With regulatory developments significantly impacting sentiment towards Chinese equities, how should investors weigh-up this near-term uncertainty against China’s long-term structural growth opportunity? In a recent letter to shareholders, Dale Nicholls, portfolio manager of Fidelity China Special Situations PLC, gives his views on the evolving landscape and the implications for portfolio positioning.
Following my last update which addressed the sharp sell-off we saw in the Chinese equities market, I wanted to once again take the opportunity to share my perspectives on the market, along with an update on changes I’ve subsequently made to the portfolio.
Market concerns over increasing regulation were a major factor in the Chinese markets’ decline over the summer of 2021. Naturally, this remains a key concern for investors. In trying to understand and analyse the government’s recent actions, I believe it is important to recognise some key points which I have outlined below.
First, the ‘hand’ of the government, coupled with regulatory direction and implementation, is core to the investment landscape in any market. This is particularly true in China. Therefore, it is important to be aware of trends and the general direction of policy. We have clearly had periods of tightening in the past, for example, government-imposed restrictions around online gaming in 2018.
In terms of future policy direction, it is important to be cognisant of the long-term goals laid out in policy documents like the Five-Year Plan when assessing how the regulatory landscape could change and impact an industry’s growth profile.
Second, many of these crackdowns are addressing problems that confront countries globally. Big tech and related challenges around anti-trust and data security and privacy are examples, as are the challenges around income inequality. While in many cases we can trace the path of regulation, unlike in most other countries, Beijing’s implementation can be swift, which often roils markets.
Outlook for property remains uncertain
The property sector has been under the spotlight of both policymakers and investors for some time. Reigning in property speculation is a crucial aspect of President Xi’s vision of a more equal society – for instance in 2017, he commented that houses are ‘for living in, not for speculation’.
While it is likely that we will see some developers default, I think that the systemic risk remains low. Although comparisons to the situation in the US around the financial crisis of 2008 can be drawn, they are very different given the nature of the companies involved and the general control Beijing has over the economy. In terms of Evergrande itself, it remains an evolving situation. My base case is a government-led restructuring, with a focus on project completion and asset disposals to meet social obligations.
Broadly speaking, while I do not expect President Xi’s drive towards a healthier, less speculative property sector to be reversed anytime soon, one should not be surprised to see some policy fine tuning in the near-term as both property and land sales continue to slow down. We are already seeing signs of accelerating mortgage approvals in some cities. Importantly, on the back of a period of tightening, there is significant scope to loosen policy.
Recent portfolio positioning
From a portfolio perspective, an underweight real estate exposure, coupled with an overweight position in the healthcare space, has benefited overall performance over recent time. Within healthcare, Wuxi AppTec Group remains a key holding. While I believe that we need to be concerned over pricing pressures in the generic drug sector, the continued emphasis from the government on developing an innovative drug sector remains very much intact. Wuxi is a major facilitator in this area. Furthermore, I believe the prospects for China establishing itself as a global hub for innovation in drug development will gain traction.
One of the bigger shifts in the portfolio has been a reduction in holdings in the consumer discretionary sector, mostly because of valuation levels, with an increase in holdings in materials and industrials. The thesis around industry consolidation in areas like building materials remains very much in place. However, I have trimmed some positions given rising concerns over the residential property slowdown and potential knock-on effects to the industry from the troubled developers in the market.
In financials, I remain positive on the outlook for life insurance on rising penetration over the mid-term. Near-term fundamentals generally remain tepid, but I believe this is more than factored into what remain very attractive valuations. Whilst I am underweight the banking sector, I have built a position in the Postal Savings Bank of China, which I believe is undervalued given its strong, growing position in retail banking and wealth management. This is helping drive superior returns relative to the sector. We are also encouraged by the clear focus of the new management team, including a strong emphasis on growing green financing.
FIDELITY CHINA SPECIAL SITUATIONS PLC
|Nov 16 -
|Nov 17 -
|Nov 18 -
|Nov 19 -
|Nov 20 -
|Net Asset Value||26.2%||-12.0%||5.1%||61.7%||-9.4%|
|MSCI China Index||33.8%||-6.6%||5.6%||32.3%||-16.2%|
Past Performance is not a reliable indicator of future returns.
Source: Morningstar as at 30.11.2021, bid-bid, net income reinvested.
© 2021 Morningstar Inc. All rights reserved. The MSCI China Index is a comparative index of the Investment trust.
After the significant recent correction in technology-related names, I feel that the risk/reward payoff is now tipping much more in our favour in these companies. While there is still risk of new regulation, there is a good chance that we are near or close to a “peak” in terms of news flow.
As noted earlier, the government has ambitious long-term goals in areas of economic development and innovation. Clearly, these will be difficult to achieve without a vibrant private sector. At the same time, valuations for many companies have moved to historical lows and look even more compelling when we compare to global peers.
As is often the case with broad-based corrections, some stocks with less regulatory risk have also been sold-off, presenting opportunities. This includes some smaller companies that could actually be beneficiaries since most of the new regulation focuses on larger companies. As I have added to some long positions, and closed some of the short positions, net gearing for the portfolio has increased.
I also continue to feel positive about the outlook for the unlisted portion of the portfolio and the progress being made in the respective businesses. This includes new unlisted holdings including Tuhu Car, the number one brand for independent auto aftermarket product and services in China; Cutia Therapeutics, an emerging leader in the dermatology and medical aesthetics space in China; and Beijing Beisen, a leading human resources management software company.
The road ahead
It clearly has been a volatile period, but we have seen times like this before, and most likely will see them again. While the combination of the risks I have outlined is negatively impacting sentiment towards China currently, history teaches us that these are usually the periods that offer the most attractive opportunities.
Corporate earnings for the market are forecast to grow over for the next 12 months, with the portfolio comfortably above this level. Meanwhile, the market overall is trading at a level that is attractive relative to history and relative to other stock markets globally.
As always, the key thing will be individual companies’ ability to deliver on their earnings potential over time. Our growing team continues to be active on the ground, engaging with companies and understanding how they are navigating any shifts in the operating landscape, which naturally includes 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.
News & Insights - China Special Situations PLC
Taking stock of China’s shifting regulatory landscape
With regulatory developments significantly impacting sentiment towards Chines…