may 2020 investing in china: consumers and technology ... · top-down view of beijing’s...

FRANKLIN TEMPLETON THINKSTM EQUITY MARKETS

Investing in China: Consumers and technology recovering

MAY 2020

Investing in China: Consumers and technology recovering2

Introduction

China has been much in the news recently as it handles the COVID-19 virus, and because of political and trade tensions with the West. We continue to believe China remains a growth opportunity for investors. Indeed, by early-March, the Chinese A-share market hit a 12-month high and was one of the world’s best-performing equity markets. Our emerging markets team was on the cusp of publishing fresh thoughts on China in January when Beijing locked down China’s economy to flatten the COVID-19 infection curve. In scenes that were soon replayed across the globe, factories, offices, restaurants and shops all closed. Although China’s economy is opening again, it’s not back to normal. Companies like Foxconn, which assembles iPhones for Apple, aren’t back to full employment due to sagging global demand. Overall, retail activity is improving, but discretionary spending remains muted, while lingering anxieties over infections are accelerating consumer migration to more online purchases and home deliveries. That said, the macro themes and companies our emerging markets analysts wrote of in January remain relevant to investors looking for growth opportuni-ties today. In the near-term, we believe the business prospects for the companies we highlight have brightened. Whether trade tensions eventually prompt companies like Apple to pull supply chains out of China remains to be seen. This updated discussion offers a window into a post-COVID-19 economic recovery.

Stephen Dover, CFA

Head of Equities

Franklin Templeton

3Investing in China: Consumers and technology recovering

Innovation at work

In the wake of the global COVID-19 recession, we believe China’s long-term prospects remain intact. China’s ability to innovate (not simply replicate) in areas like artificial intelligence and e-commerce offers significant long-term opportunities for equity investors.

From our vantage inside China, analyzing China-based companies starts with a top-down view of Beijing’s industrial policies, which can drive systematic risks and profitable tailwinds. “Made in China 2025,” for example, earmarked RMB¥2.08 trillion or US$282 billion in 2015 to speed up China’s shift to a new economy that’s oriented to home-grown technologies and China’s expanding middle class.

To bring aspects of our security analysis to life, our Shanghai- and Hong Kong-based analysts have divided their discussion into three companies—each highlights a macro investment theme that shapes our China equity strategies.

• China has shifted its manufacturing sector from low-cost output toward high-tech exports—requiring a flexible and educated work-force. We think Luxshare Precision represents one upside of China’s investments in science and tech-nology education. It resumed full production of Apple’s technically complex AirPods in early-March.

• With the world’s second largest consumer class, more of China’s consumers are gravitating toward higher-quality premium brands, including locally grown ones like Three Squirrels. Its ability to transform a humdrum commodity— nuts—into a sought-after millennial brand offers fresh insights into China’s “premiumization” trend. As online purchases soared during China’s lockdown, Three Squirrels’ revenues jumped nearly 25% in 2020’s first quarter.

• China’s innovation in high-tech fields helps explain the dramatic rise of its largest technology start-up: ByteDance. As investors in China-based technology firms that compete directly with ByteDance, which is privately held, it’s important for us to stay closely abreast of its rapid evolution. Its ability to engage consumers globally with algorithms showcases how “Internet Plus” strategies can drive ad reve-nues through the mobile internet using big data analytics. With the popularity of its apps skyrocketing globally, ByteDance announced in April it’s hiring 10,000 new workers.

Three takeaways


One cornerstone of China’s new economy is the size and skill of its workforce. Thanks to investments in science and engineering education at elite schools, such as Peking University, China’s modern labor force is primed for innovation. China now issues over 1.65 million undergraduate degrees annually in natural sciences and engineering, quadruple the amount from 2000, and double the annual number issued in the United States and European Union (EU).1 All said, China’s investments in science and technology overtook the United States in 2019, according to the National Science Board.2

We think China’s support for education and research has been key to helping it transition toward high value-add exports like biopharmaceuticals and electronics, and away from lower-cost exports like textiles and footwear. As illustrated in Exhibit 1, China’s global share of high value-add exports now surpasses coun-tries like the United States, Germany and Japan.

