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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