipes, siding, and beams. These metals would suffer from a slowdown in China's capital expenditures. Aluminum's pain would be mitigated by the fact that consumption is a major end market—think aluminum beverage cans and automobiles. And while weakness in Chinese steel consumption would have negative effects on U.S. and international steel companies, the fallout would likely be moderated by lower input costs.
China will play a pivotal role in the fortunes of the global seaborne metallurgical coal market. While China's metallurgical coal import volume remains modest compared with the roughly 500 million metric tons the Chinese steel industry consumes annually, it is large relative to the 200-million-metric-ton global seaborne metallurgical coal trade. Continued growth in Chinese steel production, if not matched by domestic metallurgical coal output, would have major consequences for the seaborne market. On the flip side, a reversal in the nonstop expansion of Chinese steel output would have deleterious consequences for the seaborne metallurgical coal market, making sub-$100-per-metric-ton prices a distinct possibility.
Building materials producers within China would suffer from a slowdown in fixed-asset investment. However, Chinese cement production contributes only a small portion of global cement producers' profitability. We think the infungibility of cement would shield non-Chinese production from weakness in Chinese cement markets. Because it's costly to transport cement over land, plants typically have a shipping radius of no more than 300 kilometers.
A slowdown in China's capital expenditures would be a mixed bag for global chemicals companies. While end markets for chemicals include construction, consumption-driven markets such as agriculture, electronics, and consumer products are just as important to overall profitability.
Investors looking for a way to maintain exposure to metals and mining while protecting against the likelihood of a rebalancing of China's economy should consider Anglo American
Health Care Evolves
China's health-care system evolved into one of haves and have-nots when China kicked off its economic reforms in 1979, which resulted in the widespread privatization of public health facilities. Two years ago, the government embarked on a reform effort with an investment of $125 billion to accomplish goals such as universal medical insurance by 2020 and infrastructure improvements. Against this backdrop, we see several dynamics that should contribute to continued robust growth of health-care spending in China:
- China's profit-driven, fee-for-service system leads to care levels that correlate with patient wealth levels. Wealthy, urban patients are demanding modern medicine practices with high-priced new technology that is highly profitable to caregivers.
- The government is focused on growing the domestic biotechnology sector, which should spur a rapid build-out of research and drug development centers, which in turn would be a boon to the lab-supply industry.
- The government is cracking down on collusion between health-care providers and drug companies. Firms that make generic drugs will benefit most from this initiative.
- China is set to become the second-largest prescription-drug market in the world by 2015. (It's seventh now.) The market is extremely fragmented, with no single firm having more than 2% of total prescriptions, so it looks ripe for Big Pharma firms.
The health-care firms with the widest moats in China are the large multinationals. Sanofi-Aventis
As one of the first multinational medical-device makers to establish a footprint in China, Medtronic
Foreign Automakers Rule the Road
Over the past decade, China has been the go-to place for growth among many industrial companies. In particular, automotive manufacturers and heavy-equipment manufacturers have enjoyed robust gains because of the country's emerging middle class and government- funded infrastructure boom. We expect these gains to continue, although we caution that rising capabilities among domestic Chinese manufacturers could crimp the market share of many foreign producers.
In 2010, as the global automotive industry rebounded sharply from its recessionary lows, China surpassed Europe as the largest passenger and light commercial vehicle market in the world. Foreign manufacturers dominate sales, comprising the top seven market shares and eight of the top 10. Volkswagen