From our vantage in Shanghai, we think Luxshare Precision offers one of the best examples of China’s shift up the export value chain. Founded in Shenzen in 2004 as an electronics manufacturer, Luxshare initially focused on assembling basics such as cables and chargers that connect computers, like the iMac, to power sources. As new wireless technologies took hold, Luxshare expanded its expertise by producing more complex wireless char-gers, and eventually Apple’s intricately designed wireless AirPods in 2017.

When Apple first sent its engineers to Luxshare to guide AirPods’ production, there were big assembly challenges to

overcome. AirPods are quite complex, with several hundred tiny electric components that must be carefully knitted together—a process akin to brain surgery. Fortunately, Luxshare’s core management philosophy takes technical challenges in stride: when confronting new hurdles “we simply make it happen.” (使命必达) To boost efficiencies, Luxshare encourages its managers to continually experiment with new assembly processes, even though new approaches sometimes fail.

We think Luxshare’s drive to continually fine-tune production is central to its ongoing success and point to founder, Wang Lai Chen, as an important conveyer of its workplace culture. She built this view from the ground up, starting her career in 1988 as a factory worker at Foxconn, a Taiwanese company that opened a manufacturing facility in mainland China. Over the

course of 10 years, she learned the firm’s business philosophy and work style, eventually becoming Foxconn’s highest-ranking mainland China employee.

Luxshare’s ability to continually increase efficiencies and lower costs hasn’t gone unnoticed by Apple. In addition to being the exclusive manufacturer of Apple’s new noise-cancelling AirPods Pro, Luxshare will also produce Apple’s newest technological jewel— the Series 6 watch. With demand for AirPods expected at 90 million headsets this year (up from 60 million in 2019), Luxshare revenues may experi-ence a tailwind.3

Although Luxshare’s AirPods production slumped 20% in February in the wake of China’s lockdowns, the company announced in early-March it would resume full operations, with plans to produce 48 million units of

Investing in science

20%

18%

16%

14%

12%

10%

8%

6%

4%

2%

% Exports

CHINA SHIFTS TO HIGH VALUE EXPORTS Exhibit 1: Percentage of global high value-added exports As of August 2019

Sources: Intracen; As of August 2019. High Value Exports includes electrical machinery and equipment and parts thereof; sound recorders and reproducers, television, machinery, mechanical appliances, nuclear reactors, boilers; parts thereof, optical, photographic, cinematographic, measuring, checking, precision, medical or surgical, plastics and articles thereof, vehicles other than railway or tramway rolling stock, and parts and accessories thereof, aircraft, spacecraft,. and parts thereof. See www.franklintempletondatasources.com for additional data provider information. Indexes are unmanaged, and one cannot invest directly in an index.

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

China Germany Japan KoreaUS


AirPods in 2020.4 To ensure worker safety, Luxshare makes its own COVID-19 face masks, tests employee temperatures each morning before entry, and re-configured its assembly lines to maintain China’s country-wide social distancing protocols.

It’s important to point out that Luxshare’s return to full operating capacity didn’t happen on its own. Without Beijing’s rapid mobilization of national COVID-19 testing, digital tracing and targeted quarantines, even the best manufacturer would be

hard pressed to resume full operations without production interruptions. Given China’s educated workforce and Luxshare’s innovative management practices, we think Luxshare remains a standout inside China’s electronics sector.

For companies the world over, the chief allure of China’s new economy is its enormous, and digitally sophisticated, consumer class. The scale is impres-sive—China’s middle class could surpass 550 million people by 2022.5 At the same time, rising female labor participation is producing more dual income households eager to try new premium brands, healthier foods and eco-friendly products.

Although foreign brands used to capture a larger slice of China’s premium purchases (imports were perceived as higher quality), a flood of new local brands is showing strong momentum. Since 2016, upstart brands home-grown in China grew their market share by 15%, whereas foreign brands grew just 9%.6 They’ve largely done so by tailoring products to local tastes, and harnessing China’s advanced e-commerce technologies and online platforms. To succeed in China, foreign companies must do a better job orienting their products to match China’s distinct tastes and culture or continue losing market share.

To understand how local companies are capturing market share, look no further than Three Squirrels. Its success selling nuts and snacks online is now studied at business schools across the globe. Founded in 2012 as a five-person startup, Three Squirrels is now one of

China’s top 10 brands, sitting alongside tech giants Alibaba and Huawei.7 By that measure, it’s done a far better job figuring out China’s millennial consumers than most global food conglomerates.

