Image: Worker rests on his shovel at a residential area under construction in Beijing © Zheyang Soohoo, Newscom, RTR

When China's leaders introduced the country's 12th five-year plan, in March 2011, it included the wildly ambitious goals of rebalancing the economy away from exports and toward domestic consumption, of closing some of the huge gap between rich and poor by raising the minimum wage by at least 13% a year, on average, and of reducing rural poverty by extending programs such as pensions across the country. All while keeping the economy growing by 7% a year with stable prices.

You don't suppose they actually meant it?

Absolutely they did, recent data say.

In 2012, rural incomes rose faster than urban incomes -- for the third consecutive year. Rural income from benefits payments rose 21.9%, twice the rate in urban areas, as the government increased its spending on health care subsidies by 36%. And because poor families tend to consume a higher portion of their income than the wealthy, the growth in rural incomes should help with the goal of rebalancing the Chinese economy toward consumption.

What does this mean for investing in China?

It's certainly not time to throw out the traditional model, which has stressed the shares of exporting companies and the commodity producers that fuel their growth. Nor is it time to abandon the shares of companies that cater to the rising incomes -- and in some cases rising wealth -- of city dwellers. China's urban population accounts for about 53% of its total population of 1.35 billion, according to the National Bureau of Statistics. But rural spending in 2012 was less than a fifth -- at $447 billion -- of urban spending.

Still, given the trend, I'd recommend adding a stock or two or three from companies positioned to profit from growing rural incomes. Retail sales in rural regions grew by 14.5% in 2012, faster than the 14.3% growth for retail sales in urban areas. That's a new development. (Growth for both rural and urban retail sales was down last year from the 16.7% and 17.2%, respectively, recorded in 2011.)

Jim Jubak

Jim Jubak

But to understand which companies will do best in this changing Chinese landscape, you have to understand that the biggest beneficiaries of a rise in rural incomes aren't actually rural areas, but China's small and medium-size cities. In this column, I'm going to begin by explaining how China's "rural" trend works to benefit China's smaller urban areas. And then I'll give you the names of some stocks I think are well positioned to profit from the way rising "rural" incomes work on the ground in China.

Money to spend

There's no doubt that rural incomes are rising. Rural per-capita net income grew 10.7% in 2012, according to the National Bureau of Statistics (versus 9.6% for city dwellers).

Part of that is an increase in government "transfer" payments for pensions and health care. Part of it is an increase in farm incomes as agricultural production and prices rise. But a big part of the increase comes from growing wages for China's army of migrant workers -- 230 million by official count -- who aren't really rural at all.

China's system of household registration -- known as hukou -- prevents migrant workers from rural areas from getting permanent residency status in the urban areas where they work. They make their money working in the city (and their wages are rising, thanks to government policy and China's growing shortage of workers for factory jobs). But these workers are still officially residents of the rural towns they came from. They aren't eligible for education or health care in the urban areas where they live. Further, their incomes count as rural for official statistical purposes.

In February 2012, the State Council announced a major effort to tackle the unregistered-migrant-worker problem. The government will implement a policy to help migrant workers register in urban areas -- but not in all of them. The government will continue policies to limit the growth of the country's biggest cities, such as Shanghai and Beijing.

The new registration policy will be targeted at helping migrant workers attain residence status in small townships and in small and medium-size cities. In effect, as these policies are implemented, migrant workers who are now registered in rural areas will become residents of the small and medium-size urban areas. From the point of view of government statistics, they will take their incomes with them. In reality, many of these workers will move their families from rural areas to these small cities, where they will see their discretionary incomes increase as they become eligible for government-funded education and health care.

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Follow the leaders

From this perspective, the "rural" income story is actually a "third-tier cities" story. China has 12 first-tier cities with populations of 5 million or more. These are the cities in China most familiar to us -- Beijing and Shanghai, for example. But tier-one cities account for just 9% of China's population. Second-tier cities number somewhere between 23 and 60, depending on your definition.

But 160 of China's cities fall into tier three. With each boasting a population of 1 million or more, China's third-tier cities represent a total market of 300 million. That's roughly the size of the U.S. market.

And tier-three cities represent an extraordinary opportunity for the right companies. Yes, the growing incomes in third-tier cities make them attractive new markets for companies like Yum Brands (YUM) and McDonald's (MCD) that have expanded from tier-one to tier-two cities and now need new worlds to conquer.

But when these big boys arrive, they're going to discover rival Chinese companies already in place. These companies have been building positions in third-tier cities for years. They know local markets and have tailored products for local markets. At least initially, much of the growing income in tier-three cities will go to these incumbents. Only gradually will some of the most flexible and innovative big players grab a piece of this market.

Buying into these masters and even into the flexible big players that will gradually work their way into tier-three markets isn't always easy. Many trade only in Hong Kong or Shanghai. It's not that hard for U.S. investors to buy on the Hong Kong market these days. In the following suggestions I've tried to give a mix of Hong Kong- and New York-traded stocks.

Hengan International Group (1044.HK in Hong Kong) sells disposable diapers under the Anerle brand name. It is China's largest tissue-paper producer and the country's second-largest diaper producer. The company has focused on building its brand and sales network in rural areas. (Baby products in any part of China's market should do well during China's 2005-2020 baby boom. The boom is projected to peak in 2016.)

Sun Art Retail Group (6808.HK) is the biggest operator of hypermarkets -- 12.8% market share -- in China, so I wouldn't say that it has focused on rural or third-tier cities. But the joint venture between Taiwan's RT-Mart and France's Groupe Auchan has beaten Wal-Mart Stores (WMT); Tesco (TSCDY), traded as TSCO.LN in London; and Carrefour (CRRFY), which trades as CA.FP in Paris, to a pulp in China by fine-tuning a combination of Wal-Mart-style prices and selection with features that draw in local shoppers accustomed to selecting their own fresh fish from tanks and buying dishes such as steamed pork buns and fried noodles from store kitchens while they shop.

The company's experience in hiring local managers and then giving them the room to adapt to local markets will be a huge edge in tackling third-tier cities. And don't overlook a regional chain such as the Suguo Supermarkets operated by China Resources Enterprise (CRHKY), which trades as 291.HK in Hong Kong.

Tingyi (TCYMY), which trades as 322.HK, owns Master Kong, the second-most-valuable brand (2011 survey data) in China after Sony (SNE). That and an extraordinary distribution network give Tingyi the ability to expand sales of its instant noodles (the company is the largest instant-noodle producer in China) and beverages (including soft drinks) to new markets in smaller cities and rural areas as incomes rise.

Another name I suggest you watch is Gree Electric Appliances, but at the moment the stock trades only in Shanghai (000651.CH.)

A final stock that's fits this shift in China's economy is Home Inns & Hotels Management (HMIN), but those shares are already part of my Jubak's Picks portfolio.

Updates to Jubak's Picks

These recent blog posts contain updates to the stocks in Jubak's market-beating portfolios:

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At the time of publication, Jim Jubak did not own or control shares of any company mentioned in this column in his personal portfolio. The mutual fund he manages, Jubak Global Equity Fund(JUBAX), may or may not now own positions in any company mentioned in this post. The fund did own shares of Home Inns & Hotels Management and Tingyi as of the end of September.

Jim Jubak's column has run on MSN Money since 1997. He is the author of the book "The Jubak Picks," based on his market-beating Jubak's Picks portfolio; the writer of the Jubak's Picks blog; and the senior markets editor at MoneyShow.com. Get a free 60-day trial subscription to JAM, his premium investment letter, by using this code: MSN60 when you register at the Jubak Asset Management website.

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