China has long been considered the low-cost manufacturing capital of the world given its plentiful and relatively cheap labor. Since the 1980s, many Chinese corporates had been importing “know-how” and intellectual property to manufacture sophisticated end-products, rather than cultivating in-house expertise. However, with the continued increase in Chinese wages, the focus on margins is becoming more acute. An increasing number of companies we meet have been promoting in-house innovation in an attempt to transition to a more profitable and sustainable business model.
Firstly, China is imbued with a culture that emphasizes education and, more recently, entrepreneurship. The country welcomes a staggering 8 million college graduates each year, with a rapidly-growing number of Master’s degree and PhD graduates, particularly from Science, Technology, Engineering and Mathematics (STEM) disciplines.1 We believe this giant pool of highly educated employees is essential to generating technological developments the new wave of innovation. Secondly, the Chinese government has been focused on supporting the rapid expansion and upgrade of its infrastructure and facilities, which we believe are vital to boosting labor productivity. Beijing’s Zhongguancun district was ranked as 2017’s top technology hub in the world, beating Silicon Valley, following the government’s $1.5bn infrastructure investment boost in 2016.2 The number of tech business incubators, high-tech industrial center and software industrial bases has increased at a breakneck pace over the last decade. Finally, China has seen a significant increase in research and development (R&D) expenditure in recent years, surpassing Japan and the European Union in total R&D spend and forecasted to overtake the US next year as the global leader.3 And this has had tangible results. The number of new patents granted in China has grown tenfold since 2000, faster than any other region.4 The radical improvement of in-house innovation could reduce the economy’s dependence on capital-heavy industries while precipitating the transition towards a “New China.”
Source: OECD, as of March 2018.
Just as important has been the changing consumption behavior towards higher quality, lifestyle-related spending. This has driven significant growth in the Chinese population’s spending on technology, now over 12% of the World’s total and second only to the US.5 We are also starting to see the emergence of home-grown brands that are increasingly competitive on the global stage, further supporting the Chinese economy’s transition toward higher value-add manufacturing. Companies and component-makers in industries such as smartphones, robotics, and drones have been gaining market share, leading to stronger brand recognition and pricing power. We are also seeing this growth in industries supported by global secular growth trends, such as electric vehicles, solar panels, factory automation, lithium battery manufacturing and pharmaceuticals.
Rapid innovation has also occurred in reaction to changing consumer habits and values. As mentioned in previous Viewpoints, this phenomenon has been accelerated by the rising wealth of the millennial cohort. Aided by more tech-savvy consumers, cutting-edge mobile payment systems and almost universal internet access, online sales in China have been rapidly accelerating – last year online retail grew by 36%, compared to offline sales growth of just 6%.6 This has left Chinese e-commerce penetration at over 30% of total retail, compared to less than 15% in the West.7 We expect this phenomenon to continue as Chinese government continues to focus on a gradual transition to a more consumer-orientated economy.
With China, there are often geopolitical and headline risks as well as continued governance challenges in State-dominated parts of the equity market. The recent headline proposals of US tariffs on Chinese technology goods and restrictions on Chinese STEM student visas is one such example. That said, we believe the opportunities outweigh the risks and encourage investors to look beyond short-term volatility and beyond standard benchmarks as there are a significant number of companies with unique, scalable and innovation-led business models that benefit from this structural theme. And while we do still find select opportunities in the industrials-led “Old China” economy, the vast majority of these world-beaters are coming from the “New China”. Spurred by secular growth tailwinds and the drive for innovation, these companies can, in our opinion, continue to grow substantially faster than the broader Chinese economy and generate strong returns for investors.