Fidelity China Special Situations — Update 6 September 2016

Following a strong run in the local Chinese ‘A’ share market in the first half of 2015, fuelled by margin financing, the subsequent correction, as a result of government intervention and a loosening of the exchange rate mechanism, led to a reduction in the forward P/E multiple from a peak of 19.6x in mid-June 2015 to 10.9x in late-January 2016. Considering the valuation of the Hong Kong-listed ‘H’ share market (Exhibit 2, left hand side), the current forward P/E multiple of 7.3x compares to a range of 5.3x to 8.3x over the last five years and is close to a low relative to world markets. China’s transition from an investment- to a consumption-led economy supports the expectation of superior earnings growth prospects for consumer-oriented sectors, while the implementation of further capital market reforms by the Chinese authorities suggests potential for Chinese equities to rerate over time. In its April 2016 World Economic Outlook, the IMF forecasts higher medium-term GDP growth for China than advanced and most other emerging economies. Although the forecast is lower for the next six years versus the last 20, this is not unexpected given the economy is now more mature. While being mindful of the historical volatility of the stock market, for investors wishing to gain exposure to Chinese equities, a fund focused on finding mispriced opportunities across the market capitalisation spectrum, may hold appeal.

FCSS was launched in April 2010; its aim is to generate long-term capital growth via investment primarily in equities and related securities issued by Chinese companies in China and Hong Kong. The trust may also invest in companies listed elsewhere that generate a significant amount of their revenues in China and Hong Kong. Since 1 April 2014, FCSS has been managed by Dale Nicholls, who joined Fidelity as a research analyst in 1996; he has experience in managing portfolios of Asian companies, including China, and has a small/mid cap investment style. FCSS is benchmarked against the MSCI China index (sterling adjusted). Broad investment limits are in place such as at the time of acquisition, no single investment may exceed 15% of net assets, while short positions are permitted up to a maximum 15% of gross assets. At the July 2016 AGM, the limit on investment in unlisted securities was increased from 5% to 10% of gross assets. FCSS may invest directly in China ‘A’ shares via its Qualified Foreign Institutional Investor (QFII) licence and indirectly through third parties who hold a QFII. Derivatives are permitted for efficient portfolio management, gearing and hedging purposes and exposure to a single counterparty may not exceed 15% of gross assets. FCSS may borrow up to 25% of net assets and gross asset exposure either from borrowing or via derivatives will not exceed net assets by more than 30%.

Manager Dale Nicholls sees the merit of increasing the permitted investment in unlisted securities from 5% to 10% of net assets as providing additional investment flexibility. Following the successful IPO of Alibaba, which FCSS invested in at an early stage, there has been a trend to raise capital in the private markets, before in due course, proceeding to an IPO. The portfolio currently holds two unlisted companies: Didi Chuxing and Meituan-Dianping. Didi Chuxing is the market-leading taxi-hailing service via smartphone app in China and its recently agreed acquisition of Uber’s China operations is expected to give it unassailable market leadership. In the most recent round of funding, the valuation of Didi Chuxing increased from US$16bn to in excess of US$20bn, which has been reflected in FCSS’s NAV. Following completion of the deal with Uber, market speculation is that the valuation could exceed US$30bn. Meituan-Dianping is China’s largest online to offline service provider, where the market has potential to be greater than for online goods and has Alibaba and Tencent as strategic investors. In Nicholls’ view, both Didi Chuxing and Meituan-Dianping have strong growth potential.

