This is part II in a five part series about Ensemble’s recent trip to China. Read part I for more context about the intent of the trip. Ensemble does not currently make direct investments in Chinese companies.

The rise of local Chinese brands

Over the past thirty years, emerging market GDP growth has been faster than US GDP growth. Yet the US stock market has outperformed emerging markets. One important reason for this is that US listed companies have captured a significant portion of non-US economic growth. In the early 1990s, about 24% of S&P 500 revenue came from outside the US, while today that mix stands at 43%. In our own portfolio, the majority of our holdings generate at least some of the demand for their products and services from China and other emerging markets.

In China in particular, the rise in per capita GDP has been astounding. Chinese consumers have used their rising income to purchase more products, with US based companies capturing a significant portion of this growth. Whether it is cars, luxury products, consumer goods, baby formula, or snack food, developed market companies have benefited handsomely from the rise in Chinese consumer spending.

But this easy fuel for growth may be coming to an end, even if China’s economy reaccelerates. The fact is that China’s locally produced products are rising quickly in quality. While in the past, Chinese consumers allocated a significant portion of new spending to developed market brands due to their significant quality advantage, today Chinese consumers are being presented with quickly improving local brand quality, which is blunting the degree to which Chinese economic growth drives sales of develop market products. The number of examples of this trend we heard about during our trip were numerous.

At Nio, a Chinese electric car company, we got to test drive their new SUV, which from a consumer experience was on par or better than the driving experience of US and European made electric cars (whether Nio can survive financial is a different question). During our visit, a Nio representative talked about how Apple didn’t initially have to advertise in China because there was no real high end smartphone competition. But today Apple needs to advertise heavily due to prevalent high end, Chinese made smartphones. But while Apple had a large head start in this regard, Tesla only had about 24 months of being the only quality electric car brand in China, before Nio and others emerged and forced Tesla to start advertising heavily.

(The Nio electric SUV we test drove)

Our contact a TalkingData, third party data intelligence provider, described the way that Chinese made cosmetic brands are exploding in popularity. According to their data, lipstick sales are up an astounding 150% over the last year. But while developed market cosmetic brands may be seeing strong growth in China, they certainly aren’t seeing 150% year over year growth because high quality, local cosmetic brands are capturing most of the growth. With the price for a comparable Chinese cosmetic product at about one third of foreign brands, now that quality standards are rising quickly Chinese consumers are allocating more and more of their spending locally.

This idea is true at the concept level, not just the product level. For instance, while you may have read about Costco’s huge first day opening of their first store in China, MissFresh is a Chinese grocery shopping concept already thriving in the country. With micro warehouses located close to consumers and delivery available within 30 to 60 minutes, Costco is entering an already competitive market. Given Chinese households often do not have extra storage space to put away a month worth of bulk purchases from Costco, the MissFresh model may prove to be better suited to the Chinese consumer especially as it is likely they will be able to consistently source high quality local Chinese made products more effectively and efficiently than Costco, at least for some time.

During our visit to Qutoutiao, an online content aggregator, the executive talked about how consumers are rotating to local instead of global brands. In their view, Chinese companies are not nearly as good at marketing as western companies. But today, consumers are learning about locally produced brands via online influencers and what are called Key Opinion Leaders (KOLs). The original distinction between an influencer and a KOL was that an influencer is native to social media, while a KOL is someone who has established expertise offline that they bring to social media, although this distinction has faded over time. As we see with the growing impact of influencers like Kylie Jenner in the US, KOLs are providing a platform to expose Chinese consumers to locally produced brands that they may not have heard of previously. The growing importance of social commerce vs traditional e-commerce is a topic we’ll discuss further below, but at this point it is important to recognize that it is the combination of rising local product quality along with a newly emerging way to expose these local products to Chinese consumers that is one of the main reasons for the shift of wallet share to Chinese goods.

What all of this means, is that investors in multinational companies, particularly those selling consumer branded products, should not count on a continuation of solid growth contribution from China. Between a slowdown in total Chinese growth and a mix shift towards the purchase of locally produced goods, it is quite possible that China may cease to be a contributor to growth entirely for many Western consumer product companies.

It is worth noting that one category that was repeatedly cited as not being impacted by this trend was luxury products. Given the extremely long heritage (on the order of 150 years or more in many cases) of many global luxury companies, it isn’t possible for a new local Chinese luxury brand with similar heritage to emerge overnight. Therefore, it seems likely that Western luxury products will be relatively immune from the shifts we’ve described, at least for many years.

Read Part III.

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