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With less than two months left until 2023 ends, consumer stocks have already shown a general performance: the Wind Consumer Index (888013.WI) and the Hang Seng Consumer Index (HSCGSI.HI) have dropped 10% and 23% respectively from the beginning of the year. Among them, the food and beverage sector, the largest weight in A-shares, has performed poorly, lagging behind home appliances, textiles and apparel, light industry manufacturing, and pharmaceutical biology.

The dairy industry, home to leading consumer brands, has also been immersed in the harsh market atmosphere. Since the beginning of 2023, the Wind Dairy Index (884662.WI) has fallen by 15.92%, and the Hong Kong Dairy Index (887661.WI) has dropped by 23.71%.

In early reports, Barron’s Chinese Edition raised two questions about the profit growth and valuation potential of the dairy industry. Looking back now, these two questions seem to merge into a new one: has the investment logic for the dairy industry changed? If we place this question in a broader consumer goods context, we can easily see subtle shifts in the investment logic of consumer stocks:

From a macro perspective, the recovery of consumer demand is highly certain. In the first nine months of 2023, China's total retail sales of consumer goods grew by 6.8% year-on-year. As a traditional sector, food and beverage stands to benefit from consumer growth and the optimization of economic structure. For example, in the dairy industry, the negative impact of costs has weakened, market competition has improved, and some long-term improvements in industry profit structures are beginning to materialize.

Many market opinions suggest that with the economic transformation and enhanced recovery momentum, now is a good time to invest in consumer stocks, and leading consumer companies are expected to "stand out."

"Good Milk is Grown"

One of the key valuation logic factors for consumer stocks is profit growth. The dairy industry’s profit growth model can be observed in the case of Dengkou County, located in the Inner Mongolia Autonomous Region’s Bayannur City.

Dengkou County, a small city with a population of just 100,000, is unfamiliar to most. However, its unique geographical conditions, located on the 40th parallel north (recognized worldwide as a prime dairy belt), make it stand out: it is situated at the foot of the Yin Mountain, benefiting from both farming and pastoral agriculture; it is at the source of the Hetao Plain, where the Yellow River flows through; and it has abundant surface water resources that can be used for irrigation.

These geographical conditions are crucial because, as Mengniu Dairy’s (2319.HK) Dairy Source Division General Manager Cheng Xiaofei told Barron’s Chinese Edition, “Milk is grown.” Only with good environmental conditions can there be good pastures, and only with good pastures can cows be raised well to produce high-quality milk. This has become a consensus in the dairy industry.

Over the past 13 years, people have transformed a 200-square-kilometer area in the heart of the Ulan Buh Desert into a green oasis. In this oasis, not only have essential cow feeds such as corn, oats, and alfalfa been planted, but 23 dairy farms have also been built, housing 102,000 dairy cows and producing 600,000 tons of raw milk annually.

Today, this oasis, developed by China Shengmu (1432.HK), has become the world’s largest organic raw milk production base.

These 13 years coincide with a period when China's dairy industry, following the melamine contamination incident, restructured its industry regulations and reshaped its market structure. Quality has become the dominant factor for downstream dairy producers, driving the industry’s shift upstream. The "dairy + livestock" model has become standard for leading domestic dairy producers, and dairy companies' control over upstream dairy farms continues to grow.

For investors, the first shift in dairy stock investment logic is the focus on industry investment returns rather than just cash flow performance. In the broader consumer goods market, companies with dominant positions in the supply chain are becoming more attractive for long-term investment.

“Consumption Upgrade and Downgrade May Be a False Dilemma”

First comes quality improvement, then profit improvement. Since Mengniu launched China’s first premium milk brand, Telunsu, in 2006, “premiumization” has become a regular keyword in the financial reports and public information of dairy companies. From the high-end product revenues of the domestic market’s “duopoly” — Mengniu Dairy and Yili (600887.SH) — it’s clear that "premiumization" has become one of the most conventional strategies in the industry.

The reason for this is obvious: for Chinese dairy consumers, quality is of utmost importance. This has brought dairy companies, already striving for higher product quality, into alignment with consumer demands.

