China’s swift return to “normality” should mean lower risks compared to many developed countries still struggling with the impact of the virus. Dale Nicholls, portfolio manager of Fidelity China Special Situations PLC, examines the investment opportunities ahead as selected areas continue to reap benefits from the structural trends accelerated by Covid-19.
- The near-term economic outlook for China is well supported as key laggards in the service sector – travel and leisure – are gaining momentum.
- We continue to favour sectors that will become more significant drivers of overall growth over time, particularly consumer-related, technology and healthcare.
- While US-China trade tensions will continue for decades to come, we expect a more measured approach from the US side under the new administration.
What is your investment outlook for 2021?
While there are variances between regions and sectors, the economic backdrop for China remains supportive of markets as the economy continues to recover. Strong control of the Covid-19 virus has clearly been a factor supporting the recovery. Small localised outbreaks within the region were handled swiftly and have not really dented the overall economic momentum. This is reflected in Purchasing Managers’ Index (PMIs) which have recovered well ahead of other Asian countries. 1
The third quarter GDP figure of 4.9% was supported by stronger services and external demand. The fourth quarter GDP figure should exceed this level as key laggards in the service sector – travel and leisure – are gaining momentum.2 Government stimulus has clearly been a factor supporting the recovery, but overall has been more restrained and targeted than measures seen in most western economies. This therefore leaves room for further policy support if required.
Regarding markets, while valuations are clearly not as attractive as they were at the start of 2020 , they continue to trade at a significant discount to the US markets, despite arguably better growth prospects. The return to “normality” in China should mean lower risks relative to many other countries with higher uncertainty as they still struggle to get the virus under control.
At a stock level, while some individual names have done quite well, particularly the Covid-19 beneficiaries, there are many laggards that offer significant value. We remain overweight in sectors that will grow in their share of the economy over time, particularly consumer-related, technology and healthcare.
1. Source: Bloomberg News as at 30.11.2020
2. Source: Fortune.com as at 19.10.20
What do you think could surprise the market in 2021?
Geopolitics and capital market reform are two areas to monitor. Throughout the year we have continued to see tensions rise between the US and China. We continue to believe that these tensions will be with us for decades to come, but it seems more likely we will see a more measured approach from the US side under the new administration. On the positive side, we believe this has become more of a consensus view and thus more “established” in markets ‒ thus a more collaborative dialogue could be an area of positive upside.
On the negative side, Taiwan relations remain a sensitive issue and any developments there are worth watching. We would highlight that the portfolio remains focused on opportunities supported by ongoing structural shifts in China’s domestic economy and only limited revenue from underlying holdings exposed to the US.
We continue to see progress in capital market reforms in China from initiatives such as the loosening of short-selling restrictions, lowering of foreign investment restrictions and the implementation of a registration-based IPO mechanism. The registration-based IPO mechanism was launched last July on the STAR Board and is now being employed on ChiNext. In these markets listing criteria are also more flexible, such as alternative criteria on market cap, profitability and allowing VIE-structured companies to list. Those were restricted under previous rules, so given this we could expect more tech/new economy companies to list on the A-share market.
Looking ahead, we believe further expansion of these reforms to the broader A-share markets would be a positive for markets. We have already seen more IPOs of A-shares and Red Chip companies this year and there could be more to come given the US issues and more flexible listing requirements.
On the negative risk side, as always, we do need to follow regulatory developments closely. Recently we have seen draft regulation in the fintech space (resulting in the delay of the Ant IPO) and antitrust in the technology space. We don’t sense that these will change the outlook significantly for the large technology companies, but developments here do need to be monitored.
What themes, sectors or regions would offer opportunities or potential risks in a post Covid-19 world?
The portfolio continues to focus on ‘New’ China ‒ those sectors we know have good growth prospects over the mid-term, such as consumption-related, technology and healthcare sectors. In many of these areas, Covid-19 has accelerated structural trends already underway in China. Additionally, many consumer goods in China are still underpenetrated versus other countries, and the trend towards upgrading and premiumisation remains strong.
In the financials space, we are particularly interested in the insurance sub-sector given the still low penetration in ‘protection’ type life insurance areas ‒ demand here will naturally rise with higher incomes. We believe the insurance sector could also, over time, see renewed demand coming out of Covid-19 as people focus more on protection in areas like health insurance, even though right now companies may not be seeing the immediate change.
How do you expect sustainability factors to influence returns and how is this reflected in your portfolio?
Sustainable investing remains a core part of our investment process. We believe that high standards of corporate responsibility make good business sense and have the potential to protect and enhance investment returns. Consequently, we integrate Environmental, Social and Governance (ESG) issues into our research and investment decision-making process.
We favour engagement over exclusion as positive influences on corporate behaviour can add real value for companies, our investors and society. The priority themes that have formed part of our recent ESG engagements include supply chain sustainability and corporate sustainability reporting.
Based on our own ESG ratings, around three-quarters of the portfolio is currently invested in relatively highly rated companies from a sustainability perspective. While most of the remainder are not rated, this portion has been falling as our ESG research coverage expands. We continue to believe our work in this area can be a source of alpha generation going forward.
Within your portfolio, what areas have highest convictions and what areas are you avoiding?
Our focus continues to be on the underlying value of companies assessed by their growth prospects, underlying competitive strengths and the quality of management teams. This has led to a bias towards smaller companies. We continue to believe that as long as these companies can execute and deliver on their strategies and earnings over the mid-term, this should get reflected in stock prices over time.
As noted above, we continue to focus on sectors that will benefit from China’s long-term structural growth story.
Another area we are finding opportunities is in the materials space in China. There are several sectors that are still very fragmented, but signs of consolidation are underway, and we are focused on the leaders coming out of this process. Examples would be in areas like paint and floor tiles.
More generally, given the strong run in markets - notably in technology, healthcare and staples sectors - value is becoming harder to find, but there are still opportunities, especially in the small-cap space. For example, many Hong Kong small-caps are trading at single-digit PE ratios, even when their businesses are viable with healthy cashflows.
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