Understanding China’s Next Wave of Innovation

In recent years, a handful of Chinese companies have emerged as global innovators and have garnered a lot of attention. This group includes online retail giant Alibaba, appliance maker Haier, search and data technology provider Baidu, and Tencent, the social communication and gaming ecosystem. These companies are challenging the R&D strategies of foreign companies to keep up with the pace in China,1 and they are providing valuable lessons on how to make ideas commercially viable.2 But there’s another, less obvious force to be reckoned with in China as well: thousands of innovative companies that are quietly disrupting numerous industries, overtaking incumbents, and developing new products and new business models. For a variety of reasons we’ll discuss here, these emerging innovators are not easy to identify — yet they pose real threats, often in unexpected places.

For example, Royole, a Shenzhen-based startup that develops electronic products capable of bending and folding, has entered the automotive market with a superthin flexible display that can serve as the interface of a car’s dashboard. Backed by an abundance of venture capital, Royole has also introduced the world’s first bendable smartphone, which can be folded like a wallet.3

By expanding the distribution of their products, some established companies are also catching multinationals off guard. One such company is Jiangsu Dongcheng M&E Tools, a manufacturer of power hand tools. In the early 2000s, Dongcheng operated at the low end of the local market and was not seen as a serious rival to name-brand competitors like Bosch and Stanley Black & Decker. However, today it is China’s best-selling power-tool brand, outselling Stanley Black & Decker 10 to 1 there, and it is competitive in markets all over the world.

Over the past decade, we interviewed hundreds of executives, entrepreneurs, and investors in China and studied more than 200 Chinese companies. Our goal was to understand how innovation is being practiced in China and how it is changing. We identified three types of Chinese innovators, each of which presents a different set of challenges for competitors. We refer to them as hidden champions, tech underdogs, and change makers. (See “About the Research,” and “Three Types of Emerging Chinese Innovators.”) We will describe them here in detail so companies seeking to operate in China or compete globally can see how each type of innovator conducts business and understand what multinationals may be up against in the future.

Hidden Champions

Hidden champions4 are highly specialized companies. Typically, they are among the top three players in their industries in China and globally. But in contrast to big-name Chinese companies that are recognized as market leaders around the world, they tend not to be well-known and their revenues are less than $5 billion. They are driven by a quest for long-term growth, and they pursue continual innovation in their respective niches in an effort to add value for their existing customers. We identified more than 200 hidden champions in various sectors, including machinery, chemicals, materials, and electronics.5

Companies in this category usually customize their products to meet the needs of global customers, and they are accustomed to using a rapid trial-and-error approach to testing the market, adjusting, and learning. Many of them are tinkerers: They develop products, identify new resources, test solutions, and then rebuild.

Consider Lens Technology, China’s largest producer of lens components such as sensor modules that are used in smartphone cameras. Founded by entrepreneur Zhou Qunfei, a high school dropout from Hunan province, the company began as a maker of glass screens for digital watches and then quickly recognized an opportunity to produce screens for flip phones for TCL, a major electronics company headquartered in the city of Huizhou in China’s Guangdong province. At that time, plastic was the industry standard material for phone screens, but Lens Technology sold TCL on the advantages of glass. On the heels of that success, in 2003 Lens Technology became a supplier to Motorola and began producing glass screens for its Razr V3 flip phone. Lens Technology now supplies screens to Apple, Samsung, and other smartphone makers.

Many of the representatives of hidden champions that we interviewed said they faced challenges in competing against much larger companies with significant technological and resource advantages. But we found that hidden champions worked hard to make up for their deficiencies by moving fast, continually updating their offerings, and keeping their costs in check.

Hikvision is another good example of a hidden champion. In 2002, the company launched a video compressor card for computers based on MPEG-4 technology; the next year it released a new set of products based on a new video compression standard. Hikvision typically upgrades its offerings multiple times every year, and it views that approach as a way to stay ahead of competitors and copycats.

One way hidden champions achieve cost advantages over Western competitors is through their recruitment strategies. Unlike better-known Chinese companies such as Haier and Alibaba — and, indeed, many multinationals around the world — they don’t focus on candidates’ academic pedigrees and instead concentrate on identifying people who will bring a certain attitude to the job. Rather than specifically recruiting graduates of top universities, they look for people who are happy to focus on improving product value for customers.

China’s hidden champions pose three big challenges to non-Chinese competitors. The first involves the way they think about technology: As they pursue continuous product innovation, they often create opportunities for themselves to expand their offerings or enter niche markets. Many of them have leveraged their R&D capabilities and their rapid growth in the domestic Chinese market to achieve global market leadership. For instance, Hikvision invests an average of 8% of its revenues in R&D, and about 47% of its employees work in this area of the business.

