INCOMPARABLE CHINA Lawrence Burns, Investment Manager

INCOMPARABLE CHINA Lawrence Burns, Investment Manager. First Quarter 2018

THIS PAPER IS INTENDED SOLELY FOR THE USE OF PROFESSIONAL INVESTORS AND UK INTERMEDIARIES AND SHOULD NOT BE RELIED UPON BY ANY OTHER PERSON. IT IS NOT INTENDED FOR USE BY RETAIL CLIENTS. – Incomparable China Baillie Gifford

IMPORTANT INFORMATION AND RISK FACTORS

The views expressed in this article are those of This article contains information on investments which Lawrence Burns and should not be considered as advice does not constitute independent research. Accordingly, it or a recommendation to buy, sell or hold a particular is not subject to the protections afforded to independent investment. They reflect personal opinion and should not research and Baillie Gifford and its staff may have dealt in be taken as statements of fact nor should any reliance be the investments concerned. placed on them when making investment decisions. All information is sourced from Baillie Gifford & Co and is current unless otherwise stated. Potential for Profit and Loss The images used in this article are for illustrative purposes All investment strategies have the potential for profit and only. loss, your or your clients’ capital may be at risk. Past performance is not a guide to future returns.

Stock Examples

Any stock examples and images used in this article are not intended to represent recommendations to buy or sell, neither is it implied that they will prove profitable in the future. It is not known whether they will feature in any future portfolio produced by us. Any individual examples will represent only a small part of the overall portfolio and are inserted purely to help illustrate our investment style.

Baillie Gifford holds the following stocks: Alibaba, Amazon, Baidu, Ctrip, Meituan Dianping, TAL Education, Tencent.

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LAWRENCE BURNS Investment Manager

Lawrence graduated BA in Geography from the University of Cambridge in 2009. He joined Baillie Gifford the same year and has spent time working in both the Emerging Markets and UK Equities departments. Lawrence is a co-manager of the International Concentrated Growth strategy as well as a member of the EAFE Alpha Portfolio Construction Group. He is involved in both listed and unlisted investing and travels extensively researching his particular interest in how pervasive technology and China are changing our world.

3 – Incomparable China

I NCOMPAR ABLE CHINA

BY LAWRENCE BURNS

As I waited for my flight home from China, my eyes drifted to the large television screens in the departure hall. There was Nicole Kidman live at Alibaba’s annual shopping gala, part of the company’s build up to the world’s largest shopping event (Singles’ Day). She was introducing the man I and my colleague James Anderson met just hours earlier – “the incomparable Jack Ma” – to a live television audience twice that of the US Super Bowl. Indeed, few visionary founders are able to captivate their audience the way Jack Ma can. Fewer still can do so with Michael Jackson dance moves, singing ballads and by starring in Kung Fu movies, with 100 million online views and counting. It’s a unique combination of serious vision and entertainment, but it works.

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Jack Ma at the Gong Shou Dao opening match in Beijing. © Getty Images AsiaPac. 5 – Incomparable China

Jack Ma is undoubtedly incomparable but then so too is China. The numbers of Alibaba’s Singles’ Day provided sufficient testament to the uniqueness of both. Within 24 hours Alibaba had sold over $25 billion (up 39% year on year), 3.5 times more than was sold in the entire US on Black Friday and Cyber Monday combined the year before. At its peak, Alibaba was processing 325,000 orders per second, and routing 256,000 payments a second through Alipay, its online and mobile payment platform. It then falls to its logistics platform, Cainiao to ensure delivery of the resulting 812 million packages in the days following At its peak, Alibaba the event.

was processing These numbers dwarf anything that America has ever produced and requires a complete shift in mindsight 325,000 orders on the part of investors with regard to where China is heading, the scale of companies that will arise and their per second, and ability to compete and even dominate globally. For years, we at Baillie Gifford have been in awe of routing 256,000 China’s scale and its ability to use technology to accelerate growth and leapfrog in areas such as retail payments a second and finance, but this bypasses even our erstwhile expectations of what can be achieved. It is no longer to through Alipay, its do with cheap manufacturing, nor avoiding the middle income trap, nor even China merely catching up. In the online and mobile 21st century, China has structural advantages that other countries can only dream of and this should be payment platform. prompting us to ask ourselves bold questions, along the lines of, why can’t China’s GDP per capita catch up with America? And what, if anything, prevents this century from being one in which China leads both in innovation and company creation with even greater ease than their western counterparts?

By taking a closer look at China’s structural advantages, through the eyes of its business leaders, one is provided with a compelling case for why China should be the main hunting ground for exceptional growth companies in the decade ahead.

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Worker at small parts manufacturing factory in China inspecting microchips.

