Fidelity China Special Situations 06 July 2023
Disclosure – Non-Independent Marketing Communication
This is a non-independent marketing communication commissioned by Fidelity China Special Situations. The report has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on the dealing ahead of the dissemination of investment research.
Fidelity China Special Situations (LON:FCSS) offers a highly differentiated way to invest in the growth potential in China via an active strategy which gives the manager the freedom to generate alpha in multiple ways.
FCSS has been managed by Dale Nicholls since 2014, and he runs a portfolio which is heavily tilted towards small- and mid-caps and has substantial unlisted equity exposure, currently in the mid-teens. Dale also uses derivatives to take long or short positions in companies as well as to effectively gear up the portfolio. In fact, Gearing is a feature of the trust, adding to the growth potential: it has averaged 20% since Dale took over.
Thematically, the largest feature of the portfolio is the exposure to the growing wealth and changing purchasing choices of the Chinese consumer. While he is happy to own the well-known large-caps when he sees value in them, the portfolio is packed with lesser-known companies which are strong in their niche and/or which are at an earlier stage of their growth trajectory. As such, these tend to be in the small-cap part of the investible universe. Growth is the aim and earnings growth is a key characteristic which Dale looks for. But he is also sensitive to valuations, as we discuss under Portfolio.
Dale has the advantage of working with Fidelity’s large, locally based analyst teams, with analysts working in onshore China, as well as elsewhere in the Asia Pacific region. Their coverage of Chinese companies, and their peers elsewhere, gives Dale a 360-degree view of many companies’ operations, and the deep human resources allows for substantial investment in the unlisted sphere.
FCSS’s shares trade at a wide Discount of 10.9% at the time of writing compared to a five-year average of 7.3%. Chinese markets have been weak overall since the end of the pandemic, but Dale sees as many exciting growth stories as before.
We think FCSS looks like an excellent way for long-term investors to access the growth potential in China. The gearing, small and mid-cap tilt and active approach all bring risks, but they all add extra growth potential, which could reap dividends in the long run. Interestingly, large-caps have outperformed SMIDs in recent years in China. This is in contrast to the long-term tendency for smaller companies to deliver greater earnings growth. Dale does own large-caps, where he sees the best long-term earnings growth potential, but nonetheless a return to the historical norm would help FCSS in relative terms. We think this shift in market dynamics may be brought about by structurally higher interest rates and a retreat from globalisation.
At the time of writing, FCSS trades at a double-digit discount. We think this represents an opportunity. Historically, the trust has seen its discount narrow when Chinese equities are in favour and we see the potential for the same to happen again. That said, we cannot predict when, and it may not be in the short term. Nonetheless, the discount provides extra return potential in any rally and is defended by the board with buybacks.
- Manager has full toolkit for adding alpha
- Offers differentiated exposure to Chinese small and mid-caps via the work of a broad local analyst team
- Current wide discount could provide good entry point
- Gearing brings sensitivity to falling markets, as well as rising markets
- Political risk is high in China
- Although charges are higher relative to peers when the trust outperforms, shareholders pay less when the trust underperforms, as a result of the performance-related component. This aligns the interests of manager and shareholders.