The second challenge for non-Chinese companies is the global competitive threat hidden champions pose. Even though they do business in a very large home market, most hidden champions look for ways to expand internationally within five or 10 years, but they pursue expansion in various ways. For example, Goldwind, a producer of wind turbines, set out to internationalize its technology and products by engaging in a research collaboration with Vensys Energy, a German wind energy company, before it established a subsidiary and started exporting products. For their part, Hikvision and medical equipment manufacturer Mindray Medical International chose to expand aggressively overseas by creating dozens of subsidiaries. Nearly half of their revenues now come from abroad.

The third challenge for non-Chinese competitors is how quickly hidden champions can make decisions and grow. Many became domestic and global market leaders in about a decade, significantly faster than competitors from countries such as Germany, Japan, and the United States. It’s dangerous for multinational companies to underestimate the speed with which these new competitors can emerge.

Tech Underdogs

Tech underdogs are small and midsize enterprises with revenues of less than $60 million. They use their intellectual property to create a stream of innovative products. Many of these companies were founded by people returning to China from overseas, having studied at elite universities in the United States and Europe. Our analysis suggests there are tens of thousands of such enterprises in China.6

Unlike innovators in Silicon Valley, Chinese entrepreneurs work collectively to innovate and push technology and market boundaries. Although many of the ventures aren’t able to survive, some become viable competitors and even market leaders. The large number of players in any given category in China increases the chances that at least one innovator will be able to break through.

In our research on the solar power industry in 2016, for example, we identified more than 150 Chinese companies with significant intellectual property in photovoltaic technology. Weihua Solar, for example, was founded in 2010 by three graduates of Tsinghua University. One of its founders, Fan Bin, received a Ph.D. from Switzerland’s École Polytechnique Fédérale de Lausanne, studying under one of the leading experts in photovoltaic cell technology. In 2013, Weihua Solar and German chemical company Merck entered into an agreement under which Merck agreed to supply advanced materials and gave Weihua Solar permission to use relevant patents. This partnership, in combination with Weihua Solar’s internal R&D efforts, has led to the development of a light, flexible solar cell that is more efficient than any other solar cell of its kind.7

Another notable group of Chinese tech underdogs is involved in artificial intelligence. By our count, there were more than 80 AI-driven health care ventures in China in the summer of 2018. One of them, Beijing-based Huiying Medical Technology, which was established in 2012, had built a smart medical-image cloud platform. It partners with schools such as Tsinghua University and Stanford University and collaborates with more than 800 Chinese hospitals to provide AI-assisted diagnosis and treatment support. Another tech underdog, Malong Technologies, specializes in advanced image recognition, enabling commercial equipment to use X-ray technology to see things at a microscopic level. This has applications in retail (for rapid merchandise checkout in unmanned stores, for example), manufacturing (in systems designed to detect defects), and security (for baggage scanning). In addition to being available in both public- and private-cloud versions, it can be embedded in a system or server appliance, which can operate without a public internet connection.

Like hidden champions, Chinese tech underdogs pose three challenges to non-Chinese multinational companies. First, the sheer number of ventures makes it difficult for multinationals to know which local companies represent a threat and which do not. Compared with their Chinese counterparts, multinationals based outside China tend to have fewer connections with local companies and investors; as a result, they are not part of the conversation about emerging threats.

Second, tech underdogs launched after 2000 tend to be based on cutting-edge technologies (more than earlier Chinese ventures), and the founders are getting more and more sophisticated. The companies are targeting increasingly advanced fields, including genetics, solar technology, AI, new materials, and agri-tech.

Third, many of them have little or no media presence. That lack of visibility can be an advantage that enables tech underdogs to catch established competitors off guard when entering new markets.

Change Makers

Change makers try to gain advantage from digital disruption. Many of them are funded with large amounts of venture capital. They operate in a variety of industries, including media and information, ride-hailing, and retail. Unlike hidden champions and tech underdogs, change makers are highly visible, and their ranks appear to be growing.

Toutiao, for example, which uses artificial intelligence to provide mobile customized news recommendations, is one of China’s most visible change makers. Founded in 2012 and supported by more than $3 billion in venture capital over several years, Toutiao distributes personalized information to users based on their stated interests and browsing habits in social media. Thanks to its robust funding, Toutiao has been able to provide coverage of topics not generally featured in the mainstream media. As long as it stays away from content that’s critical of the state or goes against state interests, it is able to disrupt state-controlled media, which tends to be less responsive to user needs. By July 2018, Toutiao had more than 120 million daily active users (a high percentage of whom were under the age of 30) and was valued at more than $11 billion.8

Due to the plentiful supply of venture capital financing in China (increasingly from foreign sources), there is no shortage of young people eager to start digital businesses. The online food-ordering service Ele.me, for example, was founded in 2008 by two students from Shanghai Jiaotong University who got hungry while playing video games at night. (The name Ele.me is inspired by the Mandarin phrase for “Are you hungry?”) Leveraging social media and aggressive marketing, they forged links with other young customers who wanted nighttime food deliveries. By 2015, the company’s revenues had surpassed $1 billion, and in 2018 it was acquired by Alibaba.

