Playing China's Surging Inflation - Buy Retailers

When China releases its economic data Friday, all eyes will be on the inflation numbers, which analysts say will be at a record high. March CPI is expected to rise more than 5 percent on year to touch a 32-month high.

Another set of figures - retail sales - an indication of consumer spending, will also be on the investors’ radar and is forecast to rise 16.5 percent on year. This means inflation has not yet hit discretionary spending in China.

“China is trying to rebalance its economy to become more consumer oriented. Wages are rising. People are earning more and will shop more, and that’s good news for Chinese retailers,” says Andrew Sullivan, Director of Institutional Sales Trading at OSK Securities, Hong Kong, who is upbeat on Chinese consumer discretionary stocks.

When Inflation Is Good

Eddie Lau, Regional Head of Consumer at Citi, says despite CPI volatility in China seen in the past 10 years, retail sales have been growing steadily.

“We also noticed a positive co-relation between the share-price performance of consumer discretionary companies and inflation. That may be due to the fact that high inflation generally reflects a strong economy.”

Citi is forecasting private consumption to grow to 9.5 percent in 2011 from 9 percent last year. China’s provincial governments raised minimum wages an average 20 percent in 2010, and Citi expects that to further increase by double-digits this year.

Wage growth is key to higher disposable incomes and discretionary spending.

Consumption Plays

For investors looking to pick up quality stocks, Citi recommends Chinese sportswear retailer Peak. According to Lau, Peak is best buffered against rising cost pressures as it has managed to cut operational costs even as raw material costs have gone up.

Citi has raised its earnings estimates for Peak by 3 to 5 percent over 2011-2013 and sees earnings per share at a compounded annual growth rate of 19.6 percent over 2010-2013.

Sullivan’s top picks are China’s largest shoe retailer Belle International, and luxury watch retailer Hengdeli.

Belle, which is also the world's No.3 apparel and accessories retailer by market value, is banking on growing urbanization and consumption to fuel its growth. China profits at Belle grew 34 percent in the second half of 2010.

Luxury player Hengdeli, on the other hand, will benefit from the increasing appetite of China’s growing millionaires, says Sullivan.

The latest number of millionaires on the mainland is up 9.7 percent on year, according to the Group M Knowledge-Hurun Wealth Report 2011, China Daily has reported.

But these consumer discretionary stocks don’t look cheap. Belle has a 2011 P/E ratio of 25 and Hengdeli is at  23.7.

That’s a lot pricier compared with the broader H-share market, which has a forward P/E of about 11 times.

“They may look expensive from the valuation point, but do understand that they’re coming from a low base. These companies have very good potential, and you’re buying into their growth story,” says Sullivan.

Lau was concerned about these high valuations after their strong performance last year.  Seventy one percent of China’s consumer discretionary stocks under Citi’s watch were trading at or above their historical valuation for most of 2010.

“But share prices for the sector have corrected substantially since last November. Valuations in the sector are now looking less stretched.”

Today 47 percent of the companies under Citi’s watch are trading higher than their historical valuations.

Less Risky Than Consumer Staples

Another plus for these companies is that unlike consumer staples, the government is not likely to step in to curb price rises in the retail sector.

“Beijing is less concerned if the price of a pair of shoes goes up compared with the price of food or daily essentials. Earnings for Chinese retailers will grow because consumers have enough disposable income to purchase a ‘cheap pick me up’ even in a high inflationary environment,” said Sullivan.

So while Chinese food manufacturers might have sleepless nights over high inflation,  Lau says Chinese consumer discretionary stocks will continue to outperform in the months ahead.