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China's Middle Class Is Fueling A Boom In This Overlooked Sector

Daniel Cross

There's a sector in China that's booming right now, and U.S. companies are just now starting to take advantage.

Consider a few statistics.

In 2000, a mere 4% of urban Chinese households were considered middle class. By 2012, that figure had grown to 66%. If current trends continue, by 2022 the middle class population will be 75% of urban households. That's nearly 630 million consumers -- nearly twice the entire population of the United States.

The average annual income of the urban Chinese middle class was $760 per person in 2000. In cities like Bejing or Shanghai, disposable income now averages nearly $12,000 per person. In addition, these figures are probably underestimated, as tax avoidance runs rampant in China.

In another emerging trend, China has begun to implement a financial assistance program for some of its residents. Due to the lack of safety-net welfare programs like Social Security, the Chinese savings rate is around 50%. Compare this to the savings rate for American households, which was 2.6% as of this year's first quarter.

So what does all this mean?

China's industrial and manufacturing economy is giving way to a consumption-driven economy. As the focus on the emerging Chinese middle class heats up, retailers have begun pouring in investment money to cater to the new levels of household demand. 

Value Retail, a European discount outlet chain, is opening up a mall just outside Shanghai to keep up with a growing Chinese customer base, and American retailers are taking notice. The Gap (GPS) has expanded aggressively into China, opening 50 new stores since establishing its presence there in 2011. 

It appears that "keeping up with the Joneses" is becoming more of a Chinese colloquialism than an American one these days. Electronic goods such as computers and flat-panel TVs are selling in record numbers, surpassing U.S. sales figures. For instance, as of last year, 68% of Chinese urban middle-class households owned at least one flat-panel TV.

The services sector is a particularly bright spot for China's future. The burgeoning middle class is expected to spend more heavily on leisure activities, education, and financial services. By 2022, this sector is predicted to make up half of China's overall GDP. Compared with their parents, the younger generation has been raised with wealthier living standards and is adapting to the new paradigm. As major buyers of services, they are expected to account for 35% of all consumer consumption by 2020.

So how can U.S. investors play the trend in China? Several U.S. companies have begun to position themselves to take advantage.

Yum Brands (YUM) has found success in adapting its business practices to China, opening almost 5,000 KFCs and Pizza Huts. The recent poultry scare helped cause a 20% miss in Yum's same-store sales, according to the company's second-quarter earnings report. But Yum notes that consumers are beginning to return to restaurants and predicts a strong bounce-back year in 2014.

Apple (AAPL) has already enjoyed tremendous success in China, as seen in its record iPhone 5 sales and booming iPad sales last year. The company plans to open 11 new stores in the next two years, doubling its retail presence in China.

So far, no U.S. firms have been able to gain a sizable foothold in the services sector in China, but one company has shown potential. Bona Film Group (BONA) is the biggest private distributor of films in China, whose film industry is now the second-largest in the world after the U.S. With the prevailing winds of consumer spending behind it, Bona Film Group could easily double in value.

Risks to Consider: China's growth will depend on consumer spending -- and consumer confidence. To that end, Chinese leaders must be aggressive and diligent in creating a social support system that will instill confidence in the middle class to spend more and save less. A failure to enact these measures may lead to further slowing of GDP growth and a pullback in the Chinese markets.

Actions to Take --> Watch the economic and market data coming out of China, specifically regarding consumer spending and further government stimulus. Reports of positive consumer confidence may be good opportunities to start buying ahead of the trend.

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