Download China`s Consumer Industry: Find the Innovators, Don`t Just Play the

China's Consumer Industry: Find the
Innovators, Don't Just Play the Trend
June 17, 2016
by Jerry Zhang, Ph.D., CFA, and Derrick Irwin, CFA
of Wells Fargo Asset Management
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.
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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.
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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
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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-productcompany 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.
Original blog post.
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The views expressed are as of 6-8-16 and are those of Jerry Zhang, Ph.D., CFA, and Derrick Irwin,
CFA, and Wells Fargo Funds Management, LLC. The information and statistics in this report have
been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or
complete. Any and all earnings, projections, and estimates assume certain conditions and industry
developments, which are subject to change. The opinions stated are those of the authors and are not
intended to be used as investment advice. The views and any forward-looking statements are subject
to change at any time in response to changing circumstances in the market and are not intended to
predict or guarantee the future performance of any individual security, market sector or the markets
generally, or any mutual fund. Wells Fargo Funds Management, LLC, disclaims any obligation to
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publicly update or revise any views expressed or forward-looking statements.
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of Wells Fargo & Company. Wells Fargo Funds Management, LLC, a wholly owned subsidiary of
Wells Fargo & Company, provides investment advisory and administrative services for Wells Fargo
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