Three Squirrels founder Liaoyuan Zhang started with an asset-light digital model—another hallmark of China’s new economy. By selling high-quality nuts directly to consumers online, the company wouldn’t need to own factories or manage nut farms.

Instead, Three Squirrels would focus on online customer service and (eventu-ally) two- or same-day delivery, while handling the blocking and tackling of supply chain infrastructure in the background.

The nuts proved popular with consumers looking for a healthy protein punch, confirming Liaoyuan Zhang’s asset-light model was profitable. To boost sales higher, the company focused on tapping into Chinese millennials’ affinity for cute animals by creating three cartoon squirrels as mascots.

Craving premium experiences

Cosmetics

Spirits

Wine

Rice

Hair Care

Dairy Milk

Fresh produce

Bottled water

Beer

Frozen pre-cooked meals

Salty packaged snacks

Juice

Cookies

Carbonated beverages

10% 0% 10% 20% 30% 40% 50%

CHINA’S CONSUMERS ARE TRADING UP Exhibit 2: Percentage of consumers intending to trade up vs. trade down in 2019 As of 2018

Source: McKinsey Consumer Sentiment Survey; McKinsey Global Institute analysis.

Intend to trade down Intend to trade up


For Three Squirrels, its brand “experi-ence” now spreads beyond its fastidious packaging and animated commercials to include the interactions Three Squirrels employees have with online customers on digital plat-forms like WeChat. Liaoyuan Zhang, for example, calls himself “鼠老爹” (Chinese for “the papa squirrel”), while employee nicknames start with the Chinese character “鼠” (the last char-acter of “squirrel” in Chinese).8

More recently, Three Squirrels began integrating over 70 brick-and-mortar locations (called Feeding Stores) in smaller cities with lower online shopping

rates. Other than snacks, offline customers can buy special merchandise not available online, including Three Squirrels smartphone cases, school bags, pillows and stuffed toys. The strategy is less about boosting bottom-line profits—offline sales average RMB¥8 million or US$1.1 million per store—and more about expanding the Three Squirrels brand experience while collecting more customer data to stay abreast of millennial trends.9

From the outset of China’s COVID-19 lockdown, online food purchases rock-eted across China, as did the frequency of snacking for middle class consumers who suddenly found themselves working

from home. By offering online discounts to grab market share, Three Squirrels saw its revenues jump 20%–25% in the first quarter, besting many of its competitors. Profit margins, however, took a hit. In addition to promotional charges, the costs of “contactless home delivery” spiked higher in China as its logistics industry struggled to adapt to new lockdown procedures, social distancing and record demand. That said, we think Three Squirrels remains an online leader in food retailing, demonstrating the importance of tailoring brands to fit China’s consumer culture.

Twenty years ago, China’s factories were very good at replicating products from overseas. Few, however, appeared able to come up with their own world-beating products or services. To help China innovate at home, Beijing started delivering strategic industrial policies that aimed to catapult China to the forefront of high-tech sectors. Backed by major investments from Beijing, China now leads the world in areas like 5G infrastructure and is busy patenting its own breakthroughs: inventors in China now account for nearly half (49%) of worldwide patents, as shown in Exhibit 3.10

Within the field of social media apps, our team thinks ByteDance (an unlisted tech start-up) offers one of the best illustrations of China’s home-grown innovations succeeding outside China. Recently valued between US$90 billion–US$100 billion, demand for ByteDance’s suite of apps—spanning

news, short videos and streaming music—is positively booming.11 Indeed, while other companies are downsizing in the wake of the COVID-19 recession, ByteDance announced in April it is

hiring 10,000 new employees, and expects to have 100,000 by year-end globally (up from 62,000 in 2019).12

ByteDance is the brainchild of Zhang Yiming (張一鳴), a millennial entrepreneur who majored in software engineering at Nankai University in Tianjin. Zhang Yiming’s early vision for ByteDance was to harness machine learning algorithms to feed tailored streams of content to mobile users. Many of China’s 847 million mobile internet users find search engines like China’s Baidu cumbersome.13 With algorithms, ByteDance would keep consumers engaged by feeding them individually tailored content. The more time spent on ByteDance apps, the more advertising revenues it could collect.