7 – Incomparable China

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As Liang also pointed out, it is the companies could eventually lead mass adoption of models such as globally, because they will be able these, that so wonderfully blend the to invest more in technology and digital and physical world, which get back more in data than foreign SCALE AND has made China’s payment systems companies could justify in their own more advanced than anywhere in smaller home markets. Zhang mused DENSITY the world. Mobile payments are over that American consumer service 50 times that of the US at $5.5 trillion companies had been able to dominate and Tencent’s WeixinPay, for example, on the world stage because their home already accounts for 29% of all of market was the world’s largest, but Starbucks sales in China. Meanwhile that accolade is increasingly falling Alibaba’s Alipay allows you to pay to China. Moreover, in an ever more China’s primary advantage is clearly through a smile at KFC in Hangzhou digital age, the advantage of a large scale. A population of 1.4 billion with through facial recognition. home market is becoming even a GDP per capita of $8,000 means that greater. Serving more students China has already become the world’s The advantages of urban density allows TAL to gather more data and largest market for various products will of course only increase. China’s to improve its product in ways that and services. James Liang, who is the urbanisation rate is 56% compared to other companies will struggle to keep founder of Ctrip and is writing a book 70%–80% in the US. Migration into pace with. on urbanisation, made the point that the cities will only continue and is it was the density not just the scale of being actively encouraged in lower Ctrip’s founder, Liang echoed the China that matters. The East Coast of tier cities. view that China’s size provides China provides a single homogenous an incentive to invest heavily in TAL Education is but one example technology because the returns to scale market without compare. There are of a Chinese company that intends to no fly-over states and it is far more support it. China’s scale and Ctrip’s reap the rewards of operating in the corresponding technology investments of a singular market than the US or world’s largest market, in its case, the Europe. China has 160 cities of over a mean their product is now at least as after-school tutoring market. When we good as Priceline, if not better. This is million people compared to America’s met TAL’s founder, Bangxin Zhang, mere 10. If New York was in China it creating the foundations for Ctrip to his opinion was that, in education expand and compete globally. would only rank as the seventh largest and other service industries, Chinese city after Shenzhen.

China’s super cities, with their dense concentrations of population, slash frictional costs. The cost of delivery services is far lower due to labour costs but also shorter distances. Migration into the cities Enterprising students order not just their breakfast, lunch and dinner on will only continue and is the food delivery app Meituan, but all their snacks in between. And Didi is being actively encouraged possibly the only car hailing app in the world where relying on it is already in lower tier cities. cheaper than private car ownership.

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STEPPING FURTHER AFIELD

This ambition to globalise was one of the trip’s striking themes. Ant Financial indicated that it was looking to acquire two billion customers, a credible goal given that it already boasts a staggering 450 million. Given their resources, technology and business model that allows for transactions at around 50bps, compared to around 300bps for Visa and Mastercard, I wouldn’t want to bet against them. Likewise, while it might be little known in the West, Toutiao, which runs a Beijing-based news content platform, already has 100 million users a day and a valuation of $20 billion. It too is taking its new monetisation model for news media global, having leveraged the data insights from hundreds of millions of users in China to train its machine learning algorithms to tailor users’ individual content feeds, ensuring the right articles (and adverts) are put before the right users.

Artificial intelligence, in particular, was highlighted as a development that would strongly reward China’s scale advantage. Baidu’s Chief Operating Officer Qi Lu was adamant that he came to Baidu because he believes China has powerful advantages in this field. In the artificial intelligence revolution, data is the fuel. Therefore, in having not just the largest population but the largest internet population (720 million versus 290 million in the US) China has a distinct advantage. Its data sets are larger and, as such, its machine learning programs should be superior. All that time spent on Alibaba, Baidu and Tencent will not be wasted.

Furthering this advantage, Qi Lu highlighted that China’s regulatory environment on data sharing is more lax, allowing data to be collated and harnessed. This is underpinned by a different cultural attitude to data privacy. For example, only 38% of Chinese people even consider health and genetic data to be private. This greater ability to collect data only augments the scale advantage even 10 further. If, as he foretells, the primary means of production will become data, then China will have more of this The Tencent booth at the Sportel Asia Conference in Singapore resource than anyone else. Some believe that China’s data © Getty Images AsiaPac. First Quarter 2018

edge may be even more powerful than its manufacturing …Alibaba, Tencent edge has been. and Baidu are not just More broadly China’s approach to technology is aided by the implicit recognition from both government and tolerated but embraced business leaders that technological solutions are a necessity to solve the challenges China faces. The need to address even as they disrupt financial inclusion, environmental degradation, healthcare and education and to rebalance the economy towards state run enterprises. consumption are forcing companies to innovate, leading to new models and new technologies. This is why Alibaba, Tencent and Baidu are not just tolerated but embraced even as they disrupt state run enterprises. This stands in notable and rather stark contrast to US tech where the relationship with government appears more strained.

