China investment opportunities: In-depth analysis of Fidelity China Special Situations (LON:FCSS)

Fidelity China Special Situations plc (LON:FCSS) is the topic of conversation when Hardman and Co’s Analyst Mark Thomas caught up with DirectorsTalk for an exclusive interview.

Q1:You called your report on Fidelity China Special Situations ‘If you like China, why invest via FCSS?’.What is your brief summary of it?

A1: Our recent notes explored why investor concerns over the whole Chinese market appeared overdone. With the recent rise in these markets, it appears that these disquiets have moderated. Accordingly, in this note, we consider why investors, having decided that they like China, would choose FCSS as their investment vehicle.

We note that i) it has delivered superior returns, ii) Fidelity’s processes and infrastructure are the drivers to this outperformance, iii) it is a large, liquid, closed-ended vehicle, offering whole market exposure, iv) it has falling, variable and relatively low fees, and v) it has delivered rising dividends over a decade.

We have increased our FY’23-24 NAV estimates by ca.20p to reflect the year-to-date performance.

Q2: So tell us a bit more about the superior returns?

A2: Taking a slightly longer-term view, FCSS’s cumulative growth has outperformed the MSCI China Index on each of three- and five-year time horizons, and since inception, with the cumulative NAV growth since launch at ca.3x the level of the index. We included a number of charts in our report highlighting the performance.

Q3: So how has it delivered this outperformance?

A3: That is the key question to ask when considering whether FCSS is the right way to invest in China. The Trust has given us a detailed attribution analysis in its Report and Accounts for many years now.

On average, FY’11-22 saw a 13.3% NAV annual accretion, of which the index accounted for 7.1%, stock selection 7.2% and gearing 1.3% (the balance being the net negative effects of currency, costs, cash and other effects). The mid-teen return is despite an especially challenging FY’22, which saw sharp index falls (-32.1%), compounded by gearing (-10.9%), and only partially offset by continued good stock selection (+6.6%).

In terms of gross performance, taking the whole period FY’11-22, the stock selection and gearing by the manager have added 8.5% to annual NAV, more than doubling the average annual index contribution of 7.1%. Over time, investors further benefited from the compounding value of the higher returns (over 10 years, 7.1% p.a. growth saw the investment double, while 15.6% p.a. growth compounds to see the investment more than quadruple).

Q4: So what does it do differently in terms of its approach to stock selection?

A4: It is important to understand how the manager goes about making the investment decisions that have generated this performance.

Fidelity’s focus is on the underlying value of companies assessed by their growth prospects over the medium term, underlying competitive strengths and the quality of management teams. This is overlaid with thematic drivers such as potential beneficiaries of a “new China”, including the shift to online usage and structural growth in areas like healthcare and life insurance. Its valuation discipline has led to a bias towards smaller companies. The latest portfolio position was explained further in the manager’s report, ‘Will Chinese equities hop ahead in the Year of Rabbit?’.

At its core are the local and global research capabilities of Fidelity, the flexible mandate of the Trust, which allows unlisted investments and gearing, and an active approach to managing investments.

Q5: And what advantages does the Trust itself offer?

A5: FCSS is a large, liquid, closed-ended structure, offering whole market exposure to sterling investors.

There are many open-ended investment vehicles available to those wanting such an exposure, but we see four advantages: i) a closed-ended structure, which typically outperforms open-ended ones, as it has less cash drag and it can invest long term; ii) the fact that it trades through the day on a major exchange, giving good liquidity; iii) there is good corporate governance; and iv) the Trust has a flexible mandate, which allows investment in unlisted companies, and also allows gearing.

Q6: And the risks?

A6: Further regulation in China is a risk, but Fidelity China Special Situations’ exposure appears limited. Geopolitics may affect sentiment, but they are domestically focused. Sentiment can go against FCSS’s investment style. The economic outlook remains uncertain, as is the policy response to it. Returns may be expected to be volatile.

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