Why China’s edge in key industries looks set to last
- Visiting companies in China, Baillie Gifford’s Lawrence Burns is struck by progress in electric vehicles and drone delivery
- Companies such as BYD, NIO and Meituan have benefitted from industrial policy to build impregnable advantage
- Although investing in China has got harder the potential rewards are too big to ignore
All investment strategies have the potential for profit and loss, capital is at risk.
The moment I left the airport and traveled along the busy highway into Shanghai something struck me as different. I had become accustomed to seeing more electric vehicles in cities across the world, but here I found myself surrounded by them.
In Shanghai, this is far from unusual. Half of all new cars sold in the city are electric. Across China, a total of 6.8 million electric vehicles (EVs) were sold last year alone. That’s over 60 per cent of the total sold globally and dwarfs the less than a million sold in the US. When meeting with BYD, a leading EV maker, they told me they expect 90 per cent of new car sales in China to be electric within five years. China is therefore on a clear path to being the first major economy to make the EV transition.
Crucially this is a homegrown transition. While the Chinese automotive market has long been dominated by foreign brands, in EVs it is local brands that dominate, with a commanding market share of over 80 per cent. China is already the world’s leading EV manufacturer and is likely to become the global automotive leader. In the words of Ford’s CEO Jim Farley, “It’s a bit of a new world order”.
None of this has happened overnight. It is the result of industrial policies dating back to the turn of the millennium. China understood that with cars, that use internal combustion engines, it would always be playing catch-up with the Germans, Americans and Japanese who had been perfecting the technology for decades. EVs offered a reset, a level playing field and an opportunity to leapfrog. The government supported the industry’s development with large procurement contracts to build electric buses allowing EV and battery manufacturers to build scale and accumulate experience. It then poured in over $30bn of subsidies to nurture the electric passenger car market while giving preferential access to highly sought-after new urban license plates.
The advantages that China has built up will be hard to overcome. It dominates the EV supply chain with three-quarters of the world’s battery manufacturing capacity and is home to the world’s two largest battery manufacturers, CATL and BYD. CATL’s co-founder Li Ping said over dinner that it now has a research and development budget double the rest of the battery industry put together. China also controls the supply chain for battery components and is home to half the world’s processing and refining of essential raw materials for electric vehicles such as lithium, cobalt and graphite.
The combination of economies of scale, supply chain domination, accumulated battery experience, and lower labour costs now confer a significant cost advantage on China’s EV makers. William Li the founder of our holding NIO, a premium Chinese electric car company, believes this cost advantage is about 20 per cent. For this reason, Tesla now produces over half of its cars from its Shanghai factory. The west will need companies like European battery manufacturer Northvolt to succeed to avoid total dependence on this supply chain.
Yet it is not just cost where China is showing leadership. Innovation is plentiful. NIO has built out a battery swapping network allowing customers to swap for a fully charged or longer-range battery depending on need. The car drives itself into the swap station and without human intervention the battery is taken out of the car and replaced in a matter of minutes. NIO also has a popular AI-powered in-car assistant that can provide directions, play music, change the temperature, take that much-needed in-car selfie, or tell you off when you are not paying enough attention to the road.
The aim of many of the Chinese EV companies is now to go overseas. NIO is expanding further into Europe. It even has a new brand called Firefly designed specifically for the European consumer. If Chinese automotive domination of Europe sounds farfetched then consider that the second best-selling electric car in the UK is the MG4 made by Chinese state-owned enterprise, SAIC. Top Gear and other automotive media have greeted it with rave reviews. The real challenge for Tesla therefore seems highly unlikely to be Ford, Toyota, or Volkswagen but Chinese electric vehicle makers. However, electric cars were not the only radical change at nearly unimaginable scale I encountered during two weeks in China. I could have talked about how China is expected to build out 150GW of solar capacity this year. That’s greater than the entire installed capacity of the US. Alternatively, I could have talked about my surprise that another holding, food delivery company Meituan, did over 100,000 drone deliveries in Shenzhen alone last year. The joy of ordering everything from breakfast to dinner to a refreshing iced tea delivered across the urban sky was made to seem almost mundane.
Despite this awe-inspiring progress, it would be wrong to deny that investing in China has become much harder. The geopolitical risks are genuine and complex. Our assumption is that Sino-US relations are characterised by chronic tensions. There is at least good reason to try to keep these tensions in check. For the US and China, the cost of not doing so is not mutually assured destruction but rather mutually assured stagflation – slow growth, high unemployment, rising prices – should there be a true decoupling and fracturing of global supply chains. The Taiwan Strait is the obvious flashpoint but it would require a significant change in the military capabilities of the US or China for either side to believe anything but the most pyrrhic of military victories would be possible. Accidents and miscalculations are the real risk, at least for now.
China’s regulatory environment also presents its own challenges. We need to be open that we have not navigated these as well as we should have. The pandemic limited access and we relied on too narrow a set of corporate leaders for insight. This trip, our first since the pandemic, allowed us to meet a wide range of knowledgeable contacts.
The message received was one of optimism albeit from a low base. A leading economist noted that the government knows it made mistakes in its handling of the regulatory clampdown, but we should not expect it to admit that. Multiple founders noted “a massive sea change” with the appointment of the new premier, Li Qiang. In China, the premier traditionally manages the economy but his predecessor Li Keqiang was a former rival of President Xi. This made coordinating policy difficult as Li Keqiang was seen by regulators as speaking without the authority of the president. Now, we were told by multiple founders, Li Qiang, a Xi protégé, can push through a pro-growth, pro-business agenda with greater ease.
Shortly after my visit Li Qiang referred to consumer internet companies as the “trailblazers of the era,” while the government signalled the end of a period of ‘rectification’ for financial technology companies. There will still be regulatory issues in the future but all those we met seemed to agree that the situation was now much improved.
What remains clear though is that the geopolitical and regulatory risks need to be factored into our analysis and valuations of companies. The result has been that we have further raised our bar for investing in China. Investments in China must offer the possibility of truly exceptional upside to compensate investors for the risks incurred. This reassessment has driven reductions in our investments in China over the last couple of years. As part of this we sold our longstanding holding in Alibaba. We do not think the shares are particularly expensive but nor do we believe it offers the potential of truly exceptional upside to meet this higher bar.
However, given that China is a continent-sized country, with bold industrial policies and an ambitious entrepreneurial culture, the possibility for extraordinary firms to emerge still seems high. Last year was a good reminder of this as, despite the negative China headlines, Pinduoduo, another Chinese holding, has continued to grow both top and bottom line very rapidly despite an undemanding valuation. Many in the West are also now getting to know Pinduoduo through its international version Temu which has been dominating app downloads around the world.
The future will always be uncertain but what I am convinced by is that any attempt to understand the world without trying to understand China is doomed to failure. There is still much we need to observe and learn from the world’s second-largest economy and its ambitious and innovative companies.
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