Fidelity China Special Situations — Update 20 April 2016

The sharp correction in Chinese equities in 2015 has seen valuations move substantially lower with the domestic China ‘A’ share market’s forward P/E multiple declining from a peak of 18.2x to its current level of 13.0x. While this represents a 14% discount to world markets, it is not as wide as its five-year average discount of 20%. As illustrated in Exhibit 2 (left-hand chart), the market decline pushed the forward P/E multiple of the Hong Kong-listed China ‘H’ share market down to a five-year low both in absolute terms and relative to world markets. This suggests significant scope for Chinese equities to move higher due to re-rating as well as earnings growth.

Over the next six years, while GDP growth is projected to be distinctly lower than that achieved over the last 20 years, China is expected to remain one of the faster-growing emerging economies and substantially outpace advanced economies (Exhibit 2 right-hand chart). Concerns over further slowing of the Chinese economy have been driven by weak data from industrial sectors that have historically been the main drivers of growth. However, the Chinese government continues to focus on implementing market reforms and transitioning towards a consumer-driven economy, which implies a more favourable backdrop for corporate earnings growth in consumer-oriented sectors.

The disparity in growth prospects and valuations across and within sectors makes a fund such as FCSS with its bottom-up approach appear well-suited to selecting the more sustainable growth opportunities in the Chinese market. While high levels of market volatility over the last year suggest an element of caution may be appropriate for investors seeking to gain exposure to Chinese equities, the associated short-term mispricing of stocks can create investment opportunities for longer-term investors who are not constrained by benchmark allocations.

FCSS is an LSE-listed closed-ended investment trust, which was launched in April 2010 to provide UK investors with a simple way to gain exposure to the China growth story in a diversified portfolio. The trust’s objective is to achieve long-term capital growth by investing in an actively managed portfolio of Chinese equities, primarily comprising securities of companies listed in China or Hong Kong and Chinese companies listed on other recognised exchanges, but also including other listed companies with significant interests in China and Hong Kong. While portfolio allocations are not constrained by index weightings, performance is benchmarked against the MSCI China Index expressed in UK sterling. The portfolio is managed by Fidelity International (Fidelity), whose investment approach is characterised by bottom-up stock picking facilitated by extensive research capabilities. Anthony Bolton managed the trust from launch, succeeded by Dale Nicholls in April 2014. Nicholls has 20 years’ investment experience in the Asia-Pacific region and has managed Fidelity’s Pacific Fund since September 2003. While Nicholls is not solely focused on FCSS, China remains the Pacific Fund’s largest exposure and there is a large overlap in holdings between the two funds.

Dale Nicholls believes that although China’s headline economic growth is slowing, the quality of growth is improving with the rebalancing of the economy towards consumption providing a fertile environment for innovative companies to thrive and reward investors over time. The weakness in freight traffic, steel and cement production is seen as reinforcing the fundamental case for investing in the consumer-oriented sectors of the economy. Nicholls points to the portfolio’s 11-12x forward P/E multiple with c 20% expected forward earnings growth, highlighting FCSS’s minimal exposure to the energy and materials stocks, which have seen the largest earnings downgrades.

Nicholls has sought to take advantage of share price falls seen as excessive in certain market segments by adding to existing holdings, notably in the industrials, consumer staples and information technology sectors, while also reducing short positions. This has led to an increase in gearing towards the trust’s upper limit, corresponding with Nicholls’s positive longer-term outlook.

Nicholls highlights the recent addition to the portfolio of Didi Chuxing (formerly Didi Kuaidi), FCSS’s first unlisted investment since Alibaba’s IPO in September 2014, noting an increasing number of unlisted investment opportunities arising at realistic valuations. Didi Chuxing is the market-leading taxi-hailing service via smartphone app in China with a c 80% market share and its most recent fund-raising implies a c US$20bn valuation. Formed from the merger of Didi Dache and Kuaidi Dache (backed by Tencent and Alibaba respectively), its closest rival is Uber China.

