Fidelity China Special Situations — Still finding investment opportunities

Exhibit 2 (left-hand side) shows the valuation over the last five years of Chinese companies listed in Hong Kong (the ‘H’ share market). Although there has been some positive revaluation since the relative low point in February 2016, ‘H’ shares are still trading at a c 50% discount to world indices, which is broadly in line with the average of the last five years. In absolute terms, the current 7.6x forward P/E multiple compares to the 6.6x average of the last five years. There is potential for further rerating of Chinese equities; as shown in Exhibit 2 (right-hand side) in its October 2016 World Economic Outlook, the International Monetary Fund forecasts higher economic growth for China versus both advanced economies and other emerging markets. This could translate into stronger corporate earnings growth for consumer-related sectors such as technology, as China transitions from an investment to a consumption-led economy. Also, if Chinese policymakers increase the emphasis on reform rather than economic growth, there is potential for higher returns from state-owned enterprises (SOEs). While bearing in mind that the Chinese stock market can be volatile, for investors looking to gain exposure to Chinese equities, a fund invested for the long term, with an unconstrained approach and a strong performance track record, may appeal.

Launched in April 2010, FCSS aims to generate long-term capital growth by investing primarily in a diversified portfolio of companies listed in China or Hong Kong and Chinese companies listed elsewhere. It may also invest in listed companies that have significant operations in China and Hong Kong. Derivatives are permitted for efficient portfolio management and hedging.

At the time of investment, no single position may exceed 15% of the portfolio and short positions are permitted up to 15% of gross assets. FCSS may borrow up to 25% of net assets and gross asset exposure, either from borrowing or derivatives, will not exceed net assets by more than 30%. At the July 2016 AGM, the permitted level of investment in unlisted securities was increased from 5% to 10% of gross assets. FCSS may invest in ‘A’ shares either directly through the investment manager’s Qualified Foreign Institutional Investor (QFII) licence or indirectly through third parties who hold a QFII. The trust is benchmarked against the MSCI China index (sterling adjusted).

Since 1 April 2014, FCSS has been managed by Dale Nicholls, who joined Fidelity in 1996 as a Japanese research analyst and since 2003 has managed portfolios of Asian equities, including China. Along with FCSS, he currently manages the Fidelity Funds Pacific Fund. Nicholls has a bottom-up investment style, seeking undervalued companies that have long-term growth potential.

Manager Dale Nicholls notes that there has been sector rotation within the Chinese stock market recently; cyclical companies (including financials) have performed better as an uptick in manufacturing purchasing manager indices and rising commodity prices indicate a more robust Chinese economy. However, the manager is still able to find undervalued steady, long-term growth companies to invest in. He comments that the valuation of Chinese equities remains low versus world equities with news headlines about China focusing on risks to economic growth, the amount of credit and geopolitical issues, which serve to keep relative multiples low. Nicholls believes that over time, stocks should follow earnings growth, so companies with attractive long-term growth profiles should see their share prices rerate positively in the future.

On the political front, the manager believes that with an expected change in five of the seven politburo members at the end of 2017, there will be a prospect of an increased focus on reform and less attention on economic growth. He suggests that the main driver of economic expansion will be domestic consumption as China continues its shift from an investment- to a consumption-led economy. Regarding the talk of protectionism by US president Trump, Nicholls suggests that the relationship between the US and China is already contentious and the trade balance is shifting with the percentage of Chinese exports into the US falling, while the percentage of US exports into China is rising. In addition, China is the second largest holder of US treasury bonds, which strengthens its bargaining position.

Nicholls invests on a bottom-up basis, primarily in mid and small caps, seeking companies with long-term growth potential that he views as mispriced. He stresses the importance of investing for the long term. Nicholls looks for companies with strong cash generation and capable management teams. He is able to draw on the resources of Fidelity’s team of 23 analysts researching Chinese equities (based in Hong Kong, Singapore and Shanghai). Smaller companies tend to be under-researched, which leads to a greater chance of mispricing, providing investment opportunities; however, small stocks can be considered higher risk making the company’s risk management an important part of the investment process. Company meetings are a key element both in helping to identify potential new investments and also to monitor the progress of existing portfolio companies. FCSS typically holds a large number of stocks (130-140 companies). Short positions are currently between 200bp and 300bp and unlisted investment exposure is between 300bp and 350bp.

On a sector basis (Exhibit 3), over the last 12 months the largest increase in exposure was information technology (+4.8pp), while the largest decreases were materials (-3.3pp) and financials (-2.8pp). The largest active weights within the portfolio are an 18.6pp overweight position in the consumer discretionary sector and a 17.4bp underweight position in financials. The consumer discretionary sector is a fertile hunting ground for the manager’s style of investing; many companies have attractive long-term growth profiles and Nicholls is able to identify firms trading on attractive valuations. Within financials, FCSS retains a zero weighting in Chinese banks based on the view that the level of non-performing loans will likely rise. Banks are addressing the issue by writing off bad loans, but this is occurring slowly and so may impede earnings growth over a protracted period.

Exposure to SOEs has increased from a mid-teens percentage to c 25% (although still well below the c 45% in the MSCI China benchmark). The manager’s view is that in general, SOE reform has been slow, but he suggests that improvements may be on the horizon. He looks for SOE companies where management’s interests are aligned with shareholders’ (this tends to be less prevalent at SOEs), and which hold strong assets, such as airports, where operators are benefiting from rising consumption trends; internal and overseas air travel is growing at an annual double-digit rate. There is potential for industry reform given that many Chinese airports are losing money and there are opportunities to expand non-aeronautical operations, such as increasing retail operations.

