Fidelity China Special Situations PLC’s Dale Nicholls charts China’s path as it emerges from lockdown towards recovery. He outlines how he has responded to this within the portfolio and discusses some of the areas which now offer a very attractive risk-reward profile given the price action we have seen.
- China is recovering relatively strongly and the management teams we talk to across most industries are focused on getting “back on track”.
- The trust’s core focus remains on domestic consumer and technology-related companies, but recent moves have also created opportunities in some globally focused companies.
- Markets have been volatile and it is hard to call a bottom, but we are now seeing far more value and using the flexibility the trust structure allows to capitalise.
The containment measures that we have seen in China and the rest of the world will have huge economic consequences. We have of course seen a massive fiscal and monetary response from global policymakers but at this stage we need to assume double digit declines in the broader measures of growth like GDP.
More policy support is likely
Although actions from Chinese policymakers look relatively restrained versus others so far, I believe we will see significant fiscal and monetary measures announced in the coming weeks and months. Bold moves from other Central Banks give the People’s Bank of China more room to ease. Infrastructure spending is likely to be boosted, with notable funds already being raised by local governments in bonds. I expect more to come.
Government directives to the banks will support corporates - but a concern will be how much of this makes its way to small- and medium-sized companies. Anecdotal evidence - recently 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 needs to be closely monitored.
In terms of the virus itself, we now have positive examples in Asia of declining infection rates, 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 on path to recovery. And from what I 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. The mainland today remains very strict with screening and quarantining measures. Similar to Singapore and Hong Kong, imported cases are a potential threat; China has also implemented another round of containment measures. For example, a colleague who is based in Hong Kong but had to urgently fly back to Beijing recently, a Chinese National, has 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.
Sticking to the plan
In this environment, we are sticking to the plan. We continue to assess the fundamentals of companies - although more calls are done versus one-on-one meetings. In response to the outbreak, the team is spending even more time analysing companies’ balance sheets and cash flows, plus engaging with management teams to understand the challenges of withstanding a period of significant revenue declines.
When it comes to Corporate China, 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% per cent 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 renminbi (about US$240m) 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.
Winners and losers
There has also obviously been huge volatility over recent weeks, with the market rewarding those companies that are set to benefit from the containment phase and punishing those bearing the brunt of 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, many of the trends we were seeing in the market will be further accelerated by the outbreak. 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.
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.
At a company level, despite being 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 have no exposure to banks as they are likely to take the brunt of any financial stress within the system. Conversely, I am overweight cloud related plays and as previously mentioned expect the technology shift (online and e-commerce) to only accelerate further given the situation.
Finally, the portfolio has a new exposure to an unlisted company called Pony.ai. It 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 an absolutely 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 its 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 favourably 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 towards the end of March 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.
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