From Zero To Sixty: Innovation In China

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Includes: CHN, CN, CXSE, FCA, FLCH, FXI, FXP, GCH, GXC, JFC, KGRN, MCHI, PGJ, TDF, WCHN, XPP, YANG, YAO, YINN, YXI
by: Janus Henderson Investors
Summary

China has rapidly become a force in innovation, especially in embracing technology to upend entire business models, making them more attuned to digital-centric customers.

Chinese e-commerce and financial services companies have been quick to apply artificial intelligence to all aspects of their businesses with the aim of generating revenues and reaping operational efficiencies.

The government has applied a light regulatory touch toward tech companies as their progress is helping achieve the goals of boosting consumption and climbing the value-added food chain.

By Andy Li, Denny Fish & Garth Yettick, CFA

The global economy has a new force in innovation and it's not in California. While Silicon Valley remains at the forefront of developing novel technologies, China is catching up, and even differentiating itself in some key areas, among them the deployment of artificial intelligence (AI). Rather than leading the way in specific products or services - although there are examples of each - the most compelling aspect of China's burst of innovation is how the country is leveraging technology to reimagine many of the business models that have evolved over decades in more advanced economies.

Upending Yesterday's Business Models

A range of factors have enabled innovative Chinese companies to thrive. Citizens entering their prime earning years have come of age during the digital era, making them amenable to integrating technology into many facets of their lives. Also contributing is the absence of incumbent business models that digital disruptors often must overcome in the U.S., Japan and Europe.

The rapid adoption of e-commerce is one of the most telling examples. Alibaba (NYSE:BABA), China's dominant online shopping platform, has roughly four times the gross merchandise volume - a common industry metric - than does Amazon (NASDAQ:AMZN) in the U.S. Driving home the degree to which Chinese consumers have gravitated toward e-commerce - and, in effect, are bypassing brick-and-mortar shops - is these two countries' similar size as measured by purchasing power parity. China's embrace of e-commerce also allows it to avoid a problem facing many developed countries: What to do with underutilized shopping centers as online shopping gains more traction.

Financial services is another sector where innovation is tossing out the legacy industry playbook. Chinese consumers are transitioning straight from a cash-based society to one of digital payments. Potentially disintermediated industries are credit card providers and other legacy payment processors. Driving this is the comfort consumers have in viewing mobile phones as digital wallets. Also contributing are transaction fees as little as 0.60% compared to those of credit cards, which can top 3%.

Leading providers of payment services include Tencent's (OTCPK:TCEHY) WeChat and Alibaba's Alipay. WeChat is predominantly a social media platform whose role in everyday social engagement dwarfs anything achieved by leading western social networks. In short, Chinese are living their lives online. The willingness of consumers to purchase, socialize and share online represents a treasure trove for data mining. These data, in turn, provide some of the inputs required for the pervasive rollout of AI.

Embracing Artificial Intelligence

While AI is a global phenomenon, Chinese companies have aggressively embraced it. Leading firms are deploying AI across their organizations in an effort to accelerate the evolution of their business models. In e-commerce, applying AI to analyze consumption habits is resulting in more targeted ad placements, and thus higher auction prices and take rates. By reviewing purchasing habits and other financial footprints, AI is creating an alternative to credit scoring, thus negating the need to create a domestic credit monitoring industry. Similarly, insurers intend to leverage AI to more effectively measure risk across a range of insurance products.

The Role of Government

What may come as a surprise is the Chinese government's light regulatory touch with respect to innovation. This, in part, may be due to the role technology plays making inroads toward achieving two long-held policy goals: Rebalancing the economy more toward consumption and shifting from a low-cost manufacturer to a producer of more complex, higher value products. Several investors, in fact, state that in many respects, China has a more hands-off regulatory approach than the U.S.

In other cases, the central government has wielded its authority to champion innovation. Officials are consumed with developing a domestic semiconductor industry with the goal of lowering its dependence upon foreign sources. While that has proven difficult, greater progress has been made in addressing environmental concerns. That government has tilted the deck strongly in favor of electric vehicles (NYSE:EV) in order to address the country's notorious air pollution. As a consequence, Chinese firms are making strides in developing innovative EV technology, namely battery design and production.

Global Ambitions?

While some innovative Chinese firms seek to dominate the domestic market and the government sees technology as a means of achieving economic security, other actors are likely to export their innovative business models to other emerging markets and even more advanced economies. Business leaders in the rest of the world must be mindful of this approaching challenge.

Disclaimer: Technology industries can be significantly affected by obsolescence of existing technology, short product cycles, falling prices and profits, competition from new market entrants, and general economic conditions. A concentrated investment in a single industry could be more volatile than the performance of less concentrated investments and the market as a whole.

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