There Is Money to Be Made in Mice
In a recent meeting with one of the partners in a venture capital firm, he cited some of our recent work in posing a question to us:
“You’ve caught our attention with your recent articles on the changing competitive environment. We’ve known about China’s growth for a long time, like everyone else, but we weren’t particularly focused on the emerging companies from China. If we had been able to invest in any of the companies you’ve used as Second Mouse case studies, I at least would be handling this conversation from my own island in the Caribbean.
“I did a Google search on ‘Second Mouse investment opportunities’, and, along with a few of your articles like the one on the need for western businesses to rethink their approach to M&A and integration in the context of strategic acquisitions, I came up with a number of Chinese firms that promised to bring along the next generation of computer mice and others that were willing to stock any laboratory in the world with research specimens. But I didn’t find any rosters of the next generation of Second Mouse companies.
“So my question is this: ‘Is there money to be made through Second Mouse investments, focusing on Chinese firms that have the potential to achieve a global leadership position in their industry? And, if so, how do we get into the game?’”
The question is provocative and important. The emerging economies, lead by China, will provide most of the growth of the coming decade, and the winners from that robust business environment will include many domestic companies as well as participants from the more established countries of the west. In the articles previously cited, we’ve referred to these firms as Second Mouse companies, from the saying “The early bird gets the worm, but the second mouse gets the cheese”. The incredible fast learner and fast follower skills of these companies have, in many instances, propelled them to positions of prominence in global markets.
Investing in Chinese firms remains a complicated process, as are most business transactions in China, but are increasingly feasible. Being able to cite success stories was a challenge a decade ago. There are many of them today. Ten years from now, we will have dramatic success stories available of firms that made fortunes through investments in Chinese firms, and we will probably then wonder how it could have been so easy. But today, it is anything but that.
In the section that follows, we will summarize our findings as to the path of evolution followed by many of the Second Mouse companies that are today achieving significant success in global markets. This summary provides a roadmap to spotting a potential success story from among the many little-known Chinese firms that are at various stages of evolution. In the following section, we will examine several additional investment strategies that might yield success in China.
The first task is that of spotting the candidates. This has been a challenge for any decision that requires identifying companies in China. The list usually starts with 1000s of candidates that claim to be participants in the industry or line of business of interest, with only 100s of them actually meaningfully engaged in that industry or line of business, and perhaps 10s of them serious companies with potential. That truth continues today.
In our research on the stages of evolution of Chinese Second Mouse companies, we’ve focused upon four stages:
Competency Development. In its formative years, Second Mouse companies focus upon practicing strong “fast learner” competencies. They develop world-class skills in mastering products and technologies developed elsewhere. They master strong competencies related to manufacturing and sourcing, practicing the unique strengths that define “China economics”. In combination, those two competencies allow them to produce almost as good products at a great price point. They also begin to develop strong service competencies that endear them to their customers and allow them to avoid certain higher-cost processes.
It is obviously quite difficult to separate the Second Mouse company from one that will end up as the Third Mouse or the Hundredth Mouse at this stage, a reality no different than that of picking out the most attractive start-ups in western countries. But, while spotting a future success at this stage is difficult, there are factors on the product side and factors on the cost side that can help to predict who is most likely to win that race.
In terms of products, we look for companies that have gone beyond knock-offs to actual innovation, at least in drawing the best from a number of global vendors. While many highly successful companies got that way by making blatant copies, that is not a sustainable business model against all the rest of the companies that are also good copiers and also hungry for business. We caution, though, that there is also a plethora of companies trying to be high-end market competitors through quirky innovation. These are not the companies that are likely to become the mid-market champions.
We would also look at whether success in the marketplace is based purely on cost or whether the customers show any preference for one company’s products. We have seen situations in which dozens of companies are producing from the same design and making no attempt to distinguish their “Copy of ___” brand from the others. But, if one company has achieved some advantage in the eyes of customers, either by tweaking designs or producing to higher specs, they have a head start in the “mouse race.”
In terms of “China Economics”, we have emphasized that it comes in two flavors. The easiest way to achieve low cost in China is to use relationships with the government to cut corners – not paying taxes, not following labor and environmental laws, selling products that do not meet China’s standards, and borrowing money at attractive rates with no intention to repay. A company whose success is based on such “cheating” might well move ahead of the pack initially, but its position is vulnerable to a change in local leaders and the political atmosphere. We would avoid those companies because sustainable success requires change that may or may not happen.
