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By Justin Leverenz, CFA, Director of Emerging Market Equities, Portfolio Manager and Bhavtosh Vajpayee, CFA, Senior Research Analyst
Summary: Investor perceptions are still catching up to the reality of China’s global tech leadership.
China’s rise as a global technology powerhouse is becoming broadly acknowledged, but the scale, nuance, and innovation encapsulated in that rise does not enjoy the same recognition. Indeed, many in the Western world remain fixated on a host of longstanding China stereotypes, for example, that its tech industry is thriving only because of intellectual property infringement and strict Internet regulation, known as the Great Firewall of China.The truth about China’s tech landscape is far more dynamic and, for investors, is yielding significant opportunities. In recent decades, China has essentially moved mountains when it comes to innovation, and has fostered an unparalleled technology ecosystem fueled by burgeoning competition, homegrown talent, and capital.Tracking China’s Rise as an Innovator
About five years ago, trends that emerged in China began to shape the global tech landscape, a phenomenon dubbed “reverse innovation.” As a result, Silicon Valley companies have come to increasingly regard China as the laboratory for future innovation. Notable examples include Google’s establishment of an artificial intelligence (AI) lab in Beijing, as well as an alliance between Google and Tencent focused on cloud services.For a comparison, consider the growth in market value of Internet platforms in the United States and China. Circa 2013, Amazon, Google, and Facebook had a combined market capitalization approaching $500 billion. In contrast, China’s Tencent and Baidu together amounted to just over $100 billion, and Alibaba’s IPO was still a year away. Since then, the combined value of Amazon, Google, and Facebook has risen approximately 5x, but the combined value of Tencent, Alibaba, and Baidu has risen approximately 9x. Without Alibaba, the collective value of Tencent and Baidu has still risen 5x.An investor in China tech would thus have enjoyed twin benefits – the growth of existing publicly listed platforms, and the opportunities arising from new listings, the number of which appears set to accelerate.In 2013, China’s contribution to the global creation of unicorns (private companies valued above $1 billion) was negligible, while the United States accounted for a 75% share. In 2017, China created one-third of the new unicorns globally, (CB Insights, 2017) and 7 of the top 10 in terms of market capitalization. (Exhibit 1) Of the world’s six largest private tech companies valued at more than $30 billion, four are from China: Ant Financial, Didi-Chuxing, Toutiao, and Meituan (Uber and AirBnB are the other two). 1
The Key Drivers of China’s Tech Surge
China and the United States have three macro variables in common: enormous pools of talent, deep and large reservoirs of capital, and continental-size markets that permit massive scale. The intersection of these variables has enabled the propagation of unicorns in both countries, but it is the uniqueness of the market context within China that has spurred the adoption, breadth, and profitability of these businesses.In our view, the secret to China’s technology surge lies in three interlinked factors: (1) the legacy of traditional infrastructure and the consequent opportunities to “leapfrog,” (2) the innovation within business models that created solutions tailored for China’s realities, and (3) the speed and intensity of user adoption that has driven enormous growth and capital to fund this transformation.1. Legacy of traditional infrastructure.
Offline retail space in the United States is plentiful – about 50 square feet per person (Cushman & Wakefield, 2016). In China, that number is less than one square foot per person (Haver Analytics and Bernstein Research, 2017). It should come as no surprise, therefore, that e-commerce penetration in China is in the high teens, about twice that of the United States. 2 What’s more, about 40% of incremental growth in retail sales is happening online, pointing to a likely doubling of e-commerce penetration in coming years.Meanwhile, the average number of credit cards owned in the United States is about 2.5 cards per capita and 4.0 per household,( Statista, 2016 data) about 10 times the number in China. Thanks to the widespread availability of mobile payments, Chinese users now pay with cash less than one-third of the time 3 and one-sixth of urban residents no longer consider it necessary to carry a wallet. 4 (Exhibit 2)
Legacy issues exist in businesses too. China’s per capita information technology spending is about one-eleventh of the United States’, (EITO, Statista, 2016) but with the country’s median age approaching 40 years, China is on a rapid drive to embrace automation and productivity tools. Enter cloud computing, which is being embraced by small and medium enterprises (SMEs) on a mass scale, leapfrogging the era of client-server hardware and ERP platforms. With over 40 million SMEs, 5 China’s industrial and services base is uniquely fragmented, creating further demand for platforms that enable businesses to reach their user base.In parallel, China’s technology companies have developed unique business models. The silos of e-commerce, social networks, and search seen in the Western world apply only partially in China. Examples of flexibility within business models in Chinese companies abound.2. Innovation within business models.
