Investing in China: Consumers and technology recovering - MAY 2020 EQUITY MARKETS - Templeton Emerging Markets Investment ...
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MAY 2020 Investing in China: Consumers and technology recovering FRANKLIN TEMPLETON THINKSTM EQUITY MARKETS
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
2 Investing 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.
Three takeaways
• China has shifted its manufacturing • With the world’s second largest • China’s innovation in high-tech fields
sector from low-cost output consumer class, more of China’s helps explain the dramatic rise
toward high-tech exports—requiring consumers are gravitating toward of its largest technology start-up:
a flexible and educated work- higher-quality premium brands, ByteDance. As investors in China-
force. We think Luxshare Precision including locally grown ones like based technology firms that
represents one upside of China’s Three Squirrels. Its ability to compete directly with ByteDance,
investments in science and tech- transform a humdrum commodity— which is privately held, it’s important
nology education. It resumed nuts—into a sought-after millennial for us to stay closely abreast of
full production of Apple’s technically brand offers fresh insights into its rapid evolution. Its ability to
complex AirPods in early-March. China’s “premiumization” trend. engage consumers globally with
As online purchases soared during algorithms showcases how “Internet
China’s lockdown, Three Squirrels’ Plus” strategies can drive ad reve-
revenues jumped nearly 25% in nues through the mobile internet
2020’s first quarter. using big data analytics. With the
popularity of its apps skyrocketing
globally, ByteDance announced in
April it’s hiring 10,000 new workers.
Investing in China: Consumers and technology recovering 3
Investing in science
One cornerstone of China’s new overcome. AirPods are quite complex, course of 10 years, she learned the
economy is the size and skill of its with several hundred tiny electric firm’s business philosophy and
workforce. Thanks to investments components that must be carefully work style, eventually becoming
in science and engineering education at knitted together—a process akin to Foxconn’s highest-ranking mainland
elite schools, such as Peking University, brain surgery. Fortunately, Luxshare’s China employee.
China’s modern labor force is primed core management philosophy takes
for innovation. China now issues technical challenges in stride: when Luxshare’s ability to continually increase
over 1.65 million undergraduate degrees confronting new hurdles “we simply efficiencies and lower costs hasn’t
annually in natural sciences and make it happen.” (使命必达) To boost gone unnoticed by Apple. In addition to
engineering, quadruple the amount efficiencies, Luxshare encourages its being the exclusive manufacturer of
from 2000, and double the annual managers to continually experiment with Apple’s new noise-cancelling AirPods
number issued in the United States new assembly processes, even though Pro, Luxshare will also produce
and European Union (EU).1 All said, new approaches sometimes fail. Apple’s newest technological jewel—
China’s investments in science and the Series 6 watch. With demand for
technology overtook the United States We think Luxshare’s drive to continually AirPods expected at 90 million headsets
in 2019, according to the National fine-tune production is central to its this year (up from 60 million in
Science Board.2 ongoing success and point to founder, 2019), Luxshare revenues may experi-
Wang Lai Chen, as an important ence a tailwind.3
We think China’s support for education conveyer of its workplace culture. She
and research has been key to helping it built this view from the ground up, Although Luxshare’s AirPods production
transition toward high value-add exports starting her career in 1988 as a factory slumped 20% in February in the
like biopharmaceuticals and electronics, worker at Foxconn, a Taiwanese wake of China’s lockdowns, the
and away from lower-cost exports like company that opened a manufacturing company announced in early-March it
textiles and footwear. As illustrated in facility in mainland China. Over the would resume full operations, with
Exhibit 1, China’s global share of high plans to produce 48 million units of
value-add exports now surpasses coun-
tries like the United States, Germany CHINA SHIFTS TO HIGH VALUE EXPORTS
and Japan. Exhibit 1: Percentage of global high value-added exports
As of August 2019
From our vantage in Shanghai, we think % Exports
Luxshare Precision offers one of 20%
the best examples of China’s shift up 18%
the export value chain. Founded in 16%
Shenzen in 2004 as an electronics 14%
manufacturer, Luxshare initially focused 12%
on assembling basics such as cables
10%
and chargers that connect computers,
8%
like the iMac, to power sources. As new
6%
wireless technologies took hold,
4%
Luxshare expanded its expertise by
2%
producing more complex wireless char-
gers, and eventually Apple’s intricately 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
designed wireless AirPods in 2017. China Germany US Japan Korea
Sources: Intracen; As of August 2019. High Value Exports includes electrical machinery and equipment and parts thereof;
When Apple first sent its engineers to
sound recorders and reproducers, television, machinery, mechanical appliances, nuclear reactors, boilers; parts thereof,
Luxshare to guide AirPods’ production, optical, photographic, cinematographic, measuring, checking, precision, medical or surgical, plastics and articles thereof,
there were big assembly challenges to 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.