The harder way to achieve “China Economics” is to maintain a cost-focused, rather than an innovation-focused, company culture. Companies that have a sustainable position have developed efficient manufacturing processes, possess a network of low-cost suppliers managed through strong relationship skills, and make the clever product-service tradeoffs we described above. The top leadership turns off the lights when a room is not being used. This behavior does not completely distinguish one company from the others, but understanding whether a company’s market position is based on a “real” or a “cheating” cost advantage is vital.
To the extent that it is possible to see it early and tell whether it is sustainable, it is competency superiority that should be a focal point in the selection process at this early stage of evolution of Chinese companies.
Mastery of the China Market. Second Mouse companies are ambitious, and their first focus is the middle market of China. Starting, in most instances, with local roots and relationships and facing similar competitors across the country, such expansion is a challenge. While China is evolving rapidly, it does not yet have the infrastructure elements that make such expansion easy. But this is a critical stage, one that culls the winners from the losers.
Most western companies look to identify those Chinese companies that they see as competitors in their own efforts to grow in China, but that is wrong. There are some such Chinese companies targeting the elite segments that are for the most part dominated by global firms. By contrast, the Second Mouse company is growing in the middle market, reaching and serving customers at price points typically below those of interest to western companies. Outside of some branded consumer products, the middle market is the territory of the Second Mouse firm, and the firms that are gaining share in those segments are candidates worthy of attention.
At this stage of evolution, it is also likely that the Second Mouse firm will develop a robust roster of friends in government and business, as such relationships are critical to growth in China. Relationships, for all but the most important companies of national interest, are local. That means that a company has a home-field advantage in selling to other local companies, even private ones who often have suppliers recommended by government officials. But it doesn’t help all that much when moving outside the region. Depending on relationship to support a poor product-service offering has often been a hindrance in the longer run. So, we balance the significance of relationships in success so far in determining whether it can be leveraged onto a larger stage.
We also look at the customers as an indicator of future sustainable success. Mid-market customers have told us across a wide array of industries that they buy based on the performance-price ratio. Customers who place emphasis on both hold the promise of supporting a sustainable second mouse supplier. Those whose focus is wholly on price do not.
As one final note, in another reflection of “China speed”, there is often considerable overlap between these first two stages of evolution, with competency development continuing as the firm expands across China. And the mastery of China’s market doesn’t appear to stop for Second Mouse firms as they move onto the next stage of evolution, as they typically continue to grow at faster-than-market rates in China even as they mature.
Global Expansion, by Stages. China’s Second Mouse firms are not content with China’s market, despite its scale and ongoing rapid growth. They see other attractive markets where their offer of almost as good products at a great price point can once again win. Most of them initially target other emerging Asian markets such as Indonesia and India, then move into the markets of the Middle East, Africa, and Latin America, and only finally to the developed country markets of North America, Europe, and Asia.
What is important to recognize is that these firms don’t change their character as they move into new country markets. Their value proposition remains essentially the same, even when the cost of providing services is no longer supported by low developing country wage rates. That is an additional reason to focus on the factors we have discussed above. Companies that thrive in a local China market based on copying for their products, cheating for their cost position, and only local relationships for sales do not have a business model that can in any respect transfer to a new environment.
Still, it is friends and learning skills that remain important in this stage of evolution as well. Friends from China often facilitate global expansion, as is evidenced by the success of Chinese firms in several industries targeted in recent five-year plans, such as alternative energy and high-speed rail. And new friends in newly targeted countries, from suppliers to distributors to local governments eager to woo new plants and jobs, all are important to this stage of expansion. The fast learner competencies that started these firms on their journey are also relevant as they work to adapt to new business environments, regulations, and expectations. The winners at this stage showcase these competencies once again.
Global Prominence, Second Mouse Style. In a recent workshop on a very different topic (the flavors of innovation), we asked the participants to name the three U.S. airlines that would be the industry leaders five years from now. Almost everyone selected, in some order, United, Delta, and Southwest. We then asked them to choose which one of their three picks would be the most different from the other two in terms of the innovations that they brought to the market over that time. Every participant selected Southwest. As one individual commented, “Every time I get onto a United or Delta flight, I’m greeted by a video featuring the company’s CEO welcoming me aboard. Southwest doesn’t even have video monitors. At most, a flight attendant tells a joke.”
Today, in some industries, and tomorrow, in more and more industries, there will be a Chinese Second Mouse firm on the short list of global leaders. And like Southwest in the example above, they will be considerably different from the older, long-established western firms on the list. They will probably not be considered the equals of their western firms in terms of technology leadership and other dimensions. But they will probably be growing faster, making more money, and have a higher market cap than those other firms.
