Fidelity China Special Situations PLC portfolio manager Dale Nicholls provides an update on the trust and reflects on what has been a very challenging period for investors. He discusses the themes underpinning current portfolio positioning and outlines why he is feeling increasingly optimistic on the outlook for Chinese equities.

Key points
 

  • Recent months have been very challenging for Chinese equities due to regulatory and economic uncertainty. The relative underperformance of small-cap and growth as a style factor have particularly impacted the trust.
  • A lot of the negative newsflow is now reflected in current valuations, which look very attractive relative to other markets and its own history.
  • Despite near-term uncertainty, we remain positive on the investment opportunities on offer in China. We have put money to work in areas where we see long-term value and gearing levels have increased.

The current backdrop

The property-induced economic slowdown China experienced towards the end of last year has continued into the opening months of 2022. This has been exacerbated more recently by the strict Covid lockdowns we’ve seen in large cities such as Shanghai. The direction of China’s Covid policy is hard to predict, but I do think we are likely to see a gradual opening up as more antiviral drugs - and perhaps even vaccines - get approved for use. This would clearly be a significant boost for domestic consumption as it would release pent-up demand.

On the regulatory side, the policy tightening we’ve seen over the last 12 months has also significantly impacted investor sentiment. The magnitude of tightening has been greater than what we have seen in the past, but I believe we are now past the peak and approaching the end of this cycle. Looking ahead, we may even start to see some loosening as the government has a lot of room to move, particularly in property, while some fiscal and monetary stimulus will also be required for the government to hit its 5.5% GDP growth target for 2022.

Against this backdrop, it is unsurprising that corporate earnings have generally been revised down and we have seen this come through in reporting, particularly in consumer discretionary and property-related areas. The current consensus is for around mid-teens earnings growth this year, with a pick-up over the second half of the year as the economic picture improves.

Trust performance

The last 12 months have been very challenging for the trust from both a Net Asset Value (NAV) and share price perspective. We were relatively highly geared heading into the market correction and this had a clear negative impact on performance. The relative underperformance of small-cap and growth as a style factor have also been two major drags on relative returns given the core investment philosophy of the trust. At the sector level, our holdings in technology have detracted as the above-mentioned regulatory tightening has driven broad-based weakness in this space.

Past performance

  Mar 2017 -  Mar 2018 Mar 2018 -   Mar 2019 Mar 2019 -   Mar 2020 Mar 2020 -   Mar 2021 Mar 2021 -   Mar 2022
Net Asset Value 22.2% -5.3% -5.9% 81.9% -34.9%
Share Price 23.6% -0.3% -6.5% 97.2% -39.2%
MSCI China Index 23.8% 0.9% -1.0% 29.1% -29.3%

Past performance is not a reliable indicator of future returns.
Source: Morningstar as at 31.03.2022, bid-bid, net income reinvested.
©2022 Morningstar Inc. All rights reserved. The MSCI China Index is a comparative index of the investment trust.

Outlook and positioning

Despite recent challenges and ongoing uncertainty, we remain positive on the investment opportunities on offer in China. We believe a lot of the negative newsflow is reflected in current valuations, which look very attractive relative to other markets and its own history. What’s more, a likely looser policy stance is in direct contrast to what we are seeing across other major economies - this backdrop supports the case for China to outperform on a relative basis moving forward.

Our increasingly positive outlook is reflected in current gearing levels, which have increased over the last couple of months with net gearing standing at around 125% today. This is due to a combination of adding to areas where we see significant value and closing the majority of our short positions in the wake of the market correction.

In terms of sector positioning, 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 growth of the middle class and urbanisation provide a long runway for growth.

Following the significant recent falls in technology-related names, we feel that the risk/reward payoff has tipped much more in our favour in these companies. Alibaba, for example, is trading at a mid-single digit multiple and 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 attractive opportunities. Interestingly, this includes some smaller companies that could actually be beneficiaries of regulatory changes since most of the new reforms focus more on larger companies.

We have also moved to build-up a sizeable position in industrials which now stands at the largest sector position in the trust. The core thesis around industry consolidation remains very much in place as areas like building materials in China are very fragmented relative to what you see in the West. Some of our paint holdings, for example, have underperformed due to property sector concerns, but we 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.

Finally, a note should also be made on our unlisted positions, which span a wide range of areas and collectively account for around 13% of the overall portfolio. Internet technology ByteDance 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. Notably, two other unlisted positions - HR management software provider Beisen and auto maintenance platform Tuhu - have filed for an IPO in Hong Kong and should come to the public market over the next few months.

Summary

Investor sentiment towards China has been very weak and this is something that is usually seen at market bottoms. The combination of weak sentiment and low valuations is creating opportunities and we continue to put money to work in areas where we see long-term value.

 

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