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EVENT OF THE CENTURY: The Rise of an Emerging Middle Class

In the coming decade, hundreds of millions will enter the “higher earning middle class,” creating vast wealth-building opportunities.

INTRODUCTION
A wonderful transformation is occurring throughout India, China, Brazil, Russia, South America, and other emerging economies, which has set the table for long periods of wealth creation; and, early investors in the markets will put themselves in a position to have their capital earn high rates of return.

Today much of the focus of international investing is on developed markets, such as the United Kingdom, Japan and Germany. People are familiar with these countries, which, like the United States, have mature economies and are growing very slowly. We believe they will continue along this slow growth path. The emerging markets, on the other hand, have great economic growth today — growth and success they’ve had in transforming their economy over the past ten years. Why? The entrepreneurial spirit is alive and well today, especially in China and India.

THE EMERGING MARKETS: CHINA AND INDIA
During my most recent business trips in 2007 to Singapore and Shanghai, China, in May and Beijing, Harbin, and Shenzhen, China later that year in September, I witnessed firsthand the entrepreneurial management of the companies throughout Southeast Asia. It was breathtaking — entrepreneurial activity has taken root very quickly in these economies. This is helping spur tremendous growth within these economies. The chart on the left shows their extraordinary growth.

Of course, companies, governments or regulatory bureaucracies do not create wealth; instead, it is created by people with ideas and spirit along with the enthusiasm of the people in the organization. During a previous business trip to India in February 2006, 1 encountered an excitement in my discussions with local shop owners as well as corporate CEOs and CFOs that was clearly fresh and contagious. The people of India and China have captured a glimpse of how Westerners live through time spent on the Internet and watching television, and they have decided they want the life of the developed Western countries. Further, the government leadership in most of the emerging economies is in agreement that the current process of introducing free-market initiatives in China and India must continue. I believe they understand that this free-market initiative that began nearly 15 years ago is now creating the great growth these economies are now experiencing.

Here are some reasons we believe the emerging-market economies will continue to grow at a very high level:

Government Commitments to Free-Market Reforms: In contrast to both China and Russia, India as a well-developed democracy, is helping smooth the way for the free-market reforms. Countries such as Russia and China depend upon their strong governments to establish change. There will be some pushback from the left labor-oriented side of government; however, we believe most governments want to continue the successful market reforms and will accommodate [or this process. All evidence points to continued positive support from the government entities for the free-market initiatives now driving the growth in the emerging economies.
Education: India has a highly educated workforce. in fact, more than 8% of the world’s undergraduate engineers are developed in India, while the U.S. produces only 6% of the undergraduate engineering population. Further, a highly developed educational system helps India produce some very capable advanced-degree graduates. China is also becoming a highly educated workforce. This represents one of the core areas of focus in our investment work in the coming decade.
The Power of the People: Free-market reforms are playing into the empowerment of the people of these economies. Never underestimate the ability of people to accomplish great things when given the opportunity to personally gain. The world now has roughly three billion new capitalists who are helping reform the world’s emerging economies. Successful market reforms will accommodate this process.
The Developed Economies Need Lower Labor Costs. In order to help grow earnings, the largest employers in the developed economies are looking to expand their work force in China and India and other countries so that they can compete on a global scale with the lowest-cost producers. While in China this past May, I met with an executive management team of a plastics company from Pennsylvania who told me that since they moved their plastics manufacturing facility to China last year, they have reduced costs of operations by over 50%!

In Comparison
So, where do China and India stand today when compared with other nations in the world? India is a large economy and ranks fourth in the world in terms of overall size. However, in terms of wealth measures, India has made progress but still has a long way to go to join the other economic powers of the world. India’s Gross Domestic Product in 2006 on a per capita basis (PPP adjusted) is $3,051, up dramatically from $1,178 in 1980. This is a 159% gain over the last 25 years, with much of this coming in the last 15 years. Thus, the economic reforms of the early 1990s are helping to spread wealth across the nation. We anticipate that India will eventually rise to the level of wealth China has developed that is today twice the wealth India enjoys. China’s GDP per capita in 2006 was about $6,572; but when compared to the wealth enjoyed by the United States ($41,854 GDP per capita), Canada ($32,886 GDP per capita) and United Kingdom ($32,005 GDP per capita), both India and China today are quite poor nations. A long time ago, we learned that wealth is created in free markets when problems are solved. Freedom, coupled with the fortitude of the people in Asia, is now creating tremendous growth in wealth in both India and China, and many other emerging-market countries. We believe that the wealth levels in both India and China will continue to rise dramatically in the coming years.

