Putting China in perspective

Dale Nicholls - Portfolio Manager

From growth concerns to trade tensions, a number of headline-grabbing factors have come together to create a challenging environment for Chinese equity markets over recent months.

In the interview below Dale Nicholls, Portfolio Manager for Fidelity China Special Situations PLC, reflects on these moves and discusses whether the sell-off has created opportunities for discerning investors with a long-term view.

What is going on in China and what is driving this volatile period?

Dale Nicholls: "There are a few things. The economy clearly is slowing and that is borne out in the results and forecasts coming through from the companies we’re meeting. The slowdown tends to be in the more export orientated and cyclical areas of the market. The Manufacturing and Non-Manufacturing Purchasing Managers’ Indices look better, but elsewhere the data is more measured, which isn’t entirely surprising. We have seen an intensified focus on restricting credit growth and so it shouldn’t be a surprise that this flows into economic growth at some point, but as discussed in the past, the slowdown is happening for the right reasons if it is focused on limiting the growth in credit which I see as the biggest mid-term risk in China.

I must also highlight the so-called trade war. It is in the papers every day - we see the headlines, the rhetoric being ramped up, particularly from the US-side and clearly things have not moved in the direction that we would have hoped. I think from a markets perspective, the fact that there is discussion on implementing tariffs on the full amount of Chinese exports - which you would have to view as the worse-case scenario - and I think probably getting priced into markets, could be positive in the sense that it is a worse-case scenario that is starting to get factoring into the price."

The market was driven up last year by the BAT stocks (Baidu, Alibaba & Tencent) and they seem to have taken a dip with the rest of the market this year - do you think that is unjustified and do you think they are good investment opportunities?

"I do. The core holdings in the portfolio for me are Alibaba and Tencent. For Alibaba, there are concerns around the slowdown in consumption that we are seeing, but on our analysis you can buy its e-commerce business on forward price-earnings multiples in the teens, which is not justified given the growth in evidence (compared with the price today, over 40x current PE). There is really significant monetisation potential across the whole Alibaba ecosystem, which means there is a significant opportunity and they continue to execute well. So I think that looks quite attractive here.

With Tencent there are more company-specific issues, such as new regulation around gaming, and it is not fully clear how the new regulations are going to play out; the market clearly doesn’t like that uncertainty. I do think that this will become clearer in the coming months and the market will appreciate that certainty. I think it is very likely that there will be a stricter regime around the approval of games and how the games are operated but I still think that the underlying demand is there. It is still a good growth opportunity and it is pretty clear that the strong players will come out stronger on the other side when this regulation comes into play. So I don’t think the story there is derailed in any way and obviously the real opportunity with Tencent is the monetisation of WeChat in the mid-term and I think that story is still very much there."

Markets are down quite a bit in the last six months or so and so can you tell us what activity has occurred in the portfolio?

"As you know the portfolio is made up mostly of long positions but there are some shorts (where an investor makes money if a stock falls) and as those stocks have come down I have taken some money off the table. The valuations are now looking more reasonable for those stocks.

On the long side it is really across a range of sectors where you have seen indiscriminate selling. I would highlight the more market sensitive areas, areas like insurance, some of the security brokers, which again I think have great mid-term prospects, in fact valuations are now factoring in really no growth at all, which seems implausible. Selectively in some of the consumer names again, I think these have been oversold. In the A-share market [domestic Chinese companies listed in China] we have seen some pretty significant sell-offs, tended to be focused on more of the industrial-type names.

If you think about overall net gearing for the portfolio [additional exposure to the market through borrowing], you are starting to see it moving up to capitalise on these opportunities and I must say despite relative weak markets it is good that we have had two of the unlisted companies in the portfolio list this year - China Internet Plus (formerly 'Meituan') and Aurora Mobile. It is really positive that they were able to list this year and realise part of their potential through a listing. We continue to look at ideas - it is an ongoing process. I think there is a good chance that you will see new names enter the portfolio in the unlisted space over the next twelve months - I will leave it at that."

Investment Glossary

Credit growth - amount of credit available to a people or businesses from banking institutions.

Shorts stocks - process of borrowing shares of stocks that the portfolio manager doesn’t own and then selling shoes shares at the current market price. The goal being to buy those shares of stock at a lower price in the future (and return the borrowed shares to the lender).

Long stocks - process of owning shares in the expectation that the shares will rise in value in the future.

A-shares - also known as domestic shares. Shares that are denominated in renminbi and traded in the Shanghai/Shenzhen stock exchanges.

Gearing - the amount by which gross/net asset exposure exceeds shareholders’ funds expressed as a percentage of shareholders’ funds.


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