4 Investing in China: Consumers and technology recovering
AirPods in 2020.4 To ensure worker It’s important to point out that hard pressed to resume full operations
safety, Luxshare makes its own Luxshare’s return to full operating without production interruptions.
COVID-19 face masks, tests employee capacity didn’t happen on its own. Given China’s educated workforce
temperatures each morning before Without Beijing’s rapid mobilization of and Luxshare’s innovative management
entry, and re-configured its assembly national COVID-19 testing, digital practices, we think Luxshare
lines to maintain China’s country-wide tracing and targeted quarantines, remains a standout inside China’s
social distancing protocols. even the best manufacturer would be electronics sector.
Craving premium experiences
For companies the world over, the chief CHINA’S CONSUMERS ARE TRADING UP
allure of China’s new economy is its Exhibit 2: Percentage of consumers intending to trade up vs. trade down in 2019
enormous, and digitally sophisticated, As of 2018
consumer class. The scale is impres- 10% 0% 10% 20% 30% 40% 50%
sive—China’s middle class could Cosmetics
surpass 550 million people by 2022.5 Spirits
At the same time, rising female labor Wine
participation is producing more dual Rice
income households eager to try new Hair Care
premium brands, healthier foods and Dairy Milk
eco-friendly products. Fresh produce
Bottled water
Although foreign brands used to capture Beer
a larger slice of China’s premium Frozen pre-cooked meals
purchases (imports were perceived as Salty packaged snacks
higher quality), a flood of new local Juice
brands is showing strong momentum. Cookies
Since 2016, upstart brands home- Carbonated beverages
grown in China grew their market share
Intend to trade down Intend to trade up
by 15%, whereas foreign brands
grew just 9%.6 They’ve largely done so Source: McKinsey Consumer Sentiment Survey; McKinsey Global Institute analysis.
by tailoring products to local tastes,
and harnessing China’s advanced China’s top 10 brands, sitting alongside Instead, Three Squirrels would focus
e-commerce technologies and online tech giants Alibaba and Huawei.7 on online customer service and (eventu-
platforms. To succeed in China, foreign By that measure, it’s done a far ally) two- or same-day delivery,
companies must do a better job better job figuring out China’s while handling the blocking and tackling
orienting their products to match millennial consumers than most global of supply chain infrastructure in
China’s distinct tastes and culture or food conglomerates. the background.
continue losing market share.
Three Squirrels founder Liaoyuan Zhang The nuts proved popular with consumers
To understand how local companies are started with an asset-light digital looking for a healthy protein punch,
capturing market share, look no further model—another hallmark of China’s confirming Liaoyuan Zhang’s asset-light
than Three Squirrels. Its success selling new economy. By selling high-quality model was profitable. To boost sales
nuts and snacks online is now studied nuts directly to consumers online, higher, the company focused on tapping
at business schools across the globe. the company wouldn’t need to into Chinese millennials’ affinity for
Founded in 2012 as a five-person own factories or manage nut farms. cute animals by creating three cartoon
startup, Three Squirrels is now one of squirrels as mascots.