Bottom-up stock selection forms the basis of portfolio construction with allocations unconstrained by benchmark index weightings. Overall, the manager looks for stocks that can deliver outperformance over the long term and seeks to identify companies with good long-term growth prospects, cash-generative businesses and strong management teams. The aim is to find companies trading on valuations that do not reflect the quality and potential of the business. There is a general bias towards small and mid-cap stocks as they tend to be less well researched, so offer more mispricing opportunities. Meeting management is considered an essential part of the process to gain an understanding of companies and monitor their progress. The portfolio manager undertakes an intensive schedule of c 700 company meetings and visits each year. The manager is supported by Fidelity’s significant regional resources, with 23 analysts providing relevant stock coverage, including 12 analysts dedicated to Chinese equities. Risk management is seen as key to the investment process with third-party resources employed to provide additional due diligence checks on companies and corporate governance verification before FCSS makes an investment.

FCSS uses futures, options and CFDs to enhance portfolio performance, as well as for efficient portfolio management and hedging. The trust can invest in China ‘A’ shares, both directly through the investment manager’s QFII licence and indirectly through brokers that have a QFII facility. Up to 5% of gross assets may be invested in unlisted securities and the aggregate gross asset exposure of short positions is limited to 15%.

FCSS holds c 140 investments with the top 10 holdings representing 29.5% of the portfolio at 29 February 2016 (see Exhibit 1), modestly higher than 27.3% a year earlier. The trust’s exposure is significantly less concentrated than the MSCI China Index, which had 157 constituents with the top 10 accounting for 50.1%. The manager reports portfolio turnover of c 80% in FY16, only slightly higher than recent years (68.3% in FY15 and 59.0% in FY14) despite increased market volatility and a change in the benchmark index composition during the year.1 A small/mid-cap bias is retained with stocks below £1bn market cap representing 45% of the portfolio (Exhibit 1).

The most significant change in FCSS’s portfolio’s sector exposure over the year to end-February 2016 was an 8.7pp reduction in financials, partly reflecting the sell-off of former top 10 holdings Ping An Insurance and Citic Securities during the market correction. The portfolio has no holdings in Chinese banks, contributing to a significant underweight in financials, and the other predominant active exposure is an overweight in consumer discretionary (Exhibit 3), with an increased active position in each (-3.7pp and +1.6pp respectively). The greatest change in active weight was an 8.9pp reduction in information technology, moving the sector to underweight. This was driven by the change in index composition, which saw its information technology weighting increase from 13.8% to 23.8% over the year to end-February 2016. Other active underweight exposures in the portfolio broadly correspond with sectors dominated by state-owned enterprises.

As shown in Exhibit 5, FCSS’s share price and NAV total return have both outperformed the MSCI China Index over one, three and five years and since the trust’s inception in April 2010. Although not immune to market swings and the overriding market downtrend, the trust’s performance has been differentiated from its benchmark, with a strong relative performance achieved over the last year (Exhibit 4). FCSS’s substantial outperformance of its benchmark since December 2012 in NAV terms has outweighed a weaker relative performance during 2011 and 2012 (Exhibit 6). The Chinese market as represented by MSCI China showed a relatively weak performance compared with world markets from early 2011 to mid-2014, followed by strong outperformance as the index climbed 75% in sterling terms from May 2014 to April 2015. In spite of the recent sharp decline of Chinese equities as a whole, FCSS’s NAV total return has outperformed the FTSE All-Share Index over all time periods of one year or longer and delivered a similar performance to the MSCI World index over one and five years and since inception while materially outperforming over three years.

The board has made no commitment to maintain the discount at a particular level but believes that it is in the best interests of shareholders for the share price to track closely to NAV. Having made only one repurchase of 0.1m shares in the year to 31 March 2015, the trust started buying back shares into treasury more actively in April 2015, with the discount standing at c 14%. Share buybacks continued during the Chinese market decline through to September 2015 when pressure on the discount alleviated. Buybacks were restarted in mid-January 2016 at a modest pace as the Chinese market weakened again with 3.9m shares subsequently repurchased.

