When I was in London during Chinese New Year - the same week that coincided with the Chinese government significantly ramping up their containment efforts in order to handle the virus outbreak - what was clear for me was the level of uncertainty about the virus. In fact, at the time, I thought that there was real risk in simply applying the “SARS playbook”.
Up until recently, these concerns were best represented by the portfolio’s protection strategies and a reduction in the gearing level; this in turn saw the portfolio’s net exposure fall to below 115% a few weeks ago (it should have been lower!) Additionally, my initial concerns also saw me trim positions in more economically sensitive areas, especially those names with a global exposure.
How things can change in seven weeks. The virus has gone global and markets are down significantly. As we have seen in China, containment has huge economic consequences. We need to assume double digit declines in the broader measures of growth (i.e. GDP). We have seen a massive response from governments around the world, both on the monetary and fiscal side.
So far, although actions from Chinese policymakers look relatively restrained versus others, I believe we will see significant fiscal and monetary measures announced in the coming weeks and months. Bold moves other central banks have made give the People’s Bank of China (PBOC) room to ease. Infrastructure spending is likely to be boosted, with notable funds already being raised by local governments in bonds…expect more to come.
Government directives to the banks will support corporates - but a concern will be how much of this makes sense to Small and Medium Enterprises (SMEs). Anecdotal evidence from a listed leasing company that focuses on the smaller end of town, was reassuring and surprising with relatively few signs of stress. However, this area is something that needs to be closely monitored.
A major driver for the market will be daily new infections - getting beyond this point, or at least getting it in sight, will be one important factor for the market to form a bottom. We now have positive examples in Asia of declining infections and there are signs that a number of countries in Europe are on a similar path. It is a harsh realisation, but countries have to experience the short term pain (i.e. containment actions even if heavy handed) to get through the situation and recover and from what we can see, China is recovering and recovering relatively strongly.
However, I also acknowledge the risk of a second wave of infections - and this is something we are closely watching. In terms of this risk though, we hear that the Chinese government remains very strict with their screening and quarantining measures. Similar to Singapore and Hong Kong, imported cases are a potential threat, which is why, China has also implemented another round of containment measures.
Take for example, a colleague who is based in Hong Kong but had to urgently fly back to Beijing recently; whilst a Chinese national, they have been placed in a government suggested hotel for two weeks. Like so much of what we see when it comes to policy tweaks in China, there is caution in some instances (for example, schools remain closed). Following the recovery in manufacturing, I also expect the services sector will recover albeit more slowly.
So, what are we doing?
The same! We continue to assess the fundamentals of companies - although more calls are done versus one-on-one meetings. Then again, there have actually been some changes; the team is spending even more time analyzing companies’ balance sheets and cash flows as well as engaging with management teams to understand the challenges of withstanding a period of significant revenue declines. I'm also truly proud of the way our team has pulled together globally (despite working from home). Not only are we obviously leveraging our pharma team’s expertise on the virus but also sharing views and analysis across the entire global Fidelity team relating to the economic effects and views on risks and opportunities in the market.
When it comes to corporate China, it too is in recovery mode - management teams we talk to across most industries are focused on getting “back on track”. One manufacturer told us the other day that they are back up to 80% utilisation and aim to be at 100% by the end of March. The recovery in consumption is a tougher call, but more stimulus support should help - be it towards certain geographical areas such as Hangzhou where the Zhejiang provincial government gave out 1.7bn CNY of shopping vouchers or policies that support specific sub-sectors like autos. Again, what is clear for me is that spurring on domestic consumption remains a priority for the government.
Despite these positive signs, there has also been huge volatility, with the market efficiently rewarding those companies that are set to benefit from the containment phase and punishing those in the firing line on the economic impact, especially those with a more global footprint. My core focus remains on consumer and technology related companies, which I expect to benefit from the structural growth drivers that we have been highlighting over the past years. In fact, what is becoming very evident for me is that many of the trends we were seeing in the market will be further accelerated by what has happened. The shift online, be it in e-commerce or services like online education, coupled with the need to manage the data that drives this, will become even more paramount. We estimate that approximately 40% of the portfolio is positioned in areas set to benefit from these shifts.
