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Dear Shareholder/Potential Investor - update from Portfolio Manager

Dale Nicholls

Dale Nicholls - Portfolio Manager

Dear Shareholders and Potential Investors,

It's been a turbulent start to the year so as we approach the mid-way point, I wanted to once again take the opportunity to share my perspectives on the market, and my outlook going forward.

Slowing economic growth in China - notably slowing consumer activity coming through in data points such as retail sales - has been impacted by recent COVID lockdowns as the country maintains its zero-COVID policy. This has also squeezed supply chains. We are already seeing the effect of the recent lockdowns in Shenzhen given the huge productive capacity that was affected there, while limits of ports in places like Shanghai are also clearly having a major impact. In terms of implications for the portfolio, as there is a focus on domestic consumption, we are focused on ensuring the fundamentals (such as earnings visibility) of the companies we own in the Trust remain intact.

The risks from maintaining a zero-COVID policy need to be factored into one’s risk reward assessment - I expect the short-term outlook for the consumer sector to remain difficult; and this is partly reflected in the Trust’s current underweight to consumer discretionary positions. I believe there will be increasing pressure to move away from current COVID policies given both the significant economic and social impacts. However, I remain positive on the long-term potential of the Chinese consumption theme and believe that there is good potential for the unleashing of spending power as the country comes out of the pandemic.

We are seeing increased action on both the monetary and fiscal side to support economic growth. China’s Central Bank’s recent cut of the loan prime rate is a good example. This should support a sector that has also been a major factor limiting growth - the property sector. Contract sales are down significantly, and many private developers continue to struggle. At this point, we are already seeing signs of easing measures from purchasing restrictions being lifted to mortgage lending facilitation in certain cities. I believe that measures such as these will continue and expand.

On the regulatory wave in general - I believe this has good potential to ebb, with a shift towards the implementation of announced policies versus policy surprises. A key example of this is the Government’s messaging at the end of April after its Politburo meeting where it indicated that policy would shift to support economic growth via increased infrastructure spending, more supportive property measures (albeit the policy that housing is for ‘living not speculating’ remains) and the healthy development of internet platforms in order to help underpin consumption and enable pent up demand and spending once lockdowns are lifted.

As one can see from the factors discussed above, there are plenty of challenges that are facing companies on the ground. These concerns have driven the underperformance of the market, which has driven sentiment to extremely negative levels and valuations for many companies to record lows. I believe there is good potential for less “negative news” going forward, and thus find significant opportunities in the market. While earnings are still being revised down in many sectors, easier comparisons relative to the slowdown from the first half of 2021, mean that there is considerable scope to drive faster earnings growth in the market from the second half of 2022.

In terms of opportunities and ideas, the Trust remains focused on stocks and sectors that appear well positioned to benefit from China’s long-term structural growth drivers. Indeed, despite recent uncertainties, powerful trends like the expansion of the middle class provide a long runway for growth. Following the significant recent falls in technology-related names, we feel that the risk/reward pay-off has tipped much more in our favour in these companies. Alibaba Group Holding, for example, factoring out the value of cash and investments, is trading at a single digit price/earnings ratio. Although it does face some competitive challenges, it remains the dominant platform in China and generates very high returns on capital. As is often the case with broad-based corrections, some stocks with lower regulatory risk have also sold-off, presenting some very appealing investment opportunities. Interestingly, this includes some smaller companies that could actually be beneficiaries of regulatory changes since many of the new reforms focus more on larger companies.

We have also moved to build-up a sizeable position in industrials which now stands as the largest sector overweight position in the portfolio. The core thesis around industry consolidation remains very much in place as areas like building materials in China are very fragmented relative to what one sees in the more mature markets. Some of the Trust’s paint holdings, for example, have underperformed due to property sector concerns and raw materials cost pressure, but I maintain a high level of conviction in the long-term story and see significant potential for future upside as sentiment and fundamentals start to improve.

Elsewhere, within financials, I continue to favour insurers, given the industry’s structural growth prospects driven by the country’s demographic trends and rising incomes, particularly for protection type life insurance products given relatively low levels of penetration. These companies are very attractively valued versus their mid-term growth prospects on all metrics.

The portfolio’s unlisted positions span a wide range of industries and, as of today, collectively accounts for over 14% of the overall portfolio These holdings represent some of the world’s most interesting companies. For example, ByteDance, the internet technology company, remains a major holding in this space and the company continues to deliver very strong revenue and profit growth through Douyin in China and TikTok internationally.

Investing in this space is a key differentiating factor for the Trust and while it takes some time to find the right opportunities, on balance, it is clear to me that these efforts are worthwhile. We seek to capitalise on the widest set of investment opportunities in China. The fact that world leading companies such as ByteDance and DJI International are still private, illustrates the importance of looking beyond the listed universe. Notably, two of the unlisted positions – HR management software provider Beisen and auto maintenance platform Tuhu Car – have applied for listings in Hong Kong.

It is through our growing team, who are active on the ground, that we are able to engage with companies and understand how they are navigating shifts in the operating landscape, naturally including regulatory change. This in-depth analysis gives us conviction to act and capitalise, in terms of both adding to existing holdings and seeking new ones - both in the listed and unlisted areas of the market.

As discussed, sentiment in the market remains very negative but as we have seen in the past it is often at these times when there are the most opportunities. We are seeking the capitalise on these opportunities as reflected in rising net gearing for the portfolio which has moved up to over 124%. I have also increased my personal holdings in the Trust over this period.
We greatly appreciate your support of during these challenging times.

Take care and all the best, 
Dale Nicholls
Portfolio Manager - Fidelity China Special Situations PLC

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