Like hidden champions and tech underdogs, China’s change makers pose three challenges to foreign multinational companies.

First, they often appear out of nowhere, sometimes drawing on experience from other industries. Indeed, nobody anticipated that China’s state-controlled media landscape could be upended by a company like Toutiao. But the founder used his experience in three previous roles — as an online travel agent, an engineer at Microsoft, and a builder of an online real estate platform — to think creatively about solving consumers’ needs for relevant media and venture beyond the industry’s existing boundaries.

Second, change makers apply digital business models to a wide variety of industries, such as retail, banking, and consumer transportation (which includes bike-sharing and ride-hailing services). Although China lags behind more advanced countries such as the United States in internet penetration, mobile internet usage in China is high.9 Being on-demand and mobile is no longer the standard just for internet companies. Increasingly, it’s what’s expected of companies in traditional industries too.

Third, unlike Chinese incumbents and established multinational corporations with legacy products and business models to maintain, change makers are entirely user-centered. Rather than pushing existing products, they continually engage with users through social media to adapt products and, as necessary, revamp their business models.

Lessons for Non-Chinese Multinationals

All three categories of emerging Chinese innovators include companies that are either competing globally or positioning themselves to do so. This raises obvious questions about how non-Chinese rivals should respond. Based on our research and knowledge of Western multinationals, we offer these recommendations.

1. Think beyond recognized industry borders. We found that the list of possible Chinese competitors goes well beyond the dozen or so players that international executives in any given industry might be familiar with. Although you need to identify your most likely competitors, you must also prepare for less-obvious threats from a variety of places.

Tech underdogs can be hard to spot because they are often small operations run by engineers with limited marketing experience. Hidden champions tend to be larger but are still typically less well-known globally than similar companies based in European countries.10 And though change makers may be highly visible within their industries, it can be tough to see them coming outside those traditional boundaries.

Take, for example, the Beijing-based ride-hailing business Didi Chuxing. When Uber entered China, it expected to do battle but failed to realize that Didi Chuxing was closely connected to the mobile payments businesses of Tencent and Alibaba and was therefore a complicated rival. Uber ended up selling its China business to Didi Chuxing for $1 billion in cash and a 17.7% ownership stake. In the tools business, Bosch made a similar mistake, failing to recognize that Dongcheng was a serious competitor — a blind spot that prevented Bosch from mounting a stronger challenge.

By proactively exploring unfamiliar corners of the competitive landscape, companies can improve their chances of spotting emerging trends and preempting moves by potential competitors.

2. Cast a wide net. Although traditional strategy and organizational theory stress the importance of focus,11 Chinese innovators remind us that casting a wide net when searching for opportunities can also pay off. In some cases, we found that the more organizations functioned as ecosystems (by partnering with and investing in external companies), the better they could respond to new opportunities and the challenges that emerged. For multinational companies, the key to exploiting this capability is to give Chinese subsidiaries more local autonomy than they might offer subsidiaries in other countries. That’s because it’s difficult to cast a wide net from far away — it’s unlikely that headquarters-based managers would have enough knowledge of the local ecosystem.

Many multinationals are accustomed to developing innovations internally, often in the R&D centers in China. Although it’s important for companies to pursue continual innovation internally, it’s also critical for them to invest in new ventures and participate in collaborations across the business ecosystem. That approach not only enables companies to expand their revenue streams but also allows them to stay abreast of customer requirements, competitive moves, and new wrinkles in technology — and adjust their business models accordingly.

For example, since being outflanked in the Chinese power tools market by Dongcheng, Bosch has made a concerted effort to connect with local ecosystems by organizing multiple incubator programs and investing in Chinese ventures. Bosch recently invested $15 million in a network equipment company and is developing an experimental smart factory in Chuzhou, where it will make appliances that exploit its internet of things technology. We have noticed an increase in such investments and partnerships by foreign multinationals in China. DSM, a Dutch specialty chemicals company, for example, recently acquired a Chinese photovoltaic component company. And Pfizer has developed partnerships with Tencent and Chinese insurer Ping An to run local health care business-plan contests. Such initiatives can be part of a company’s broader strategy to expand R&D efforts in China.12

3. Mind your home base. No matter how well-established companies may be in their own industries and home markets, they must stay attuned to potential competitive threats. To do that, they need to strengthen their knowledge of their home markets and understand how Chinese innovators might operate and innovate if they set up shop there. Companies should also explore changing customer needs and invest in new technologies and the digital transformation of their businesses.

Our recommendations point to ways in which non-Chinese multinational companies can more effectively compete against China’s emerging innovators. One thing multinationals should not do is walk away from what they do well. They should take full advantage of their core strengths, including their implementation capabilities, intellectual property, global talent pools, and operational experience. Rather than just trying to become “more local,” they should understand the specific challenges China’s innovators pose and develop strong countermeasures. Perhaps above all, they should study the way China’s innovators do business and rethink long-held assumptions about how to innovate successfully in China.