Investing in China: Consumers and technology recovering 5
For Three Squirrels, its brand “experi- rates. Other than snacks, offline from home. By offering online discounts
ence” now spreads beyond its customers can buy special merchandise to grab market share, Three Squirrels
fastidious packaging and animated not available online, including Three saw its revenues jump 20%–25%
commercials to include the interactions Squirrels smartphone cases, school in the first quarter, besting many of its
Three Squirrels employees have bags, pillows and stuffed toys. The competitors. Profit margins, however,
with online customers on digital plat- strategy is less about boosting bottom- took a hit. In addition to promotional
forms like WeChat. Liaoyuan Zhang, for line profits—offline sales average charges, the costs of “contactless
example, calls himself “鼠老爹” RMB¥8 million or US$1.1 million per home delivery” spiked higher in
(Chinese for “the papa squirrel”), while store—and more about expanding the China as its logistics industry struggled
employee nicknames start with the Three Squirrels brand experience while to adapt to new lockdown procedures,
Chinese character “鼠” (the last char- collecting more customer data to stay social distancing and record demand.
acter of “squirrel” in Chinese).8 abreast of millennial trends.9 That said, we think Three Squirrels
remains an online leader in food
More recently, Three Squirrels began From the outset of China’s COVID-19 retailing, demonstrating the importance
integrating over 70 brick-and-mortar lockdown, online food purchases rock- of tailoring brands to fit China’s
locations (called Feeding Stores) in eted across China, as did the frequency consumer culture.
smaller cities with lower online shopping of snacking for middle class consumers
who suddenly found themselves working
Home-grown innovations
Twenty years ago, China’s factories were CHINA TAKES THE LEAD IN PATENTS hiring 10,000 new employees, and
very good at replicating products Exhibit 3: Percentage of “patent families” expects to have 100,000 by year-end
from overseas. Few, however, appeared by country or region 2018 globally (up from 62,000 in 2019).12
As of 2019
able to come up with their own
world-beating products or services. ByteDance is the brainchild of Zhang
To help China innovate at home, US Yiming (張一鳴), a millennial
6.8% entrepreneur who majored in software
Beijing started delivering strategic EU
7.2% engineering at Nankai University
industrial policies that aimed to catapult
China to the forefront of high-tech in Tianjin. Zhang Yiming’s early vision
South Korea for ByteDance was to harness machine
sectors. Backed by major investments 12.0% China
from Beijing, China now leads the learning algorithms to feed tailored
49.4%
world in areas like 5G infrastructure and streams of content to mobile users.
is busy patenting its own breakthroughs: Japan Many of China’s 847 million mobile
inventors in China now account for
17.5% internet users find search engines
nearly half (49%) of worldwide patents, like China’s Baidu cumbersome.13
as shown in Exhibit 3.10 With algorithms, ByteDance would keep
consumers engaged by feeding
Within the field of social media apps, Source: NCSES, special tabulations (2019) of PATSTAT, them individually tailored content. The
our team thinks ByteDance (an unlisted European Patent Office. Indicators 2020: Innovation. more time spent on ByteDance
January 2020.
tech start-up) offers one of the best apps, the more advertising revenues
illustrations of China’s home-grown it could collect.
innovations succeeding outside China. news, short videos and streaming
Recently valued between US$90 music—is positively booming.11 Indeed, Zhang Yiming’s original concept struck a
billion–US$100 billion, demand for while other companies are downsizing chord with a US venture capital firm,
ByteDance’s suite of apps—spanning in the wake of the COVID-19 recession, which gave Zhang seed capital in 2012
ByteDance announced in April it is
6 Investing in China: Consumers and technology recoveringto start Toutiao, a news aggregator TIKTOK’S SWIFT RISE TO 1 BILLLION USERS
app. After surpassing 13 million daily Exhibit 4: Monthly active users since product launch (millions)
viewers in only two years, Zhang Yiming As of November 8, 2019
secured a fresh infusion of RMB¥1.45 Users (millions)
billion (US$204 million) from more 2,500
Facebook
overseas investors, including Sequoia
Capital. Two years later in 2016, Zhang 2,000
Yiming launched a video-streaming
app in China called Douyin, followed by
1,500
its international cousin TikTok in 2017. WhatsApp
WeChat
Think globally, act locally 1,000
TikTok
Instagram
To understand TikTok’s meteoric rise
outside China, it’s important to note 500 Snapchat
how it got a head start. By acquiring the Twitter
lip-syncing app Musical.ly (founded
in China) in 2017, ByteDance gained 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Years After Launch
200 million worldwide users and a
strong following in the United States.14 Source: Financial Times Research. November 8, 2019.