This is not to say that the Second Mouse firms will cease to evolve during this stage. In all of the case studies we have developed, the firms have continued to invest and often achieve successes in innovation and product development, but in areas that support their value proposition in targeted middle-market segments. A few evolve to be more like traditional western firms (Samsung is an example from an earlier time), but most will continue to win with their offer of an almost as good product at a great price point. At this stage, they will be seen as fierce competitors in even the most established country markets, gaining share from much older firms unable to match their price-value combination. At this stage, these firms are often themselves acquisitive, buying western firms with attractive technologies and/or market positions. We have recently seen acquisitions of western companies made by such Second Mouse firms as Sany and Mindray.
The insights as to the characteristics of successful Second Mouse companies at the various stages of their evolution can be used as elements of a strategic due diligence process for investors trying to identify which Chinese companies hold the most promise. While China’s companies are too young for us to claim that these factors are always present, we have seen substantial numbers of successes in which they were and many more instances in which their absence was the source of problems for a Chinese company.
Making Money in Mice
In this section, we return to the venture capitalist’s question, with which we started this paper: “Is there money to be made through Second Mouse investments, focusing on Chinese firms that have the potential to achieve a global leadership position in their industry? And, if so, how do we get into the game?” We will look at three strategies familiar to all and link them to opportunities associated with Second Mouse companies.
The first strategy is obviously that of identifying and buying high fliers – a strategy that provided the motivation for the detailed discussion of the characteristics of successful Chinese firms in the previous section of this paper. This is probably the best strategy, and the discussion of “mouse spotting” at the various stages of evolution provides our best ideas about how to implement that strategy. Obviously, the earlier that a correct call can be made, the more lucrative will be the outcome. By the fourth stage of evolution, it is probably too late – the analogies would involve buying Huawei or Haier today. So a focus on the winners in terms of competency development, mastery of China’s middle market, and staged global expansion is necessary.
Opportunities in this category require a careful look at the markets in which the candidate firms operate, as well as at the firms themselves. We have seen examples where the character of China’s market doesn’t foster domestic company success, and others in which the niches are too small or inherently too local to allow sufficient growth to build a strong enough balance sheet to allow the firm to continue its expansion.
Understanding the Chinese customer is also critical to correct evaluation and valuation of Chinese companies. With the fast changes in China’s income distribution, a significant percentage of buyers of any product are first-time buyers. And in China, they have nearly endless choices, some of which are distinct from the dominant products in western markets or even in the market along China’s east coast. The Second Mouse success stories that we’ve studied have understood their customers, and been creative in retaining those features of importance and culling out those that aren’t (and culling out their costs). The features that fall into each of those categories are often surprising to western competitors. Research on customers can help to spotlight the Chinese Second Mouse aspirants that match up well vs. those that are on the wrong path.
A second investment strategy involves roll-up concepts. In fact, many of the Second Mouse successes grew in part through roll-ups of other companies, sometimes with government encouragement (or insistence) and support. And, in thinking about this strategy, it is critical to recognize that rolls-up will in almost all instances require approval and support of China’s governments, sometimes at multiple levels. The “friends factor” enters into this strategy in an important way.
There are multiple versions of this strategy. One version reflects the fact that many Chinese companies are incredibly specialized in a very narrow product line. Putting together like companies, somewhat like assembling the pieces in the children’s game of Cooties™, can allow for the creation of a full-line company that can reach additional markets and leverage their sales model.
A second version recognizes that many Chinese firms are inherently local, at least in their early years. Many grew out of what were previously government enterprises serving a local or regional market. Some roll-up strategies can facilitate success in the second phase of evolution, giving the firm greater capabilities to master the Chinese middle market. This strategy also has the advantages of overcoming a challenge facing any Chinese firm that is trying to expand nationally. Its strength and its friends are most likely to be local. Putting multiple firms together can avoid the challenge of moving into a new market and facing local competitors who themselves have friends in the right places.
There is one caution about this strategy. We’ve seen few examples in which roll-ups have generated significant savings from cost reductions as redundant departments are consolidated and staffing is reduced. In the west, this is a cornerstone of many roll-up business plans. In China, for reasons of culture and economics, it is a stretch, at best. A plan that proposes cutting redundant staff will not gain the government support that is critical to a successful acquisition. We have seen good examples of leverage in terms of the costs of growth in the post-roll-up environment, but far fewer ones that involve taking out current spending.
A third western strategy to increase valuation, implementing actions to improve operational performance and take costs out, has less relevance in China. We have avoided the extreme of suggesting that investors buy companies that are turnaround candidates, as that is an extraordinary stretch in China. Over and over, we heard comparisons saying that starting from scratch would have been a far easier proposition than transforming a failing company into a success.