Alibaba is the world’s largest e-commerce platform – its gross market value (GMV) of $768 billion in the year ended March 2018 dwarfs Amazon’s global GMV by a factor of more than 2.5x.6 But Alibaba is also the world’s third largest advertising platform, after Google and Facebook.Elsewhere, Tencent may be the largest gaming company in the world, while also boasting over a billion monthly active users (MAUs) on its social networking platforms, but its business goes well beyond this. The company’s WeChat platform pioneered the concept of the “super-app,” a veritable operating system for daily life in China, facilitating entertainment, communication, e-commerce, travel, and lifestyle services all at once.Meituan, China’s largest food delivery platform, is also its largest domestic hotel booking service by volume.China’s online video businesses bring together both ad-supported (as with YouTube) and subscription services (as with Netflix) under one roof. Facebook may have struggled with video, but in China, Douyin – a short video platform introduced by ByteDance (also known for its Toutiao news app) – rose to 500 million MAUs in just two years. ByteDance, a business founded in 2012 with no backing from China’s technology behemoths, now owns 10% of all mobile app time in China (QuestMobile, June 2018).And Pinduoduo, a “social commerce” platform founded in 2015, recently listed at a value north of $20 billion, having grabbed over 300 million active shoppers in under three years.3. Speed and intensity of user adoption.
The third credit for China’s tech surge goes to its users. China’s nearly 800 million-strong Internet user base is unique in the speed with which it adopts new modes of living, communication, and entertainment. Consider payments. Alibaba’s Alipay mobile payment platform counts over 500 million users. But less well known is that over 300 million users also use it for wealth management, 400 million for insurance, 100 million for financing, and 260 million for credit profiling! 7 (Exhibit 3)
In e-commerce, consumers in most countries show a propensity for buying electronics and books online. Broaden the categories, and Chinese users stand out. For example, 85% of Chinese users are willing to buy beauty products online, versus just 50% of users in the United States. For household items, the Chinese propensity to buy online is 84%, versus 36% in the U.S. 8There are other differences too. On average, the Chinese spend 160 minutes a day watching linear television (including multi-tasking), well below the U.S. average of 240 minutes (Bernstein Research, January 2017). China may be an attractive box office for Hollywood, but the numbers tell a different tale – each year, per-capita cinema visits in China are well under 1.0x, (IECONOMICS, for 2016) less than one-third of the U.S. average. It is no surprise that unique opportunities in entertainment have emerged online in China, and its technology businesses have been quick to respond.An Evolution that Comes with Challenges
What’s next? China’s innovation and creativity will continue to evolve, as will its ambition. Frontier technologies around AI, autonomous driving, drones, and associated areas (such as facial recognition at scale) are the new ground zero. In 2016, China accounted for only 12% of global funding in AI startups (CB Insights, 1Q2018 update). In 2017, it leapt to a 48% share, well ahead of the United States’ share of 38%. (Exhibit 4) From 2016 to 2017, investments in facial recognition technology jumped six-fold. Between 2015 and 2017, there were 64 China-backed equity deals to U.S. AI startups. The reverse flow from the United States to China amounted to only 28 deals (CB Insights, 1Q2018 update).
But this also brings new challenges. For example, China lags quite significantly in semiconductor knowhow, in some areas by a factor of 6x-10x.9 Additionally, China needs to build and retain its AI talent; studies indicate that the country has, at best, half the number of AI experts versus the United States. 10 And finally, geopolitical concerns may limit Chinese investments into the United States and technology transfers between these twin hubs of global technology.This makes for an interesting future, but from the base that China has already reached, we view the road ahead with optimism. Within the Emerging Markets Equity Team, we believe that our early and deep involvement in the rise of China’s technology ecosystem has provided an edge that we seek to build on.________________________________
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