Upwardly Mobile In China

“China is shifting from exporting to importing,” Jack Ma, the CEO of Chinese ecommerce giant Alibaba told an audience of 3,000 small business owners in June. “China is going to be the world’s largest consumption place, and that engine is going to drive the world economy.”

Ma implored the audience to not just think about importing from China, but exporting to it as well. So great was the emerging potential purchasing power that Ma pledged to newly elected President Trump in January that Alibaba would create 1 million US jobs by allowing small and medium-size businesses to sell to China through the company’s platforms.

Ma is right to point out the watershed moment, and savvy investors are also positioning themselves to take advantage of China’s booming consumer class. Fueled by rising wages, new attitudes, and government policy to diversify away from China’s investment and export growth model, consumer spending has been surging. The Boston Consulting Group projects consumption to grow 9% annually through 2020, and notes that per-capita income in China has been increasing at an 11% annual pace since 2010. The rebalancing of the Chinese economy continued in the first half of 2017, with consumption accounting for 63.4% of GDP growth compared to 44.7% contribution during the same period in 2010, according to Matthews Asia.

The challenge for investors: identifying how best to tap into the trends stemming from the upwardly mobile Chinese consumer, while avoiding the myriad of risks that come from investing in the country. They include often poor corporate governance and volatility driven by hot capital flows. Then there is the geopolitical dimension, as Beijing juggles border disputes with India, an increasingly chaotic North Korean regime, and a contentious Trump administration.

Accessing the trends created by the rising Chinese consumer, though, continues to be the focus for investors this year. “Still the world’s best consumer story,” Andy Rothman, an investment strategist at Matthews Asia, wrote in his most recent research note in July. “Strong wage growth, low household debt, mild inflation, and consumer optimism resulted in real (inflation-adjusted) retail sales growth of 9.3% in 1H17. This compares to US real retail sales growth of 2.3% during the first five months of the year, and we note that while spending by Chinese consumers was equal to only 22% of US retail sales a decade ago, it was equal to 87% of American consumer spending last year, and is likely to surpass US retail spending by the end of the decade.” Rothman also noted that “per-capita urban household income rose 6.5% in 1H17, up from a 5.8% pace during the first half of 2016, driven by improved profitability of industrial firms.”

Those trends are enticing forward-thinking investors.

“We’re looking at the developing Asian consumer, including the rise in discretionary spending and that development of spending habits. Pockets we sought, therefore, were opportunities within the growing discretionary consumer segment. Such services would include cosmetic and beauty, dental, healthcare, and food and retail services,” said David Holmgren, the CIO of Hartford HealthCare, which manages $3.1 billion in assets. “Similarly, we felt the rise in consumer services would encourage related business services tied to this growing consumer discretionary spending. That would include things such as FinTech for everything from finance lending services, payment processing services, labor mobility services, healthcare record services, and so on.”

Holmgren wanted to take a surgical approach to consumer trends. “We’re a pretty active investor and perusing specific opportunities and themes, so for our approach, we’ve not expanded any overweight to listed Asian equities or credits as a way of limiting market and valuation risks,” Holmgren said. “In keeping with our investment philosophy, we’re pretty active in avoiding beta risks. So, we’ve chosen select private market approaches, which we believe are highly selective and best positioned to capture interesting opportunities and trends, while not being overly tied to the general market.”

For Holmgren, that meant partnering with private market managers such as GGV Capital and Trustbridge Partners, and that the firms “exemplify the caliber and niche of our Chinese growth holdings.” Holmgren said Hartford HealthCare commits roughly $20 million to each fund selected, and then a similar number to each vintage.

Identifying the right funds to invest in—and actually being able to execute the investment, however—is another major challenge.

“Clearly, the issue most LPs face is the hurdle of identifying and knowing the right partners. Even after those knowledge-based hurdles, LPs still need to be accepted by the GPs, which in itself is no easy feat given the best of the best often have a lot of demand and fund capacity can be rather scarce, especially when considering niche plays like the ones we’ve seen as the greatest opportunities,” Holmgren said. “Therefore, we likely spend an equal amount of time and resources getting to assess the investment landscape as we do the investment partners.”

Identifying the right manager is especially difficult given the high number of private managers focused on the region as activity booms. Asia saw record levels of deal-making in the second quarter—550 deals worth a total of $22 billion were announced, almost half the global total by value, according to Preqin. It marked the fourth time in six quarters in which Asia has surpassed North America to become the highest region for venture capital-backed deal value. North America saw 936 deals worth $19 billion. China, meanwhile, also saw the largest venture-backed deal ever recorded, with the $5.5 billion financing of ride-sharing company Didi Chuxing in April. The stakes in partnering with the right manager, meanwhile, are very high given the long-term nature of the commitment.

“Given the large size of the Chinese VC and PE space, we’ve had to spend a great deal of time getting to know the teams to figure out which best align with our growth thesis as well as have the presence and talent to selectively capture the trends,” Holmgren said. “As a general rule, since we’re overly conservative, we’ve generally avoided first-time funds in China, and that strategy then allows us to evaluate the GP’s investing partners experiences, connections, disciplines, reputations, and more as we place our greatest weight on backing the right people. Successful long-term investing requires partnering alongside aligned GPs, and it’s here we tend to spend the long hours getting comfortable, as otherwise the lack of knowledge would be a huge risk as misalignment always leads to underperformance and unwanted turnover.”

As a rising consumer class embraces technology, the excitement is evident in listed markets as well. Chinese consumer stocks such as 58.com (WUBA), Weibo Corp (WB), Baozun Inc. (BZUN) and Momo Inc. (MOMO) were up 140%, 138%, 120%, and 94%, respectively, from the start of the year to the end of August.

A fast-follower dynamic where Chinese companies are able to replicate US technology and internet business models as a growing number of Chinese consumers come online and gain purchasing power is fueling some of the gains for Chinese companies, points out Robert Horrocks, chief investment officer and portfolio manager for Matthews Asia.

“Over the last few years as a lot of these businesses grew, they could see what the big names in the US are doing and say ‘we can do that in China’,” Horrocks said. “You can get tremendous scale if you dominate these virtual worlds, along with knowledge and data about consumer behaviors, and that can drive a very high amount of revenue.”

Art by Brian Stauffer

Moreover, Chinese authorities are willing to allow businesses even more scale than their US counterparts as fewer players allows for more-centralized regulations on information. “With China’s regulatory regime and the party’s desire to control and monitor information flow, it’s easier to create monopolistic business there than elsewhere in the world, provided you are willing to give over more control to the authorities,” Horrocks said.

There is also an element of China leapfrogging the US in terms of technology in some regards, Horrocks said. The use of mobile phones as primary internet access devices is more widespread, and people are far more comfortable shopping on phones and purchasing games.

But investors seeking to leverage these trends—or invest in the Chinese markets more broadly—need to take some important risks into account, Horrocks said. Volatility and corporate management are chief among them.

Volatility is driven not just by monetary and economic cycles, but by momentum from investors and speculators who are often in pursuit of hot money gains. Investors should have the stomach to ride out these swings. “It’s easy to get attracted at the top of the market, but you need to think about the long term so as not to get scared out at the wrong time.”

Evaluating corporate management and its motivation is another tall order, Horrocks said. Many businesses are run more like sports franchises with many priorities above generating profits for shareholders. “If you look at a sporting team like the Yankees or Real Madrid, they are not out for profits but to win games and create a sense of legacy and pride,” Horrocks said.

Corporate management in China often similarly prioritizes items like the legacy of the founder and creating employment above generating returns for shareholders. “It’s key to understand the management of a company,” Horrocks said. —CIO