How to play a surge in Chinese domestic consumption
A number of global, emerging market and thematic investment trusts put money to work in China, but there are just two dedicated China trusts within the investment companies sector, namely JPMorgan Chinese (JMC) and Fidelity China Special Situations (FCSS). This pair have had a tough time of late.
The US/China trade dispute continues to weigh heavily on sentiment, credit growth is slowing and China’s GDP growth is trending downwards, forecast to reduce from 2017’s and 2018’s respective 6.9% and 6.6% to 6.2% this year and 6% in 2020.
However, earnings growth in China remains strong and although it has proved a volatile market, valuations remain attractive versus history and global peers.
Seeking to achieve long-term capital growth from companies listed in China or Hong Kong, and Chinese companies listed elsewhere, Fidelity China Special Situations has had a challenging past 12 months with performance impacted by a significant sell-off in Chinese equities.
The positive news is that the longer term showing remains strong in absolute and relative terms, while Hong Kong-based portfolio manager Dale Nicholls’ focus on cash-generative companies has resulted in a steadily-rising dividend.
Manager of the fund since April 2014, Nicholls insists there are notable investment opportunities in China, where the middle class is developing rapidly and his focus is on higher growth, consumer-led sectors accordingly.
Nicholls looks for undervalued companies that can deliver over the long term, believing the best investments are companies with good long term growth prospects – he asks himself ‘how big can a company be in 10 years’ time?’ – and also cash-generative businesses controlled by strong management teams. Ideally, Nicholls would look to buy at an attractive valuation.
NEW CHINA ECONOMY
Nicholls favours sectors with strong structural growth prospects, mainly related to rising domestic consumption, China’s growing middle class and ongoing structural reforms. The consumer, information technology and healthcare sectors, so-called ‘New China’ areas where innovation remains high, continue to excite.
‘I have a mid to small cap bias,’ he explains. ‘When companies are smaller they are less well covered by the market and I am investing in mis-priced stocks that can move to fair value over time.’ Company meetings and site visits are a key part of Nicholls’ process as risk management takes on increased importance when investing in small caps.
Albeit diversified across 120-to-150 holdings, the portfolio’s small and mid cap tilt has been a performance drag with Chinese small caps underperforming over the past two and a half years. Over the 12 months to 30 June 2019, Fidelity China Special Situations’ net asset value (NAV) declined by 12.8%, significantly underperforming a 3.2% drop for the MSCI China index.
Yet Nicholls appears as excited as ever about the domestic Chinese opportunity given ‘the natural development of the middle class. As people get richer, you will increasingly see a trend towards premiumisation’.
UNLISTED OPPORTUNITIES ABOUND
A potential advantage for Fidelity China Special Situations is its closed-ended structure, which means Nicholls has less liquidity constraints and can also use futures, options and CFDs to provide gearing and take short positions. However these types of assets and exposures arguably have a different risk profile to ordinary shares.
The trust is also able to invest in unlisted companies, especially advantageous in the current climate when growth companies globally are coming to the public markets later and later.
‘I’m continuing to find a lot of opportunities at the pre-IPO stage,’ enthuses Nicholls, whose biggest concern in China has been the build-up in debt, which is also the main reason he owns none of the banks.
Turning to the US/China trade war, Nicholls says the risk to earnings depends on the particular company in question, although he also stresses that ‘the thrust of this portfolio is about the consumption trend in China. Most of the companies I’m investing in are focusing on the domestic market.’
In fact, Fidelity China Special Situations has low exposure to exporters with around 90% of portfolio company revenues derived from Greater China.
‘I have some hotel exposure and I also own online travel booking company Ctip.com.’ Nicholls continues to find attractive new ideas, such as recent addition Secoo, a luxury e-commerce platform.
Since he took over the running of the trust (1 April 2014), the net asset value (NAV) and share price are up by 121.7% and 128.6% respectively versus 97.3% for the MSCI China index. The top two holdings are Tencent, the internet services and advertising titan; and Alibaba, China’s largest e-commerce and cloud provider.
The top contributors to performance in the 12 months to 30 June 2019 included search engine Baidu.
Other leading contributors included luxury car dealer China Meidong Auto; Li-Ning, the domestic sportswear brand founded by a former Chinese Olympic gymnast; as well as Macau telecom operator CITIC Telecom International.
About 6% of the portfolio is in unlisted holdings. These include global ride-hailing network Didi Chuxing and ByteDance, which operates various content platforms globally including China’s leading news aggregator Toutiao, as well as artificial intelligence technology company SenseTime.
At 222.5p, Fidelity China Special Situations trades at a 9.3% discount to NAV of 245.24p. The discount, which has ranged from 5% to 23.4% over the past five years, has recently narrowed below 10% and the board intends to keep it that way, having introduced a formal plan to that effect. We think this is a good trust to own to play the Chinese growth theme.