As illustrated in Exhibit 7, FCSS’s share price discount to NAV (including income) has followed a widening trend over the last three years with negative market sentiment towards China prevailing over the trust’s strong performance. The discount currently stands at 17.9%, which compares to its three-year average of 12.0%, suggesting scope for it to narrow when market sentiment improves supported by share buybacks.

FCSS has 553.1m shares in issue with a further 18.2m shares held in treasury. FCSS has authority to buy back up to 14.99% and allot up to 10% of its shares in issue and repurchased 17.9m (3.1% of issued capital) in the year to 31 March 2016. Shares may only be repurchased at prices below prevailing NAV per share, and only reissued from treasury at or above prevailing NAV per share. FCSS has a fully drawn US$150m three-year credit facility (to February 2017), representing c 10% of net assets against a 25% limit, and uses CFDs to achieve further gearing. Gearing is reported as the gross market exposure provided by equity and CFD investments plus the gross value of futures and options positions. This is restricted to a maximum 130% of net assets and stood at 127.7% at 29 February 2016. Net gearing (market exposure net of short positions) was 126.7% at 29 February 2016, up from 119.2% at end-December 2015 and a low of 110.0% at end-June 2015.

A management fee is paid to Fidelity International at a rate of 1.0% pa of net assets. In addition, a 15% performance fee is payable on returns more than 2% above the benchmark MSCI China Index, capped at 1.0% of net assets. There is no carry forward of excess outperformance but underperformance must be fully recouped before any further performance fee is payable. Ongoing charges were 1.29% (1.94% including performance fees) in FY15 and equivalent to an annualised rate of 1.14% (1.70% including performance fees) in H116.

FCSS aims to achieve long-term capital growth and dividends are not expected to constitute a material element of returns to shareholders. However, as an investment trust, FCSS distributes at least 85% of its net income with the flexibility to pay dividends out of capital profits if circumstances should warrant. A dividend is paid annually and has been increased in each of the four years since the first distribution in 2011 (see Exhibit 1). In line with income growth, the FY15 dividend was increased by 13% to 1.30p representing a 0.9% yield. Adjusting for payment of the FY15 dividend, revenue reserves at 31 March 2015 equated to 1.0p per share.

Exhibit 8 shows a comparison of FCSS with similar closed-ended funds as well as open-ended funds larger than £250m from the IA China/Greater China sector. JPMorgan Chinese is the only other closed-end fund focused on Chinese equities, so we show AIC Asia-Pacific ex-Japan sector averages (39% average exposure to China and Greater China). FCSS’s NAV total return ranks at or close to the top of the closed-ended and open-ended peer groups over one, three and five years, with very substantial outperformance over three years. In terms of risk-adjusted returns, FCSS’s Sharpe ratio is less than one over one year, reflecting recent market volatility, but greater than one over three years, ranking at the top of the peer group. FCSS’s ongoing charge of 1.29% (excluding performance fees) is at a broadly similar level to closed-ended peers and compares favourably with the open-ended peer group average of 1.72%.

Following the appointment of Vera Hong Wei as a director with effect from 24 March 2016, the board comprises seven non-executive directors, all of whom are independent, with the exception of Andrew Wells. Ms Wei is a Chinese national with 18 years’ experience in the Chinese financial industry, which spans the central bank, commercial bank and asset management sectors. Her previous roles include managing director of Greenwoods Asset Management, vice general manager of Ping An Annuity in Shanghai, head of corporate banking at Shenzhen Development Bank and director of the People’s Bank of China. John Owen (chairman), Nicholas Bull (senior independent director), David Causer and Peter Pleydell-Bouverie have served on the board since February 2010. Elisabeth Scott was appointed as a director in November 2011 and Andrew Wells (Fidelity’s global chief investment officer, fixed income) joined the board in May 2012.