CHINA’S MIDDLE CLASS
How does China’s middle class compare today with the middle class in the United States? They are quite different, the biggest difference being that the Chinese tend to be more prudent and do not expend much credit. The United States could adopt some of their financial practices. Note some of the differences between the middle classes of these countries:

China’s middle class save 20% of their income.
60% of China’s middle class own a home, and only 17% took out mortgages to get that home.
Only 30% of Chinese middle-class families have a credit card.
Only 20% of China’s middle class own stocks or mutual funds. The other 80% have funds in the bank.
In the next year, 44% of China’s middle class plan to travel outside of their home province.
65% of Chinese middle-class families own a personal computer.
Source: CISA China Research Mr. and Mis, China Summer 2007

Middle-class income in China is really quite low relative to the U.S. In China, approximately 60% of middle-class families have per capita disposable inco?ne in the $800 - $1,600 range, according to the CLSA research published in June 2007. Only the highest 10% have disposable income in the $3,700 range. This compares with U.S. per capita income of $31,735 in 2006. As you can see, China’s middle-class income levels are really still less than 4% that of the United States. The exciting part of this research is to see how fast incomes in China are growing. We believe that as the rate of growth in GDP continues at a high level, a very large group, maybe 200 million Chinese families, will see their disposable income rise from $1,500 per year ($3,000 for a typical two-person family) to well over $6,000 per year in the coming decade ($12,000 for a two-person family). This is achievable and represents an annual growth rate of 14% in disposable income for the average family in China, if these income growth rates become a reality, we are fairly certain that investors who focus on the top sectors will fare very well.

The top seven sectors we believe will capitalize on the growth of the middle class in all emerging economies are as follows:

Banks: Well-managed banks in India and China are growing at well over 25% per year and have very healthy profit margins. Wealth is building quickly in these economies, and banking services is one of the best places to participate in this growth.
Property Management: Another way to participate in wealth generation of the middle class is to own property companies in the strongest regions of these economies. We expect property companies to produce excellent returns in the coming years.
Education: The new capitalists in these economies are well aware of the need for higher levels of education. We believe private schools should be able to grow very profitably in the coming years. We particularly like companies in China that teach English to the local Chinese citizens. In order to attend a college in China, students must pass a comprehensive English competency exam. This ensures a growing market for years to come.
Infrastructure: Building roads, highways, power plants and water facilities are high-growth businesses in these economies. China built one new coal-fired power plant per week in 2005 and doubled to two per week in 2006. China needs a great deal more power to handle 10% growth per year. One of our favorite sectors in the Chinese infrastructure business is the water filtration and water treatment plants. It has been estimated that the Chinese government will increase water tariffs in China at approximately 10% per year for the next five years. China knows it needs to improve water systems throughout the country. This could translate into margin enhancement for the companies in China’s water business.
Media and Advertising: Opportunities in advertising, Internet commerce and many others are exciting. The Internet in China is where the U.S. Internet was in 1997— very early adoption. However, we see explosive growth in this sector as the Chinese middle class uses the Internet to buy and communicate. The payment technology in China is immature, and it will take some time for credit mechanisms to evolve so that China can maximize the c-commerce potential. We believe this will occur in the next few years.
Travel and Lodging Industry: imagine investing in TWA or American Airlines in the 1940s in the United States. That is the opportunity for travel in China and India today. The average Chinese or Indian citizen is just learning about travel. We expect this sector will be a high-growth sector for the next decade.
Medical Opportunities: With higher incomes, the desire for better medical care is natural. We believe the opportunity within the medical business in all of the emerging economies is fantastic. In some countries there has been a poor attempt to develop medical facilities that have Western standards. So far, there has only been modest success in developing a quality medical care system. We anticipate investing in this sector, as we believe this is a great opportunity for growth.

The financial markets in most of these emerging economies are progressing nicely. As the chart in the lower left-hand corner illustrates, relative to Gross Domestic Product — the Asian economies have only started to fully realize their potential. We expect that after 10 or 15 more years of rapid growth, the financial markets will look much more like those of the United States or the United Kingdom. The opportunity is present today.

