Fidelity China Special Situations investment case Q&A with Dale Nicholls (LON:FCSS)

Fidelity China Special Situations plc (LON:FCSS) is the topic of conversation when Tom Stevenson caught up with Portfolio Manager Dale Nicholls for an exclusive interview.

Q1: From an investor’s perspective, China has been pretty out of favour recently. So, maybe you could just set out the case for investing in China.

A1: I think the investment case would be you’re looking at a market where it’s heavily influenced by geopolitics, macro decisions, basically the headlines that you see every day, whereas on the ground, the companies are kind of getting on with it. There are a lot of companies that are completely not impacted at all by these factors, getting on with it and delivering earnings growth over time.

There’s a lot of change happening on the ground: there’s clear winners emerging, and at the same time, we’re seeing better shareholder returns in terms of buybacks and dividends at the same time.

So, in many ways, as a bottom-up stock picker, it’s a pretty good market.

Q2: We’ll get into some of those things that you said there but just before we get there, there are also risks involved in investing in China so could you lay those out as well.

A2: Clearly, over the past few years, regulation has been an issue, I would argue that this is somewhat cyclical in terms of tighter regulation. But clearly, the past few years, we’ve been through probably the hardest and longest tightening regulation. However, again, I would argue that the regulatory environment domestically is quite different now, and there’s a lot more support on growth. Then geopolitics has become much more of an issue and there are companies that are impacted by policies that are coming out of the US as well. So that’s a factor as well. So, I think they’re probably the biggest risks.

At the same time, domestically, clearly, the economy slowed and we’re going through a pretty significant adjustment in the property sector so we need to see how that plays out. I think the risks there can be managed but you’d have to highlight them as clear risks.

Q3: Well, I was going to ask you about the property sector because when people talk about China, it’s rare for them, in the same breath, not to be talking about what’s going on in the property sector. So, what’s the importance of that to the Chinese economy?

A3: It’s a pretty significant part, it’s up to 30% in terms of overall exposure. Many people would say that’s smaller now but still, it’s significant. It’s also a significant part of the consumer balance sheet so clearly what’s happening in the property sector is going to impact the mindset of the consumer. So, it’s significant, probably becoming less important, but still a significant factor so the trends there do need to be watched.

Q4: So, you mentioned the consumer there and I guess one of the other big factors recently has been the emergence of China from COVID. There was a lot of optimism at the start, people thought China’s coming out of COVID, it didn’t quite work out as people expected. What was going on there?

A4: I think you have to recognise that China didn’t stimulate through COVID like a lot of countries in the West did so perhaps coming out, there isn’t as a strong recovery. I think being locked up for three years also has its impact as well.

So, we came out in a weaker economic environment, I think it’s fair to say general consumer confidence is impacted by employment conditions, you had some of the big tech companies cutting quite a few staff and that sort of thing so I think there’s just been a general lack of confidence, I think, is the way I’d put it. Just not the momentum coming out that we see in many of the other countries in the West.

Q5: You’ve talked about some  China-specific things there, the emergence from COVID, the importance of the property sector, the regulation. How does investing in China differ maybe from investing in other parts? You’ve been running this trust now for 10 years, I think so you’ve got a good grasp of how to invest in China. How does it differ?

A5: I think in any market you’re investing in, regulation is an issue, in any market you’re investing in, you’re thinking about the operating environment for an individual company and clearly, regulation is obviously part of that. I think it’s fair to say it’s a bigger factor in China and I say regulation, including geopolitics as well, is a significant factor.

At the same time, I think there’s more similarities and that’s often overstated. There are a lot of companies that have very little impact from what’s happening, both in terms of domestic regulation and in terms of geopolitics, and I think that’s sometimes lost. There’s actually a lot more similarities than other markets but the differences I find are often overemphasised.

Like other markets, I think what will really drive the market over the long term is what’s happening with earnings and capital return from companies.

Q6: Well, let’s talk about that then. So what is happening on the ground? What’s happening to earnings?

A6: If you look at MSCI China, that grew probably high single digit last year and I think if you look at consensus for this year, we’re probably talking low teens. There have been down revisions, but I think it’s not a bad environment. When you consider, obviously, a 5% growth target in terms of GDP for the year, and a pretty good first quarter, as you saw, so with a slowly improving economic backdrop, I think that’s probably achievable.

That actually stacks up pretty well on a global basis in terms of overall earnings growth. Obviously, there’ll be difference between sectors but in general, I think the earnings outlook isn’t that bad. I was just going to add, particularly when you combine it with what we’re seeing in terms of companies doing more in terms of capital return, increased buybacks, increased dividends, I think that’s going to become increasingly more of a focus for investors.

Q7: So, those fundamental attractions are in place. Obviously, that’s only one half of the investment equation, valuation is the other one. and I guess that’s what really jumps out at me about the Chinese market is that it seems, on the face of it, to be a very cheap market. So, have you ever seen China this cheap, and what will the catalyst be to improve those valuations?

A7: It’s a good question. Historically, we’re looking at MSCI China maybe on about nine times forward earnings, which is, I think, more than a standard deviation off historical levels. Maybe not the cheapest it’s been, but definitely in the vicinity of the cheapest.