Scale and technology therefore appear increasingly symbiotic. Scale makes it more rewarding to invest in technology, and technology appears to be making scale a more valuable asset. Smartphones and mobile infrastructure have, for the first time, closely connected a market of more than a billion people, turning China’s large population, something that otherwise may have been disconnected and difficult to exploit into a highly exploitable asset. Indeed, it has never been so easy or quick to address a market of this size, with technology empowering both large companies and countries to coordinate their vast resources and people in ingenious ways, all of which will help to unleash the full potential of enormous workforces and large markets.

We also see this at a company level, where structures have evolved from rigid command and control centres built on military principles to ecosystems and networks where millions of individual participants can be informed, even directed, by data. This is allowing for the creation of larger and more valuable companies with China’s largest internet platform companies already growing in excess of 50% year on year each from a huge base. It also arguably underwrites the potential for them to become trillion dollar plus companies. These are organisations that differ from the traditional firm model and therefore we shouldn’t automatically expect them to suffer the same limitations of size that others have. For example, Jack Ma was adamant that it would be impossible for Alibaba to directly employ the millions of personnel needed to deliver those 800 million plus parcels generated on 11 November. But with Cainiao acting as a network, it is possible to forge a new model, allowing them to coordinate and direct dozens of 11 logistics companies. It should be no surprise that Cainiao is shaping up to be a vital and important network, just as Alibaba is in retail and Ant Financial is in finance. – Incomparable China

AN AMBITIOUS MINDSET

The other factor that should cause us to raise our expectations for what China can deliver is the mind-set and approach of the Chinese people. In the US it has taken over three decades for income per capita to double. In China it has taken just seven years and this pace of change has existed for the last 40 years. This is a country used to huge opportunities and rapid changes in lifestyle and consumption.

I think this leads people to have a far more positive outlook on the future. It has also created an incentive to work hard, both because so much is up for grabs and to avoid being left behind. It also creates a greater adaptability and open mindedness to change. The Chinese experience is one of dramatic change and, in a world of accelerating technological change, this is likely to be an increasingly helpful background.

The difference was laid out starkly by the head of Peking University’s business school. When visiting the US he hears how hard it is to attract 40 year old American professionals to go back to school and study. They all think they should be teaching. In contrast, in China they find it easy to recruit large numbers of successful professionals, and even founders, eager to continue learning. We surely should not underestimate the drive and importance placed on education or the …in China they find it fact that by 2030 China will have 200 million graduates fuelling its progress. easy to recruit large numbers of successful professionals, and 12 even founders, eager to continue learning. First Quarter 2018

GREAT EXPECTATIONS

The message of this trip for me was What was also clear from our that China was not simply playing interactions in China was the growing catch-up with the West. China’s scale confidence that technology would advantage is growing, and technology, provide the solutions needed to in the form of mobile infrastructure retool and reimagine a range of and now artificial intelligence, industries. This should provide an is making that scale advantage more increasing number of new investment valuable than ever before. opportunities for us in the years ahead. The case for automotive is perhaps Beyond the immense domestic the clearest but advances in artificial opportunity, China is now well intelligence and virtual reality mean positioned to take a number of there is a growing case for education business models global. Alibaba’s too, even if one accepts this will be far model is different, but is surely at more difficult. There is also the distinct least the equal of Amazon, and the recognition that China needs a different advantages of Ant Financial’s model healthcare model and that it will have are even clearer in the face of vastly to turn to technology to provide that less impressive Western competition. answer. Pleasingly, there already Tencent might not be as wide in reach appears to be a second tier of Chinese as Facebook but it is undeniably internet companies coalescing – Ant deeper in engagement and utility. Financial, Didi, Meituan and Toutiao, The aim of these companies is to enter all four of which could become public developing markets first, where the in the years ahead. similarities are greater, but make no mistake, their long-term ambitions include the developed world as well.

Food delivery workers from Meituan, an e-commerce company, gather for their daily briefing in Beijing. © Andy Wong/AP/REX/Shutterstock. – Incomparable China

CONCLUSION

It is hard to overstate the importance of China for our clients and for global equity markets generally. We believe that equity returns are driven by a small number of big winners, and that China is the best place to find the next generation of these rare gems. Limiting exposure to China, or worse not to have any at all, would undermine the core of our philosophy. Limited ability to invest here could even turn out to be the single greatest risk to long-term performance. Articulating a different view from the market has never felt easier. The view of Wall Street seems to be that China is a perennial risk rather than an opportunity. Undoubtedly, this is in part because the thought of China eclipsing America is an intolerable prospect for many. The Western world is seemingly doomed to underestimate China, because it cannot accept its rise without abandoning its unwavering faith in the universal power of its own values. Belief in China challenges one’s belief in the supremacy of liberal democracy as the ultimate form of government and as a prerequisite for progress and greatness. This makes the opportunity for us even greater still. If we assume that China can be as prosperous as the US and that its companies can globalise, then the investment outcomes will be

14 immense and our projections will ultimately be blown away. First Quarter 2018

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