Notes from a road trip to China 

There was much fanfare around China reopening in 2023, but as the macro headlines suggest, the recovery has been underwhelming. Analyst Mendy Zhang found quite a different story when travelling around China last month.

13 July 2023. Having not been back to China since December 2019 I planned a trip to visit companies that have been less accessible during the lockdown.

This involved going to the likes of Moutai Town, GuiYang, Chongqing Fuling County and Heifei, in addition to the better known-known locations such as Shenzhen, Hangshou and Hong Kong. I make some additional observations below, but my main take away was that beneath the bonnet that structural growth opportunities have continued to compound away. The other key observations I would make are based around self-sufficiency, SOE reform/shareholder rights and premiumisation.

Self-sufficiency

China’s eagerness to replace foreign goods with domestic products is well known, but is it happening in reality? From what I saw, there is no doubt that domestic replacement remains the most prevalent trend across multiple industries, and this should continue to drive a steady level of growth. For instance, Kingsoft, whose Office application software is gradually replacing Microsoft Office in China.

To give some context, there are 240 million domestic PC users in China, of which only 31 million are paying subscribers. Within this 31 million, around 10 million are short-term users who exit after a week or month of use, and around 20 million are stable long-term paying users. If Kingsoft is successful in incentivising users to become long-term subscribers, the company has a significant growth runway in front of it.

Another instance of domestic replacement can be found in the form of Glodon, which makes software for the construction industry, is gradually replacing Autodesk in China. The company has recently unveiled its ninth three-year plan, focusing on infrastructure as China expands its transportation network and renewable energy power plants.

Glodon’s services cover the whole process, from design, quantity of materials needed, pricing, on-site command and dispatch of materials. Such high-quality software creates very strong user stickiness, which was one of the key reasons that Glodon outperformed the broader Chinese equity market in 2022, despite the weaker macro environment.

In the healthcare space Shenzhen Mindray, a leading medical device manufacturer, is replacing the likes of Siemens, Roche, and GE in relevant product lines in China. The company has both a domestic opportunity supplying medical infrastructure, and an overseas opportunity as a value for money option in both emerging and developed markets.

Speaking with the president of R&D, it’s clear the company has a healthy product pipeline, with multiple drivers that should support management’s guidance of a stable 20% compound annual growth rate over the next five years.

The company has 10 dedicated R&D centres, and this ‘engineering dividend’ is a key driver of Mindray’s enviable R&D efficiency, as is its willingness to adapt its products for local needs. Mindray’s new product cadence is around 18 months, whereas foreign peers take in excess of three years, for example.

Shareholder rights

Having met the management teams of several State Owned Enterprises (SOEs), including Fuling Zhacai and TravelSky in addition to the chairman of Kweichow Moutai, it is clear that there is a drive from Beijing for SOEs to become more shareholder friendly, be more accessible and listen to the views of minority shareholders, especially around delivering higher quality growth and the subsequent improvement on a company’s financials.

On that front, cost and headcount control was another key theme across all the companies. The majority of them are expecting to hold headcount flat for the year – which was anecdotally supported by food delivery company Meituan telling me that it is seeing abundant rider supply this year, given it’s generally a popular choice of temporary work.

From talking with TravelSky, foot traffic has picked up materially after COVID restrictions were relaxed. In the year-to-date through May, 217 million air tickets were processed for domestic travel, double the same period in 2022 and about 95% of the comparable time frame in 2019.

Overseas travel remains weak, at just 38% of 2019’s level, with this attributed to the difficulties in granting two-way visas. Yet when talking to various smaller merchants and Didi drivers, another, more concerning theme is that consumption – especially for smaller merchants – is still weaker than pre-pandemic. This was echoed by Meituan’s management explaining that its advertising budget for SME merchants is lower than before the pandemic due to a lack of confidence.

Premiumisation

The trend of premiumisation – consumers being willing to buy new products at a higher price point – remains intact. For example, Kweichow Moutai is a company that has continued to see demand outstrip supply for its baijiu – a grain-based spirit – with an enduring motto of ‘drink less, drink better’.

The company has a strong national brand, enabling it to exhibit its pricing power. Central to this was the First Premier of China, Zhou Enlai, who helped Moutai receive widespread exposure – and cultural pride – when he hosted US President Nixon for a visit in 1972, helping cement the beverage as the national spirit.

Other sectors are also beneficiaries of premiumisation. For instance, the focus on food safety continues to drive the shift from home-made products or unknown manufacturers to branded packaged products, which benefits the likes of Fuling Zhacai, which produces pickled mustard stem, a national delicacy that is vaguely similar to sauerkraut. With 500-600 million people outside of the Tier 1 and 2 cities, this is a significant expansion opportunity for Zhacai. Beauty related products are another area seeing growing demand for more premium products.

While most companies are expecting a slow recovery in China, they expect improvement to come through quarter-on-quarter. It was also interesting that domestic investors pay a lot of attention to overseas sentiment as they believe this represents a key delta for A-share and H-share valuations.

One must be cognisant that the past couple of years have been disorderly for Chinese equities, and relations with the US remain relatively tense. However, President Xi’s recent reshuffle earlier this year provides greater clarity regarding the government’s direction of travel.

Given what I witnessed on the ground across the country, I believe that investors with a philosophy that focuses on business fundamentals and long-term trends have much to be encouraged about in the coming years ahead.