Even efforts to improve valuation by introducing improvements in operations are only rarely a possibility with Chinese companies. Few instances exist in which Chinese companies save money by implementing western processes. More often, their processes are so fully targeted towards cost avoidance that the opposite is true.
The same is true with the other traditional source of operational improvements in the west, namely the introduction of new technologies. The basis for such gains is typically improved labor productivity, a contribution that has much greater potential in high-wage countries than it does in countries like China. And, in some instances, reducing the work force isn’t even an option. At some point in the future (and in a few scattered locations in China today), productivity gains may become more of a factor, but in most industries and locations, that time has not yet arrived.
The final strategy that might be considered as a way to identify potentially lucrative investments involves “global roll-ups” that combine western firms with Chinese firms. The simple version of this strategy is based upon using the low-cost manufacturing (and other) competencies of the Chinese firm to improve the competitiveness of the western firm. There are many examples where this has been done by firms on their own behalf, with the acquisition being strategic in its contribution to the acquiring firm.
A more subtle version of this strategy is rooted in our perspective about the changing competitive environment. As we noted earlier, Chinese Second Mouse firms will become major forces in global markets, including those of the west, taking share from established firms with their offer of almost as good products at a great price point. We have argued the importance of preempting that strategy through acquisitions that get ahead of this outcome by allowing western firms to themselves bring such an offer to the table. Our focus in this regard has been on strategic acquisitions, ones designed to help a firm strengthen its global leadership position. But, to some extent, the same potential occurs as a possibility for financial investors doing global roll-ups, either to secure the long-term position of a western company in their portfolio or to become the fierce competitor that takes share from the established western market leaders.
There is a long history of investments that cross country borders and create global firms. Such traditional investment strategies, however, involved a vision of gains through arbitrage or through aggregation. Acquisitions in the former category were frequent as western firms went to China to take advantage of their low labor costs to create a source of cost advantage in their home markets. Later, other firms focused on China and acquisitions there as the country’s growth yielded enough customers to meaningfully contribute to overall scale. The rationale today is different and will represent the dominant contribution of globalization in future years. Global roll-up strategies, whether done from a strategic perspective or a financial perspective, will be successful if they successfully combine competencies that are strong in different global markets and cultures in order to achieve competitive leadership across all markets. The potential gains are enormous, including the ability to capitalize on technology leadership through the entire product life-cycle, even as innovations mature and become commonplace.
China’s tremendous growth will ensure that wealth will be created in the coming decade, perhaps at a rate that will stagger imaginations. Participating in this exciting opportunity will be a challenge for western venture capitalists, but one that can be addressed and that can yield enormous rewards.
The companies that will become attractive acquisition candidates in China will be a challenge to spot, often operating off the radar scope of western companies in the middle markets of China. They will be numerous in every industrial market segment, and sorting out those with the potential to be winners will pose additional challenges. Our research has identified the stages of evolution of Chinese firms that have made the journey to world-class performance, and spotlighted certain attributes that can be evaluated in companies at various stages of development.
Along with culling out Chinese high-flyers in which to invest through this process, there are other investment strategies that have potential in China. Roll-up strategies, both those oriented towards creating scale and profitability in China’s own markets and those that are focused on successes across global markets, have such potential. In some instances, effectively combining a western firm with strong technological strengths with a Chinese firm with the ability to reach more price-sensitive middle market customers might in fact yield a firm that makes it onto the short list of globally prominent leaders in some future year.
As the executive quoted at the beginning of this article said, there are few useful lists of acquisition candidates available for investors that are focused on China, and our experience confirms that the search and evaluation processes are difficult. But in the end, finding an emerging Second Mouse company might be the route to securing the funding for the new Caribbean headquarters of the firm that buys such a firm.
Author: George F. Brown, Jr. and David G. Hartman
 George F. Brown, Jr. and David G. Hartman, Are You Ready to Take On China’s Next Generation Competitors?, Chief Executive, September 2011.
 George F. Brown, Jr. and David G. Hartman, Second Mouse Tales from China, iPFrontline, March 2012.
 George F. Brown, Jr. and David G. Hartman, Change Before You Have To, Business Excellence, August 2011.
 David G. Hartman, Three Strategic Challenges in China Acquisitions, Blue Canyon Partners, Inc., © 2009.
 David G. Hartman, China Economics, Blue Canyon Partners, Inc., © 2008.
 George F. Brown, Jr. and David G. Hartman, Fifty Ways to Win in China, Business Excellence, August 2011.