However, improving quality inevitably requires price increases. In the essential consumer goods sector, only a few companies have pricing power. Even though disposable income in China has steadily risen over the past two decades, price increases still affect sales and revenue in a highly competitive market, as seen in many cases.

During the mid-year earnings conference, Mengniu’s President and Executive Director Lu Minfang candidly said, "We cannot understand premiumization in a one-dimensional way. I have always said that consumption upgrading or downgrading may be a false dilemma. I still believe that value is key; if there is no value, you can only lower prices."

One interpretation of this is that, as the industry’s competitive focus shifts upstream in the supply chain, companies' profit improvement is not merely about raising prices, but about optimizing product structures. Mengniu Senior Vice President and Head of the Ambient Division Gao Fei noted that, from a consumer demand perspective, China has a middle-class population of around 400 million, who certainly need good products and valuable offerings. Therefore, product structuring is essential. For example, Mengniu launched Telunsu Desert Organic Milk in the first half of 2023, further optimizing its product structure, with the company’s organic products now accounting for 30% of its sales.

Product structure optimization is not limited to the dairy industry; it has become an inevitable trend in the entire consumer goods sector. From an investor’s perspective, in the fiercely competitive consumer market, companies with product structure advantages have become a necessary condition for identifying new consumer stock leaders.

“Let the Cows Live in ‘Beijing, Shanghai, Guangzhou’”

Once the positive cycle of profit growth, quality improvement, and product structure optimization is achieved, one of the additional returns for consumer goods companies is the enhancement of the value added in the industry chain. For dairy companies, the process of improving product quality and optimizing product structure is, in fact, a process of transforming and integrating the upstream, midstream, and downstream of the industry, with agriculture, livestock, food processing, and end consumption developing in synergy.

This also means that some hidden long-term investment value has already been planted at the front end of the supply chain.

Returning to the oasis in the heart of the Ulan Buh Desert, China Shengmu has, through afforestation, created a 200-square-kilometer area in the vast desert, using a three-level protective forest system to block wind and sand. This creates a relatively isolated space, where infrastructure has been built, crops and grasses are planted, and after 13 years and an investment of 7.5 billion RMB, 97 million sand-resistant trees have transformed the desert into a grassland. Huang Yongqiang, head of Shengmu GaoKe’s grassland base, told Barron’s Chinese Edition that the grassland is now fully managed with modern techniques, with each worker managing around 10,000 mu of land.

Based on this organic grassland, the quality of life for the cows has naturally improved. "If I had to make an imperfect analogy, the cows here live as if they are in ‘Beijing, Shanghai, and Guangzhou’," Huang said. Each cow’s average activity area is 60 square meters, with a daily meal allowance of 80-90 RMB. The organic milk produced by these cows, grown in the desert, is the final product that represents the industry's quality upgrade and the consumer's demand for better products.

An ESG-focused investor in the consumer goods industry told Barron’s Chinese Edition that, looking back at the dairy industry’s ESG journey in China, it initially began as "forced." "Overseas investors care about ESG. Initially, some overseas investors benchmarked Chinese dairy companies against their international counterparts and set ESG requirements. For Chinese companies, these requirements were certainly a big challenge. But looking at the results now, China's dairy industry has done quite well."

When comparing China’s dairy companies to their international peers, the investor acknowledged that it is not possible to fully adopt international ESG standards. However, in her long-term observation, “Chinese dairy companies are improving year by year compared to themselves,” and "Mengniu and Yili are already at an international leading level."

In December 2018, Mengniu announced the purchase of a 51% stake in Shengmu GaoKe for 303 million RMB. Then, in July 2020, Mengniu subscribed to approximately 1.197 billion shares of China Shengmu at 0.33 HKD per share, becoming its largest single shareholder. As one of the companies with the longest full-chain industry layout in the dairy sector, Mengniu's demand for organic products has led Shengmu to adjust its upstream raw milk supply. According to Xu Guoren, head of investor relations at China Shengmu, in 2020, organic raw milk accounted for about 50% of Shengmu’s total milk production, but now it accounts for over 75%.

Huang Yongqiang shared that, after 13 years of development, the annual