Zhang Yiming’s original concept struck a chord with a US venture capital firm, which gave Zhang seed capital in 2012

Home-grown innovations

CHINA TAKES THE LEAD IN PATENTS Exhibit 3: Percentage of “patent families” by country or region 2018 As of 2019

Source: NCSES, special tabulations (2019) of PATSTAT, European Patent Of�ce. Indicators 2020: Innovation. January 2020.

US6.8%

EU7.2%

South Korea12.0%

Japan17.5%

China49.4%


to start Toutiao, a news aggregator app. After surpassing 13 million daily viewers in only two years, Zhang Yiming secured a fresh infusion of RMB¥1.45 billion (US$204 million) from more overseas investors, including Sequoia Capital. Two years later in 2016, Zhang Yiming launched a video-streaming app in China called Douyin, followed by its international cousin TikTok in 2017.

Think globally, act locally To understand TikTok’s meteoric rise outside China, it’s important to note how it got a head start. By acquiring the lip-syncing app Musical.ly (founded in China) in 2017, ByteDance gained 200 million worldwide users and a strong following in the United States.14 After integrating ByteDance’s sophisti-cated algorithms (which help make TikTok addictive) and slick video editing technologies, TikTok videos started going viral.

We think a key driver of TikTok’s growth spurt is its adaptability—it’s not a one-size-fits-all-cultures kind of app. When a TikTok video goes viral, it’s reflecting distinct cultural factors (geog-raphy, gender, age, local pop culture), which vary by region and country. TikTok users in the United States, for example, tend to skew younger (43% are 16–24 years old) and female, and prefer light-hearted slapstick. TikTok users in India, by contrast, skew heavily male, whereas South Korean users are largely females in their mid-40s.15 In China, knowledge-based content like cooking videos and foreign language education are quite popular on Douyin, and users skew slightly older (60% are 25–44 years old).16

Thanks to TikTok’s cultural adaptability (and ByteDance algorithms), the app has eclipsed Twitter and Snapchat in record time with 1 billion active users,

and is close to overtaking Facebook’s Instagram and Tencent’s WeChat in China, as shown in Exhibit 4.

TikTok may be a global sensation, but the majority of ByteDance profits still come from its apps in China, like Douyin, which evolved into a more overtly commercialized version of TikTok. Browsing through Douyin videos, for example, Chinese millennials can buy products featured in videos with a few clicks or take virtual tours of a city’s stores before collecting special coupons to use when visiting them in person.

China’s home-grown consumer brands are now turning to Douyin to promote their products in creative ways. Take the domestic cosmetics brand PROYA, which launched a digital campaign for its Bubble Spa Mask last year. It invested in 200 micro-influencers with large followings on Douyin to drum up sales. The Douyin campaign went viral, and PROYA sold 1 million boxes of the its spa mask in a month, and RMB¥300 million in sales over three months.17 Douyin is also popular among “mom and pop” entrepreneurs

operating from home. Consider the rustic cook Yeshi Xiaoge—roughly trans-lated, his name means “brother who cooks in the wilderness.” After gaining a large following on Douyin cooking rural meals, he bottled and sold his own beef sauce online.18

As a private company, ByteDance doesn’t publish its revenues. That said, we can confirm ByteDance raked in 23% of China’s digital ad spending (RMB¥50 billion or US$7 billion) in the first half of last year.19 In addition, some of ByteDance’s private investors indicated last year’s revenues were between RMB¥104 billion–RMB¥140 billion or US$15 billion–US$20 billion—more than Uber, Snapchat and Twitter combined.20 As investors in China-based technology firms that compete directly with ByteDance, it’s important for us to stay abreast of its rapid evolution. By offering technically advanced advertising solu-tions across its suite of apps, we think ByteDance could grow its revenues and profits even further by monetizing TikTok’s advertising potential.

2,500

2,000

1,500

1,000

500

Years After Launch

Users (millions)

TIKTOK’S SWIFT RISE TO 1 BILLLION USERS Exhibit 4: Monthly active users since product launch (millions) As of November 8, 2019

Source: Financial Times Research. November 8, 2019.

