Investing in China: Consumers and Technology Recovering

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 opportunities 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 gone unnoticed by Apple. In addition to annually in natural sciences and make it happen.” (使命必达 ) To boost 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 chargers, 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

When Apple first sent its engineers to 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, 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 able to come up with their own As of 2019 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% Beijing started delivering strategic EU entrepreneur who majored in software 7.2% industrial policies that aimed to catapult engineering at Nankai University 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 learning algorithms to feed tailored from Beijing, China now leads the 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 17.5% inventors in China now account for internet users find search engines 13 nearly half (49%) of worldwide patents, like China’s Baidu cumbersome. 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 Of ce. Indicators 2020: Innovation. more time spent on ByteDance tech start-up) offers one of the best January 2020. 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 recovering to 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 1,000 Think globally, act locally 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 12345678910111213141516 200 million worldwide users and a Years After Launch strong following in the United States.14 Source: Financial Times Research. November 8, 2019. After integrating ByteDance’s sophisticated 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 17 record time with 1 billion active users, three months. Douyin is also popular TikTok’s advertising potential. among “mom and pop” entrepreneurs

Investing in China: Consumers and technology recovering 7 Uptrend 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 investment 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.

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Stephen H. Dover, CFA Manraj S. Sekhon, CFA Michael Lai, CFA Vivian Chen Xushan Tony Sun Head of Equities Chief Investment Officer Portfolio Manager Senior Research Analyst Research Analyst Franklin Templeton Franklin Templeton Franklin Templeton Franklin Templeton Franklin Templeton Emerging Markets Equity Emerging Markets Equity Emerging Markets Equity Emerging Markets Equity

Investing in China: Consumers and technology recovering 9 Notes

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