Dear Shareholder - Update from Portfolio Manager
25 November 2021
Dear Shareholders and potential investors,
Following my last update in July, when I 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.
As you will be aware, well-publicised concerns over increasing regulation were a major factor in the Chinese markets’ decline over the summer. 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. 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.
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 – think back to 2017 when 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.
From a portfolio perspective, an underweight real estate exposure, coupled with an overweight position in the healthcare space has benefited overall performance. Within healthcare, an overweight position in Wuxi AppTec Group supported returns. 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 the innovative drug sector remains very much intact. Wuxi is a key 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, and 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 the financial space, 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 remain 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 helping to drive superior returns relative to the sector. We are encouraged by the clear focus of the new management team, including a strong emphasis on growing its green financing.
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, as we think about what could come next, there is a good chance that we are near or close to a “peak” in terms of news flow. As discussed 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 lesser 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, and at the time of writing is around 123%.
Despite the market correction, 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 leaders in the dermatology and medical aesthetics space in China and Beijing Beisen, a first-class HRM (human resources management) software company and a clear market leader due to its superior cloud and integrated solutions for talent management.
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 15% for the next twelve months, with the Company’s portfolio comfortably above this level. Meanwhile, the market overall is trading on a price earning multiple 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, 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.
Take care and all the best,
Portfolio Manager - Fidelity China Special Situations PLC
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