China’s quest for luxury

Each week, a professional investor tells MoneyWeek where she'd put her money now. This week: Nathalie Longuet, consumer goods analyst, Lombard Odier.

When China's leading maker of construction machinery, Shandong Heavy Industry, bought Italian luxury-yacht builder Ferretti, it signalled the potential for luxury goods in China. The Chinese will be the leading luxury consumers by 2014, contributing 40% to the sector's growth over the next decade. The top 0.8% of richest people in China represent 70% of the nation's wealth and their number should grow at 21% a year from 2010 to 2020.

The luxury goods sector is attractive, given its high entry barriers, pricing power and superior profitability. In the past decade luxury goods outperformed world indices, despite economic lurches. The sector is poised for growth thanks to exposure to two trends we call emerging consumer catch-up' (ECC) and new consumer behaviour' (NCB).

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ECC describes emerging markets' increasing participation in global consumption. As GDP per capita approaches $20,000, luxury spend per capita surges. China's urban population should surpass that within ten years. The number of millionaires has grown at 12% a year over the past four years. China's 535,000 high-net-worth individuals (HNWIs), with investable assets of $1m or more, puts it ahead of Britain and just behind America, Japan and Germany. Chinese HNWIs account for 0.04% of the population, compared to 1% in the US, 1.5% in Hong Kong and 2.4% in Singapore. If HNWIs reach 0.5%, there could be 6.7 million Chinese HNWIs (twice as many as in America), or $25trn-$30trn of extra wealth.

This influx of disposable income will be complemented by NCB: newly moneyed consumers seeking to spend on high-end status symbols. In China, a tradition of gift-giving and displaying wealth supports this behaviour. Chinese wealth originates from entrepreneurship.

These entrepreneurs are young (on average 39 years) and prefer to spend rather than pass on wealth to the family. They allocate a disproportionate amount to jewellery, gems and watches compared to the world average (34% versus 23%). Asian consumers spend more on luxury items than Western consumers: South Korean consumers spend 2.5 times more on luxury goods than the Italians, despite the two nations' broadly similar GDP per capita.

So how does the investor get exposure to this trend? Listed luxury companies corner 38% of the global luxury market, up from 30% in 2004. In China, the concentration is 55%. So far, Western luxury goods brands have had little to fear from Chinese competition the focus is on buying existing brands, as with Ferretti yachts.

Investors should favour brands that preserve their core luxury attributes, while also trading up the brand without alienating developing world consumers. As China raises the bar, size will become critical. Global brands appear best positioned, but smaller luxury names could provide attractive takeover opportunities.

The profit-pool is increasingly concentrated among large players: Louis Vuitton, Patek Philippe, Cartier, Giorgio Armani and Herms were rated the best luxury brands by Chinese consumers in 2009, 2010 and 2011. Of these, Richemont (SIX: CFR), LVMH (Paris: MC) and Swatch (SIX: UHR) offer the best exposure, combining strong brand cachet and solid growth momentum.