For the most globally focused companies, many are very well managed but until recently - and from a stock perspective - the risk-reward didn’t stack up against those benefiting from China’s domestic consumption story. However, given the price action we have seen, my sense now is that more opportunities are emerging in these areas. Here is an example:
Although somewhat in the "eye of the storm" given its aviation industry exposure, driving the stock well below book value, I initiated a position in the aircraft lessor, BOC Aviation. I expect the company will weather this downturn better than peers and come out stronger. While its airline clients are certainly under pressure, as we have seen in previous downturns, even failing airlines doesn’t equate to failing lessors as they are usually re-leased to stronger players. Leveraging the strength of its balance sheet, market conditions provide an opportunity for them to meaningfully grow their leasing book. The market seems to be pricing in significant changes in long-term travel patterns, which I think is unlikely to occur. Yes, there could be some impact to travel demand as we grow more comfortable with video conferencing, but the underlying propensity to travel driven by the expanding middle class in countries like China, will return.
Whilst assessing financial risk is crucial, we are also focusing on how we expect companies to be placed in a competitive sense, coming out at the other side of this hiatus. From an industry perspective, I remain naked the banks as they are likely to take the brunt of any financial stress within the system. Conversely, I am overweight cloud related plays and expect the technology shift (online and e-commerce) will only accelerate further given the situation (as previously mentioned). Finally, I am pleased to let you know that the portfolio has a new 2% exposure to an unlisted company called Pony.ai, which increases the portfolio’s total unlisted exposure to around 7%.
Pony.ai is China’s leading autonomous driving (AD) technology company, based in Silicon Valley and China. We first met the management of Pony.ai as part of our ongoing work on the AD industry and have been closely following their progress. With a stellar team, the company is a technology leader, which has helped the firm to secure strategic partnerships with leading car manufacturers, including Toyota and Hyundai. To put their business in to perspective, there are five leading players globally in this nascent industry, with limited opportunity for newcomers given high capital requirements and advanced technological progress already achieved by the incumbents. Having taken test rides in their cars several times, I can vouch for the performance - they compare very favorably versus human drivers.
With opportunities in new names like BOC Aviation, coupled with adding to oversold names and taking some profits on shorts, the portfolio’s net gearing has moved up to over 120%. I am by no means calling a market bottom, but I am seeing far more value in the market and using the flexibility the trust structure allows to capitalise.
This is now the third major bear market that I have experienced - I reiterate the point with our analysts that the most important things we can do is to remain focus on what we do best - focus now more than ever on company fundamentals and maintain the same level of engagement (or even increase it) with management teams.
I also remind myself to stay true to my investment process and style - even if it is going against me. I have always had a bias towards smaller cap companies and admittedly, it’s harder in these times - they tend to suffer more when liquidity is tighter in the market. In addition, this part of the investable universe has been out of favour with investors, not just since the start of this down market but also over the past year or two. But I continue to believe, though, that as long as these companies execute and deliver on their strategies and earnings over the mid-term, this should get reflected in stock prices over time.
Finally, and as strange as this seems, assessing the opportunities and risks in markets like this, reminds me why I love investing and why I still think I have the world’s best job. It can be gut-wrenching but also exciting when you find great value in the market.
Important information: The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments are subject to currency fluctuations. Fidelity China Special Situations PLC can use financial derivative instruments for investment purposes, which may expose it to a higher degree of risk and can cause investments to experience larger than average price fluctuations. This trust invests more heavily than others in smaller companies, which can carry a higher risk because their share prices may be more volatile than those of larger companies and the securities are often less liquid. This Investment Trust invests in emerging markets which can be more volatile than other more developed markets. The shares in the investment trust are listed on the London Stock Exchange and their price is affected by supply and demand. The investment trust can gain additional exposure to the market, known as gearing, potentially increasing volatility. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.