How to track China’s fast-changing consumer sector
by Olivia Barbee, Wells Fargo Asset Management
Today we have a guest post by Jerry Zhang, Ph.D., CFA, and Derrick Irwin, CFA, of the Wells Fargo Emerging Markets Equity Fund.
China’s shift toward consumer-facing industries might be capturing the market’s imagination. But for investors, there’s more to the story. To capture the right opportunities, you need to know which companies in China are reimagining themselves and their product offerings to meet the shifting behaviors and preferences of the country’s consumers.
China’s consumer sector: Not a straightforward trend
Much has been written about the need for China to transition its economy away from investment-driven growth and toward a more service- and consumption-oriented economic model. Often, this is discussed in terms of a transition that is barely beginning. In fact, China’s economy is well down the road toward this goal, and services and consumption now account for more than half of China’s gross domestic product and are growing more quickly than traditional, investment-led industries.
Nevertheless, China’s economy has a long way to go before services and consumption approach developed-world levels, suggesting that this investment theme will be an important one for a long time.
Playing this trend is not straightforward. China’s consumer sector is rapidly evolving and intensely competitive. Unlike developed markets, where major consumer-product companies are entrenched (think General Mills or Coca-Cola), or even other emerging markets where consumer-product companies have been established for decades (Hindustan Unilever in India, for instance), there are few national champion consumer companies in China.
In China, tastes are rapidly changing and distribution models are moving quickly from local shops to more-formal retail and internet channels.
On the logistics front, thanks to the country’s e-commerce boom, the Chinese package-delivery industry has been growing at 30% a year, according to McKinsey. Meanwhile, competition for China’s consumer-facing companies now comes from a mix of local, regional, and international players.
Thus, investing in the Chinese consumer requires a deep understanding of:
- Individual business models
- The competitive landscape
- Whether a company can innovate fast enough to succeed in the Chinese market
Why innovation matters in China’s consumer sector
One of the key challenges investors must understand in the Chinese consumer sector is the critical need for innovation. This is well known in most developed countries, and top consumer brands are constantly innovating, from a consumer-staples company that retools its product portfolio to meet customers’ changing tastes and health concerns to a consumer-electronics company that rethinks its marketing strategy to capture new customer segments.
In China, consumer-product companies have historically relied on their distribution networks and value propositions to protect market share. If they could cheaply produce standardized products and get them to the thousands of local retail shops, consumers were satisfied.
However, as the internet has exploded in China and a younger generation of consumers has emerged, competition has increased and innovation has become paramount. According to McKinsey, China’s online retail market is the world’s largest, nearly 80% bigger than the United States, with approximately $630 billion of sales in 2015.
Consumers now want quality and assurance of value, not just the cheapest product available. Two things are clear: The consumers have money, and they want to buy quality. With the internet undermining traditional distribution channels and consumers looking for quality, new winners are emerging and leaving less-nimble players behind.
For example, within China’s consumer discretionary sector, a private-education company saw an increase in enrollment rates after it launched new information technology systems that improved the level of interaction between its teachers and students. This is an example of a company that didn’t simply rest on its laurels, waiting for the positive effects of increased consumer income and spending. It invested in innovation to ensure quality and competitive advantage.
Conversely, a long-standing leader in China’s food and beverage industry is seeing a lack of product innovation weigh on earnings. This company, which offers ready-to-drink teas, juices, and bottled water through a subsidiary, has lagged behind as Chinese consumers increasingly gain access to other convenient food products, including ordering dishes on their phones or bringing home restaurant takeout. Meanwhile, its competitors have introduced beverages with lower sugar content or higher nutritional content to meet evolving consumer tastes.
Companies such as these will need to focus on innovative products and marketing skill in addition to the fundamentals of supply-chain management and cost control.
As consumer trends evolve, so must routes to market and infrastructure
Second, in the face of a rapidly changing consumer landscape, many Chinese companies still rely on inefficient routes to market. Consumer companies have historically sold to several layers of distributors, who have then shipped the goods to retailers. In the developed world, this model has been streamlined through the use of technology or eliminated altogether through alternative distribution models. China lags behind in this regard.
Furthermore, the challenges of distribution are compounded by China’s size and sometimes challenging rural infrastructure. Evidence of this can be seen in much larger swings in certain companies’ sales when compared with end-user purchases. Poorly managed supply chains can lead to massive inventory buildup and exaggerated stocking and destocking cycles, making consumer-product-company earnings surprisingly volatile. For instance, a noodle company might see sales fluctuate 10% while retail sales (end-user demand) only changes 2%. Thus, as much attention must be paid to supply-chain issues as to product innovation. Again, only by understanding the underlying business models can an investor make an informed decision about the opportunities in the consumer sector.
Over time, it is likely that national champion consumer companies will emerge, and they will create significant value for shareholders. As with all immature markets, from the early U.S. automotive industry the first part of the past century to the dot-com boom of the 1990s, there will be winners and losers. It is not enough to simply buy the sector or play a theme. China’s high level of competition and shifting nature of consumer tastes means that picking such long-term winners will be challenging and will be a task for active managers.
Copyright © Wells Fargo Asset Management