The manager reiterates his view that the Chinese economy divides into two distinct sections: consumption-driven ‘new’ China and investment-driven ‘old’ China. He prefers companies that are benefitting from rising consumption, but is also focusing on ‘old’ economy companies that are benefitting from reforms. He believes that slowing GDP growth in China is inevitable, as the previous high levels were naturally unsustainable, but is concerned about high levels of debt. Chinese debt to GDP has expanded significantly since the global financial crisis and has continued to grow. The manager is encouraged by the authorities acknowledging the issue and banks addressing their non-performing loans, but expects reported bad debt levels will continue to rise and consequently does not hold any banks in the portfolio. He also views the pace of reform at state-owned enterprises (SOEs) as disappointing. The announcement of production cutbacks in the steel and coal industries is positive, but taking capacity out of the system may prove problematic given the indebted position of some industry participants. In the two-speed economy, consumption data points are generally positive and some companies are growing rapidly, such as those benefitting from the shift to online products and services. Penetration for consumer items such as luxury cars and beauty and care goods in China remains low, which offers plenty of future growth potential for companies catering to the rising middle class.

The manager comments that, having lagged other indices, the Chinese stock market now appears cheap on both a P/E and P/B basis versus history and world markets, while its ROE remains higher. He sees that despite volatility in the Chinese stock market over the last 12 months, over the long term, investors have been rewarded. While a large percentage of FCSS’s portfolio is invested in mid- and small-cap companies, the manager is also finding opportunities in the larger-cap SOEs, where valuations are often at steep discounts to private companies. Less value is seen in small caps in the China ‘A’ share market, which is driven by retail investors, and the manager has been reducing ‘A’ share exposure, but believes that the ‘H’ share market still offers good value.

The manager follows the same investment process for listed and unlisted securities; although for unlisted securities the liquidity risk means that the potential upside from the investment needs to be higher. He draws on the resources of a team of 12 analysts dedicated to Chinese equities to identify companies with potential to outperform the benchmark MSCI China index (in sterling terms). When considering an investment for inclusion in the FCSS portfolio, the manager seeks companies with long-term growth prospects, generating robust cash flow with strong management teams. He focuses on the potential size of the market operated, the company’s market position, management’s ability to execute and whether the valuation reflects the potential of the underlying business. A large part of the portfolio is invested in mid- and small-cap companies, where information is less widely available and the manager finds more mispriced stocks. As a result, the portfolio has a large number of holdings; typically 130-140.

As shown in Exhibit 3, c 50% of the portfolio comprises consumer discretionary and technology stocks. This is representative of the focus on ‘new’ China, where demand for goods and services is being driven by the rising middle class and the widespread adoption of new technologies. Within the consumer discretionary sector, the manager considers that Macau gaming stocks look attractively valued. Share prices pulled back due to lower gross gaming revenues, as a result of a government focus on anticorruption, tightening credit and a slower economy. However, there are signs that business conditions are improving led by higher demand from the mass market, which generates higher margins than the declining VIP segment, leading to a positive mix shift. Only a small percentage of the Chinese population has visited Macau, which provides a large runway for growth and the gaming stocks are trading on historically low valuations.

In the year ending 31 March 2016, FCSS’s essentially flat NAV total return of 0.02% compared favourably to the 16.17% total return decline in the benchmark. The share price total return fell by 4.53%, with the discount increasing from 13.1% to 17.2% over the period.

Despite volatility in the Chinese stock market over the last year, as shown in Exhibit 4 (left-hand side), FCSS has achieved strong absolute returns over one, three and five years and since inception; with annualised NAV total returns of 43.2%, 27.0%, 18.3% and 12.4% respectively.

As shown in Exhibit 5, FCSS’s NAV and share price total returns have outperformed the benchmark MSCI China index (sterling adjusted) over all periods from six months to five years and since inception. As a reference for UK investors, the trust’s NAV and share price total returns have also outperformed the FTSE All-Share index over all periods shown.

Exhibit 6 shows FCSS’s relative performance since launch, highlighting the consistently strong outperformance since late 2012. Over the 12 months to the end of June 2016, the strongest contributors to performance were holdings in US-listed educational service company New Oriental Education & Technology Group (154bp), which is a market leader and is focusing on improving its margins and café store chain operator, Taiwan-listed Gourmet Master (132bp), which has a very strong business model and high incremental returns on capital with a long runway for growth. The largest detractor from relative performance (-143bp) was the portfolio’s zero weighting in telecom company China Mobile, which has a near 10% weighting in the benchmark; the manager considers that there are better investment opportunities elsewhere within the sector.

