China’s Top Bets on Luxury Retail

03/24/2016 10:00 am EST

Focus: STOCKS

Fears about China’s economic health have become top of mind for investors, creating volatility in many of the luxury stocks we cover, explains analyst Paul Swinand of Morningstar StockInvestor.

Despite China’s macroeconomic risks and imbalances, we expect the country to remain a growth driver for luxury firms. Chinese consumers already account for 30% of global luxury goods purchases.

For the decade ending in 2022, we project 1.8% average annual growth in the number of urban households in China.

However, we see the number of wealthy families more than tripling, implying a compound annual growth rate over 11%.

We also expect the “comfortable middle class” to grow at a high-single-digit rate. As these consumers acquire a taste for higher-end foreign goods, this presents a significant opportunity for luxury firms.

We prefer companies that address the Chinese middle and upper classes. As Chinese consumers fill in the ranges of income brackets, we expect more frequent but smaller luxury goods purchases, rather than a focus on very expensive trophy or status symbol items.

At the moment, we find the American brands with affordable-luxury price points to be relatively undervalued, in part because they are suffering from unfavorable exchange rate movements.

The American brands also tend to have lower exposure to China and other international locations, reducing risk to current earnings while creating a runway for future growth.

Our top picks include Ralph Lauren (RL), Tiffany (TIF), and Swatch (SWGAY); we see these brands as the most likely beneficiaries of this trend.

Ralph Lauren provides an accessible entry point to luxury and lifestyle brands, and should benefit from new Chinese consumers making their first such purchases.

At the low end, we estimate approximately 4% average annual growth for apparel-focused Ralph Lauren. The company derives about half of revenue from the US, and its international operations are dominated by Europe.

Tiffany’s engagement business is more status-and occasion-oriented, but the brand has a deep resonance with consumers.

China has a relatively low penetration of diamond engagement gifts: a long-run opportunity for Tiffany.

Lastly, we prefer Swatch among Swiss watchmakers for its advanced technologies and its role supplying watch components to other brands.

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By Paul Swinand, Analyst at Morningstar StockInvestor

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