Relatively recent additions to the portfolio include Chaowei Power, Fu Shou Yuan and Yihai. Chaowei Power is China’s largest producer of electric bike batteries; in an industry where the top two players control 80% of the market, Chaowei is by far the largest. The pricing environment has been tough, as the two dominant players fought a price war, but is now moderating. The stock is very under researched and trading at a forward P/E multiple of 6.3x. Fu Shou Yuan is the leader in private funeral homes; an industry that is very underdeveloped in China, with plenty of room for a strong operator offering a high-quality service. Customers are not price sensitive and the company is able to invest up-front payments as the ability to offer pre-need arrangements is starting to be permitted. Yihai supplies hot pot condiments, focusing on high-end products (hot pots are a staple meal in China). It is a key supplier to its strategic partner and major shareholder, Haidilao, which is a large and growing restaurant chain. Yihai is leveraging the success at Haidilao to sell its products into the retail channel.

During 2016, the permitted allocation to unlisted investments was increased from 5% to 10%. Since our last report, the manager has invested in a third unlisted company. Along with Didi Chuxing and Meituan-Dianping, FCSS holds a position in Yiguo. This company is backed by Alibaba and at two-to-three times larger than its largest competitor is the clear leader in online fresh food sales. The manager considers that Yiguo has a strong management team, business trends are very strong and it benefits from high traffic on Alibaba’s Tmall site. This latest investment means that total unlisted exposure is now between 300bp and 350bp. Nicholls suggests that there is significant entrepreneurial activity in China, especially in the technology sector, so there are plenty of unlisted opportunities in the pipeline. Expected returns from unlisted companies are significantly higher than for quoted securities, given the higher risk and that capital can be tied up for a significant period.

Absolute returns are shown in Exhibit 4 (right-hand side); over the last 12 months, FCSS’s share price and NAV total returns of 45.8% and 39.3% respectively have been boosted by the weakness of sterling. FCSS’s relative returns are illustrated in Exhibit 5; its NAV total return has outperformed the benchmark over one, three and five years and since inception. The manager comments that over the last six months, the largest detractors to performance are CT Environmental and Sinosoft Technology. Both companies have suffered from negative research coverage by short sellers (investors who sell stock, hoping to buy it back at a significantly lower price). Nicholls has thoroughly investigated the allegations contained in the research reports and has spoken at length to the management teams of both CT Environmental and Sinosoft Technology. He believes that the research is inaccurate and has added to his holdings in both of the companies following share price weakness. As a reference to UK shareholders, we show FCSS’s performance versus the FTSE All-Share index. Its share price and NAV total returns have outperformed over one, three and five years and since inception.

FCSS’s current 12.7% share price discount to cum-income NAV is narrower than the 15.6% average of the last 12 months (range of 11.6% to 19.9%). It compares to the averages of the last three and five years and since the trust’s inception of 14.3%, 11.1% and 7.3%. The discount has been in a narrowing trend since mid-2016 and there is scope for it to narrow further if investor sentiment towards Chinese equities continues to improve. It should be noted that in the past, there have been periods when FCSS traded at a premium; the last time was in early 2013.

FCSS is a conventional investment trust; there are currently 551.9m ordinary shares outstanding with a further 19.4m shares held in treasury. On 14 February 2017 it entered into a new $150m three-year revolving credit facility with Scotiabank Europe, which is fully drawn down. To achieve further gearing, FCSS uses contracts for difference (CFD) on a number of its portfolio holdings; at end-February 2017, gross gearing was 27.5%. The manager suggests that given the significant rise in the Chinese stock market since May 2016, the level of gearing may come down.

Fidelity International is paid an annual management fee of 1.0% of net assets, on a quarterly basis. An annual performance fee of 15% is payable on returns greater than 2.0% above the benchmark; this is capped at 1.0% of net assets. Excess outperformance may not be carried forward and any underperformance must be made good before any further performance fee is payable. For H117 (ending 30 September 2016), the ongoing charge (excluding performance fees) was 1.23%, which was a 9bp increase versus H116. Including performance fees, the ongoing charge in H117 was 1.38% versus 1.83% in H116.

FCSS aims for capital growth rather than income; however, the annual dividend has increased every year since 2011 (Exhibit 1). Over the last four years, the compound annual growth in the dividend is c 25%. The 2016 dividend of 1.80p was 1.15x covered and was a 38.5% increase versus the prior year. FCSS’s current dividend yield is 0.9%.

Exhibit 8 shows a comparison of FCSS with other funds investing in Chinese equities. JPMorgan Chinese is the only other fund in AIC Country Specialists: Asia Pacific sector that is focused on Chinese equities, so we show the AIC Asia Pacific ex-Japan sector 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 ahead of the Asia Pacific ex-Japan weighted average over one year and significantly ahead over three and five years. It has a similar record versus the open-ended funds shown. FCSS’s ongoing charge is modestly wider than the closed-end peer average, it has higher gearing and given its focus on capital growth, a lower-than-average dividend yield.

There are six directors on the board at FCSS of whom five are independent of the manager. Chairman Nicholas Bull was appointed in February 2010 and assumed his current role on 22 July 2016. The other four independent members and their dates of appointment are David Causer and Peter Pleydell-Bouverie (both February 2010), Elisabeth Scott (November 2011) and Vera Hong Wei (March 2016). John Ford was appointed on 22 July 2016 as Fidelity International’s global chief investment officer, fixed income, solutions and real estate; he is considered a non-independent member of the board.