Are Diamonds the New Gold for China?

The World Gold Council’s first quarter report shows demand from China for gold jewelry jumped 21 percent year on year to 142.9 tons, but some fund managers are betting on diamond and gem set jewelry to give higher returns.

Flawless pear-shaped 72.22-carat diamond
Flawless pear-shaped 72.22-carat diamond

"Gold no longer satisfies status demand, you need bling, you need something shiny, you need diamonds, " says Eddie Tam who runs the hedge fund CAI Global.

The fund, which returned 48 percent last year has increased its exposure to two high-performing Hong Kong listed jewelry stocks - Look Fuk whoseshares have surged 261 percent over one year and Chow Sang Sang , which is up 80 percent over the same period.

Edwin Fan, who covers the jewelry sector for Bank of China International is equally bullish on both names, which he rates as a buy.

"The strong gold and diamond prices of late as well as the mounting inflationary pressures bode well for Hong Kong jewelers in terms of both revenue and margins."

Jewelry chains enjoy a 10 percent profit margin on gold, but hedge fund manager Tam says they can make 3 to 5 times more on gem set jewelry.

So far, the bulk of jewelry chains’ revenues still come from gold. A spokesman for Chow Sang Sang told CNBC, 55 percent of their sales come from gold and just 35 percent from non-gold jewelry. The rest comes from watches.

But Tam expects this product mix to change, with diamonds and gem set jewelery set to grow as advertising campaigns try and influence more Chinese men to buy diamond engagement rings.

According to De Beers, diamond sales grew 25 percent in Chinain 2010 and the country is now tied with Japan as the second-biggest consumer of diamonds, with the U.S. taking the top spot. Tam says China's demand for diamonds is about to go non-linear because of income growth and will soon hit high double-digit percentage increases, if not triple digits.

Despite being bullish, Bank of China says investors need to be wary of two risks. For one, same store sales may drop if China experiences a major slowdown caused by a downturn in the property sector. And two, both companies have large inventories of gold and diamonds that could decline in value if jewelry prices drop.