Despite strong relative performance over the last three years, FCSS’s share price discount to NAV has widened as a result of negative sentiment towards investment in Chinese stocks. While the current discount of 14.6% is narrower than the 16.8% average of the last 12 months (range of 13.7% to 20.0%), it is wider than the averages of the last three and five years, and since inception (13.2%, 9.7% and 6.6% respectively). Given FCSS’s strong performance track record, there is significant scope for the discount to narrow further if sentiment towards the Chinese stock market improves. Although there is no formal discount control mechanism in place, shares are repurchased when deemed appropriate, with the aim of keeping the share price close to NAV. During FY16, 3.1% of the share base was repurchased into treasury at a 16.4% average discount.

FCSS currently has 551.9m ordinary shares in issue plus a further 19.4m shares held in treasury. It has a US$150m revolving credit facility with Scotiabank Europe and has the ability to increase gearing via contracts for differences (CFDs) on a number of portfolio holdings. During FY16, the fund was geared in a falling market, which during the year detracted 1.8% from NAV total return performance. The current level of gearing reflects the manager’s belief that current valuations in the market do not reflect companies’ fundamentals and growth prospects.

Fidelity International is paid an annual management fee of 1.0% of net assets. A 15% performance fee is payable on returns higher than 2% above the benchmark, capped at 1.0% of net assets. Excess outperformance cannot be carried forward and any underperformance must be made good before any further performance fee is payable. In FY16, ongoing charges of 1.2% were nine basis points lower than in the prior year. The performance fee was capped at the maximum level of £9.1m in FY16, bringing the ongoing charge including performance fees to 2.2%.

Although FCSS’s primary aim is capital growth, the dividend has been increased consistently since 2011. Over the last four years the dividend has compounded at an annual rate of c 25%. The 2016 dividend of 1.80p per share was a 38.5% increase on the prior year and represents a current yield of 1.1%. Revenue earnings of 2.07p per share ensured that the dividend was 1.15x covered.

Exhibit 8 shows a comparison of FCSS with other funds investing in Chinese equities. JPMorgan Chinese is the only other closed-ended fund focused on Chinese equities, so we show the AIC Asia Pacific ex-Japan averages (37% average exposure to China & Greater China). We also include open-ended funds larger than £250m from the IA China/Greater China sector. FCSS’s NAV total return is significantly higher than the Asia Pacific ex-Japan closed-end sector average over one, three and five years. Its NAV total return is above the China open-ended funds over one, three and five years, significantly higher than the top ranked open-ended fund over these periods. FCSS’s risk-adjusted returns, measured by the Sharpe ratio, are above the closed-ended peer group average over one and three years. FCSS’s 1.2% ongoing charge is modestly above the Asia Pacific ex-Japan fund average and appreciably lower than the open-ended funds, while its 2.2% ongoing charge including performance fees is similar to the open-ended fund average.

The board of FCSS comprises six directors, five of whom are independent. Having served as chairman since the trust’s inception, John Owen stepped down at the July 2016 AGM; he is replaced by Nicholas Bull, who was appointed in 2010. Andrew Wells, Fidelity’s former global chief investment officer, fixed income, now vice chairman for Fidelity Canada, also stepped down having served on the board since 2012. David Causer and Peter Pleydell-Bouverie were appointed in 2010 and senior independent director, Elizabeth Scott in 2011. The newest members of the board are Vera Hong Wei appointed with effect from 24 March 2016 and John Ford at the 22 July 2016 AGM. Ford is Fidelity’s global chief investment officer, fixed income, solutions and real estate, and therefore is considered not to be independent.