After integrating ByteDance’s sophisti-
cated algorithms (which help make and is close to overtaking Facebook’s operating from home. Consider the
TikTok addictive) and slick video editing Instagram and Tencent’s WeChat in rustic cook Yeshi Xiaoge—roughly trans-
technologies, TikTok videos started China, as shown in Exhibit 4. lated, his name means “brother who
going viral. cooks in the wilderness.” After gaining
TikTok may be a global sensation, but a large following on Douyin cooking
We think a key driver of TikTok’s growth the majority of ByteDance profits still rural meals, he bottled and sold his own
spurt is its adaptability—it’s not a come from its apps in China, like beef sauce online.18
one-size-fits-all-cultures kind of app. Douyin, which evolved into a more
When a TikTok video goes viral, it’s overtly commercialized version of As a private company, ByteDance
reflecting distinct cultural factors (geog- TikTok. Browsing through Douyin videos, doesn’t publish its revenues. That said,
raphy, gender, age, local pop culture), for example, Chinese millennials can we can confirm ByteDance raked in
which vary by region and country. buy products featured in videos with a 23% of China’s digital ad spending
TikTok users in the United States, for few clicks or take virtual tours of a city’s (RMB¥50 billion or US$7 billion) in the
example, tend to skew younger (43% stores before collecting special coupons first half of last year.19 In addition,
are 16–24 years old) and female, and to use when visiting them in person. some of ByteDance’s private investors
prefer light-hearted slapstick. TikTok indicated last year’s revenues were
users in India, by contrast, skew heavily China’s home-grown consumer brands between RMB¥104 billion–RMB¥140
male, whereas South Korean users are now turning to Douyin to promote billion or US$15 billion–US$20
are largely females in their mid-40s.15 their products in creative ways. Take the billion—more than Uber, Snapchat
In China, knowledge-based content like domestic cosmetics brand PROYA, and Twitter combined.20 As investors in
cooking videos and foreign language which launched a digital campaign for China-based technology firms that
education are quite popular on Douyin, its Bubble Spa Mask last year. It compete directly with ByteDance,
and users skew slightly older (60% are invested in 200 micro-influencers with it’s important for us to stay abreast of
25–44 years old).16 large followings on Douyin to drum up its rapid evolution. By offering
sales. The Douyin campaign went technically advanced advertising solu-
Thanks to TikTok’s cultural adaptability viral, and PROYA sold 1 million boxes tions across its suite of apps, we think
(and ByteDance algorithms), the app of the its spa mask in a month, and ByteDance could grow its revenues
has eclipsed Twitter and Snapchat in RMB¥300 million in sales over and profits even further by monetizing
record time with 1 billion active users, three months.17 Douyin is also popular TikTok’s advertising potential.
among “mom and pop” entrepreneurs
Investing in China: Consumers and technology recovering 7Uptrend continues China was the first to experience class that is eager to spend, and these On top of this, the consumer base is COVID-19, and it’s the first to emerge companies are devoting their know-how diverse, with urban and rural regions from lockdown. The macro themes to fulfill these needs. For home-grown at different stages of economic develop- that shaped our China equity strategies companies like Three Squirrels, success ment exhibiting different spending last year remain intact—driving tail- requires leapfrogging over traditional patterns. However, technology and the winds that can boost company profits business models, and tailoring brands to expansion of apps and mobile and earnings power. In our view, a fit China’s distinct culture and trends. technologies are quickly bridging this variety of China’s companies are finding We view China’s consumer market gap across China. Understanding success by engineering consumer- as a force to be reckoned with—growing these dynamics in the wake of focused innovations that integrate at a breakneck pace over the past COVID-19 is necessary to find the best advanced technologies. They are keenly 20 years. We believe the uptrend local and global investing opportunities. attuned to the needs of a rising middle can continue as incomes increase. 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. 8 Investing in China: Consumers and technology recovering
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
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Investing in China: Consumers and technology recovering 9Notes 10 Investing in China: Consumers and technology recovering
WHAT ARE THE RISKS?
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factors, in addition to those associated with these markets’ smaller size and lesser liquidity. Investments in fast-
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