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

TikTok

WeChat

Instagram

Snapchat

Twitter

WhatsApp

Facebook


Endnotes 1. Source: National Science Board, “Rapid Rise of China’s STEM Workforce Charted by National Science Board Report,” January 31, 2018. 2. Source: Philips, J. “The State of U.S. Science and Engineering 2020”. National Science Board. January 15, 2020. 3. Source: Wuerthele, M. “Third generation AirPods expected in 2021, new AirPods Pro in 2022,” Apple Insider, April 23, 2020. 4. Source: Ho, A. “AirPods Producer Luxshare Gains More Than 6% as Operations in China Resume,” Investing.com, March 10, 2020. 5. Source: McKinsey, 2019. There is no assurance that any estimate, forecast or projection will be realized.6. Source: B. Lannes, D. Deng, M. Kou, and J. Yu. “Premium Products, Small Brands and New Retail,” Bain & Company, June 20, 2019. 7. Source: China People’s Media Network and Baidu. November 2019. 8. Source: Dauxe Consulting. “How the Chinese brand Three squirrels uses Meng Culture to become No.1,” November 27, 2018.9. Source: Liang S. “Chinese Consumers are Nuts for Thee Squirrels” Equal Ocean, April 2, 2019.10. Source: Decker, S. “China Erodes U.S. Dominance in Tech With an Avalanche of Patents,” Bloomberg, May 10, 2019. 11. Source: The Economist. “ByteDance is going from strength to strength,” April 18, 2020.12. Source: McMorrow, R. “ByteDance looks to hire 10,000 thanks to TikTok boom,” Financial Times, April 15, 2020. 13. Source: China Internet Network Information Center. June 30, 2019. 14. Source: Schneider, M. “Musical.ly Acquired By Chinese Startup for $800 Million,” Billboard, November 10, 2017.15. Source: Yokota, S. “A Look at TikTok Overtaking the World in 2019,” App Ape Lab., January 23, 2020. 16. Source: Douyin Data Report. ByteDance, January 2020.17. Source: Chen. T. “2020 China Digital Marketing Trend,” WalktheChat, December 29, 2019. 18. Source: Tolentino, J. “How TikTok Holds Our Attention,” The New Yorker, September 23, 2019.19. Handley, L. “TikTok’s owner ByteDance just beat Tencent and Baidu in digital ad revenue,” CNBC, November 19, 2019. 20. Source: The Economist. “ByteDance is going from strength to strength,” April 18, 2020.

China was the first to experience COVID-19, and it’s the first to emerge from lockdown. The macro themes that shaped our China equity strategies last year remain intact—driving tail-winds that can boost company profits and earnings power. In our view, a variety of China’s companies are finding success by engineering consumer- focused innovations that integrate advanced technologies. They are keenly attuned to the needs of a rising middle

class that is eager to spend, and these companies are devoting their know-how to fulfill these needs. For home-grown companies like Three Squirrels, success requires leapfrogging over traditional business models, and tailoring brands to fit China’s distinct culture and trends. We view China’s consumer market as a force to be reckoned with—growing at a breakneck pace over the past 20 years. We believe the uptrend can continue as incomes increase.

On top of this, the consumer base is diverse, with urban and rural regions at different stages of economic develop-ment exhibiting different spending patterns. However, technology and the expansion of apps and mobile technologies are quickly bridging this gap across China. Understanding these dynamics in the wake of COVID-19 is necessary to find the best local and global investing opportunities.

Uptrend continues


Franklin Templeton Thinks: Equity Markets highlights the global views our equity invest-ment teams have across developed and emerging economies, sectors and individual companies. Each quarterly issue spotlights fresh insights that our analysts and portfolio managers bring to active security research, examining risks and opportunities from both growth and value frameworks.

Contributors

Stephen H. Dover, CFA

Head of Equities

Franklin Templeton

Manraj S. Sekhon, CFA

Chief Investment Officer

Franklin Templeton Emerging Markets Equity

Michael Lai, CFA

Portfolio Manager


Vivian Chen Xushan

Senior Research Analyst


Tony Sun

Research Analyst



Notes


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may 2020 investing in china: consumers and technology ... · top-down view of beijing’s...

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