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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 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 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 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 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
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