China tech is a jade diamond in the rough

In trying times, the Sino Silicon Valley is a game-changer

Andrew Willis 25 February, 2019 | 6:00PM

China’s slowing economy is making headlines and as a result, many investors are keeping a distance and  missing out, as they wait for the outcome of the negotiations with the U.S.

However, there’s something brewing in China – something leveraging a massive base of netizens and being ignited by equally massive central government investments, that should trump any trepidations.

Developments in the Chinese technology space, driven by an army of app-enabled online shoppers and highly integrated internet-based consumption habits, are surpassing developments elsewhere. Mobile payments - the preferred route for online purchases in China - currently top US$ 9 trillion per year, compared to only US$ 110 billion in the U.S. That's eighty times the amount of monetized consumer app-activity.

There must be a lot of processing power behind this.

China has a high AI IQ

“Artificial intelligence funding in China has really taken off, now at 48% of the global share compared to 38% in the U.S.,” says Regina Chi, Vice-President and Portfolio Manager at AGF Investments, who holds an overweight allocation to China in her AGF Emerging Markets Fund.

Made in China 2025 is focused on progressing high-tech industries like robotics and artificial intelligence through major investments and subsidies, to the point that it threatens to redirect investments out East. It made such an impact that it was a target of a recent policy speech on China by U.S. Vice President Mike Pence.

This strain with the West and dour economic reports on the economy out East contributed to a broad decline in Chinese stocks at the end of last year. And Chi says the China tech space was oversold. The AlphaShares China Technology Index lost more than 40% of its value in the onslaught of selling throughout 2018, before gaining 20% since the beginning of this year.

The Chinese technology sector is making a recovery and rightly so. Before its decline, the e-commerce penetration rate in China stood at only 10%, while still generating a trillion-dollar economy.

There are concerns that remain on the telecom side, with spying allegations and bans on Chinese technology applications abroad. The validity of concerns aside, it will leave the West in the dust as China switches to 5G and turbocharges the services of mobile offerings while making new offerings possible.

Young Chinese are moving markets

Another concern shared by investors hesitant to enter the Chinese market is declining consumption levels. But anyone watching their children on their smartphones will know that consumption among this consumer group is far from declining.

In fact, in China, smartphone usage levels – particularly around videos games – became so high that the government sought to curtail addiction by temporarily suspending the approval of licenses for new games. 

And with 400 million of them, all frequently spending small fragments of their disposable incomes in an internet ecosystem, it’s a force to be reckoned with. The mobile e-commerce sector is less sensitive to declining consumption levels.

“Their sheer numbers, rising incomes, greater overall wealth and technological savviness, combined with the proliferation of online social networks, are all contributing to [a] rapid rise in growth,” says Mark Weinberg, Vice-President, at AGF Investments.

Young Chinese consumers prefer a cashless shopping experience, says Chi, using digital wallets and peer-to-peer payments over credit cards. They have adopted this evolution in e-commerce far ahead of their Western counterparts, adds Chi, incentivizing the FinTech industry to develop a much wider array of offerings – and revenue channels.  

Chelsey Tam, an equity analyst for Morningstar covering China also suggests staying tuned for the Z-generation - those below the age of 24 – as well to deploy their digital capital. “They account for over 30% of Chinese netizens,” says Tam, adding that they use their smartphone for a range of services from food delivery to gaming, music, and literature.  

Ctrip, the largest online travel agency in China, says 70% of its customers are under the age of 35 in the past 5 years, adds Tam. “They reckon young generation users under the age of 29 continues to grow from 30% to almost 50%, which represents the fastest-growing age group in their portfolio.” 

Prepare for a ‘leapfrog’ event 

Chi says that young Chinese consumers are at the forefront of the adoption of new technologies, resulting in the evolution of wide retail and consumption trends. “Unlike in the West, [they] are not pursuing the typical transition to mobile (PC to laptop to tablets and then smartphones), but rather bypassing the intermediate steps and going straight to smartphones.”

And Tam says that the local smartphone market is giving foreign phones a run for their money. “While Apple remains well entrenched at the top of the smartphone value chain in developed markets, the likes of Huawei and Xiaomi are catching up in terms of global market share.” Tam says that in 2014, Apple shipped around 15% of global smartphone handsets, with Huawei at 5.5% and Xiaomi at around 4%. In 2018, Apple’s market share was still around 15% but Huawei was very close behind at 14.5% and Xiaomi was around 8.5%.

Tam says Huawei and Xiaomi (and other unlisted Chinese companies such as Oppo and Vivo) are taking market share in developing markets which are growing at a faster pace than developed markets.

Take a look at Tencent

As investors eyeing this space should also consider the homogeneity of the local language and culture in China – something which can act as a moat against foreign competition -  it makes sense to invest domestically.

Tam suggests taking a look at Tencent (TCEHY). Tencent’s WeChat messaging app has over one billion users, which gives it a very strong network effect. With the resumption of gaming license approvals, Tam sees more games being approved and monetized this year. There are many areas that Tencent  can further monetize, such as mini-programs and internet finance as well.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Apple Inc219.19 USD-0.80
Tencent Holdings Ltd42.95 -0.69
Xiaomi Corp ADR5.86 1.56

About Author

Andrew Willis

Andrew Willis  Andrew Willis is a content editor for Morningstar.ca.