PERSONAL OBSERVATIONS OF ECONOMIC REALITY
Markln February 2006 while in India, I interviewed several CFOs of companies that in America would be considered small- to mid-capitalization companies; but, in India, these companies are the blue chips. The CFO of a well-known Indian bank explained that they’ve created a financial management system that allows their management team to measure profitability by customer, by branch, thus allowing branch managers to build a more profitable branch. They are encouraged through their profit-sharing compensation to grow the bank profitably. In contrast, the State Bank of India, the government-controlled bank, does not pay on performance and is still controlled by the oppressive labor unions. Employees are paid to show up, not to perform. They are trying to make changes but are having trouble. In the meantime, his bank is growing about 30% per year. We believe this kind of growth will continue for at least five to seven years.

Turning to China: we think that there are opportunities to capitalize on within the coming decade of wealth creation. However, one should pay more attention to the government’s regulatory situation and its intentions in China. It is critical to invest with the flow of money and regulations in specific industries. A good example of this is China’s water industry, which is in great need of substantial infrastructure improvement. There are over 600 large cities in China today that have no sewer treatment facilities. China’s Water Ministry has made it clear they will do whatever it takes to improve the water quality and infrastructure of these services.

Nonetheless, one should not expect a smooth ride in the emerging economies; there will be disruptions and problems in the process. However, we believe India will continue both economic and market growth in the coining years. As the numbers to the left indicate, this is exactly what has occurred in the past 16 years. The power is now moving away from
government and into the free-market economies, which is allowing the large, untapped educational abilities and talent of the people in these emerging economies to be unleashed. India’s highly educated population is ready for capitalism.

How has India’s stock market as measured by the BSE Sensex (Index of 30 India Blue Chips) been doing over the past few decades? During the 16-year period from 1990 to 2006, the S&P 500 appreciated about 8.4% per year (excluding dividends). Through the same time period, the Indian BSE Sensex appreciated at an annual rate of return of 16.6% without dividends. The China A-share Shanghai SE Composite IX Index appreciated 16.25% annually excluding dividends over a 12-year time frame (the Chinese market started trading in 1995). So over this 16-year period, the Indian Sensex approximately doubled the performance of the S&P500. Will the coming ten years produce similar results? We cannot say with certainty, however, our judgment is that the conditions in China and India today may possibly be even better for wealth creation than any other time in the past 16 years. We believe in the possibility that the Indian and Chinese stock markets could double the performance of the U.S. markets in the coming 10 years.

A Word of Caution: As I said before, do not expect a smooth ride. We fully anticipate that there will be many market corrections, possibly ranging from 20% — 40%, along the way within the coming decade. The financial markets in India are still fairly immature and are subject to significant fluctuations and volatility. How does one proceed? Make small commitments today, and make further commitments when the markets enter these periods of consolidation. Further, to keep risk in check, invest in larger blue chips and well-managed companies and diversify among several different industries. This will act to smooth out the overall market fluctuations.

The emerging economies today represent both risk and reward. The one intangible that we believe tips the scale in favor of sizable reward is the human element of the people. For many years the government limited their growth opportunity. However, this situation is changing today. The emerging economies’ equity markets will climb the ever-present “wall of worry” in the coming years. Skeptics will cite valuations, recent performance, regulatory concerns, as well as labor and government issues along with many other concerns as reasons the equity markets in the emerging economies are not worthy of investment.

Change is ever-present in our economic world. The winds of change in emerging economies now make for a very favorable investment environment that is not fully appreciated today.

About The Author
Robert Lutts serves as president and chief investment officer For Cabot Money Management. lie received his MBA degree in investments and finance from the University of Massachusetts in Amherst and his Bachelor of Science degree in finance and management from Babson College. Before founding Cabot, Mr. Lutts was with Amherst Associates. a financial consulting heaLth care management firm.

Rob has made several appearances on CNBC, Bloomherg and FOX Business Network. He has also been quoted in both local and national publications such as The Boston Globe, The Chicago Tribune, and The New York Times.

Cabot Money Management, Inc. is a wealth management firm based in Salem, MA, with additional office space in Boston. As a Firm with nearly 25 years of experience, Cabot has a national clientele and is a frequent contributor to CNBC, Bloomberg. The Wall Street journal, The New York Times, and other local, national and international media. Cabot provides highly customized global investment management services coupled with tax, state and financial advice for individuals and their families.

If you have any questions regarding this white paper, please call us at (800) 888- MGMT or send us your question by email to info@eCabot.com.

Any advice or suggestions are provided for informational purposes only and is not a solicitation to purchase any investments or services described herein. Please consult your advisor to determine if an investment strategy is appropriate for you. Past performance of either the domestic or international markets or any specific investments is not predictive of future results nor will diversification alone protect front loss.