In terms of that discount versus other markets like the US, obviously, I think it is the widest we’ve seen but in terms of what’s required for that value to be recognised, I don’t know if there’s a specific catalyst. I think it’s just about the delivery of earnings. Despite all these concerns, the regulatory concerns, the geopolitical concerns, the macro concerns, companies delivering earnings. I think when people realise, hang on, despite all these concerns, earnings are still growing, the winners are winning, taking share, getting stronger, and combined with what I said about potentially more capital return, I think they’re probably the factors that can come together to help things get re-rated.

Q8: So, it requires investors generally, probably within China and externally, to see the opportunities. Where are you seeing the opportunities at the moment?

A8: If you look at the overall fund in terms of the way it’s positioned, the biggest bet from a sector perspective is actually industrials, and that is obviously pretty broad so it spans a number of areas. But we’re seeing the emergence of very strong companies in the industrial space that have invested heavily in R&D and you see that coming through in the strength of the products, in terms of pricing power. There’s also the consolidation element that I talked about that’s definitely underway.

There’s a lot of domestic substitution that’s happening as well, there are still quite a few sectors that are dominated by foreign players and with the bifurcation of supply chains etc. I think there is probably an emerging preference for domestic suppliers. So, that stands out.

In terms of the bigger change more recently, I would just say the consumer. So, we talked about how cheap stocks have got and a number of companies that are actually not influenced or impacted by what’s happening geopolitically, a lot of names in the consumer space, around concerns about weak consumer confidence etc., but companies with very strong franchises that are trading at bargain valuation.

So I think at the margin, I’m probably doing more in the consumer space than others.

Q9: We’ve talked a bit about the macro backdrop and the sector backdrop, let’s talk a bit about the trust itself now. Please could you describe what the objectives are of the Fidelity China Special Situations’ trust, how you go about managing it, and what the advantages are of investing through the investment trust structure?

A9: Obviously, the goal is to beat the benchmark but I think more broadly, we’re trying to give investors the broadest exposure to the range of opportunities that are in China, and I think the trust is uniquely structured to capitalise on that.

Obviously, we can use the gearing so at a time like now where sentiment is bad, stocks are cheap, this is the time when gearing is higher so that’s why we’re currently more than 120% geared in the trust. So relatively high from that perspective.

Q10: Just to explain that a little bit, so that means that you’ve borrowed money in addition to the funds provided by shareholders. You’ve leveraged up the potential returns?

A10: Yes, that’s the way the fund is structured and we feel like we’re capitalising on the tools that are given to us to, again, capitalise at a time when sentiment is bad, stocks are cheap. Now is the time to be more aggressive on that front.

Again, given that it is a closed end vehicle, we can do more in the small cap space without having concerns about flows. We can also invest in private companies so as you know, we can invest up to 15% in private companies.

Q11: And are you using that?

A11: Absolutely. That percentage for us is down about 13%, now it’s come down with the broader base of assets that we now have with the acquisition so it’s come down a little but yes, we can invest in private companies as well.

That really fits into that narrative of the broader scope of opportunities, there are (unlisted) private companies like ByteDance that are now the biggest company in terms of earnings in the whole tech sector in China. So, we definitely want to have the opportunity to invest in those types of opportunities and I think you actually have to have a full picture of what’s happening in the whole sector. So, that ability to invest in private companies, I think, is really important.

Finally, I’d just say the ability to use derivatives, to be able to short as well. Obviously, now is a time with valuations where there’s probably less shorting opportunities, but they’re there as well.

Q12: So, these are negative bets on companies that you don’t think are going to do well?

A12: Yes.

Q13: So, there are a number of ways in which the trust is different from maybe other vehicles for investing in China. You mentioned the private companies, the derivatives, the gearing. I just wonder in what sort of market conditions you would expect this trust to do well, or conversely, not to do so well?

A13: It’s an interesting question because obviously we have gearing, we have a fair proportion of small cap companies, which generally do better in up markets, but we do have a fair proportion of companies that I think you’d put in the value category and are more steady growth companies.

So I think the ideal environment would be one of steady returns, a nice steady up market, slow up market, I think would probably be the ideal environment for the companies that we have in the portfolio for that value to be realised.

Q14: Now, just focusing on the trust itself again, recently there was a bit of corporate activity, the trust was merged with another investment trust in the sector, Aberdeen. How important was that? And how important is size in this regard?

A14: Well, obviously having more, we’re bigger as a result and having more liquidity is great for our investors. I think consolidation in the sector is also probably a positive as well, from that same liquidity perspective.

For us, I think the timing is good so having more assets now at a time where, as I’ve said, there’s a lot of opportunity in the market, it’s good to be putting more money to work in this type of environment.

So, yes, it’s all quite positive, I think.

Q15: Finally, just one aspect of investment trust that we haven’t mentioned yet is that as quoted companies themselves, they have an ability to trade at a premium or discount to the value of their underlying assets. In line with most investment trusts, Fidelity China Special Situations has traded at a discount. So what is the Board doing  to manage that discount?

A15: So, the Board has an express policy of obviously keeping the discount in single digits so they’re quite active in the market most days buying back stock. I think we’ve bought back around 4% of outstanding shares in the last year and that makes sense.

Obviously, it’s immediately accretive when we’re buying at a discount so they’re pretty active in the market at these times where you see the discount where it is.

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