Slowing economic growth in China has been one of the major headwinds investors have been faced with over recent years and questions over how the country’s economic model will change from being export and infrastructure based to a consumer driven one has weighed on its equity market.
According to FE Analytics, the MSCI China index has returned 15 per cent over four years – with most of those returns coming over the past nine months or so – while the FTSE All Share is up 30 per cent and the S&P 500 has gained 75 per cent.
Performance of indices over 4yrs
Source: FE Analytics
The slowing growth has led to concerns about debt levels in China’s financial system, the rise of ‘shadow banks’ and the country’s overheating property market.
However, Nicholls – who took over former star manager Anthony Bolton’s Fidelity China Special Situations investment trust in April last year – says those fears are now priced into the market and, as they have also been overhyped, investors can expect strong returns from Chinese equities over the medium term.
“I actually see a lot of opportunity,” Nicholls (pictured) said.
“As we know, valuations are very cheap in an historical context and I think that is for more macro reasons, but that is more than factored into stock prices and I think most of those challenges are manageable.”
“You’ve still got the long-term drivers which are there and I think, particularly in the area of consumption, that is where you are going to see very strong tailwinds and growth in the medium term; that’s the area that will be most interesting.”
There are a number of experts who have told FE Trustnet they think China is currently attractive, such as Margetts’ Toby Ricketts who said it would benefit from the lower oil price and Old Mutual’s John Ventre who said the current valuations mean investors are more than compensated for buying into its equity market at the moment.
However, while Nicholls is bullish on Chinese equities, he isn’t getting carried away with the prospects for the future of the economy.
He admits the authorities have made clear that the rebalancing of the economy needs to happen – a shift away from a reliance on investment and exports to consumption – and that, as part of that process, China is heading towards a period of lower growth.
He also says that investors have been right in the past to be concerned about the knock-on effects of slowing growth, such as the high levels of indebtedness within the financial system. Nevertheless, he says that those concerns have now gone too far.
“I think there are a number of challenges for China, but the biggest one is, given that we have seen debt levels increase quite significantly since 2008, how that is dealt with,” Nicholls said.
“I think we will clearly see that lead to a rise in non-performing loans and I’d like to see the banks deal with those as quickly as possible – that process of dealing with and taking the losses of those loans.”
“That is going to be a challenge. You hear people talking about the potential for a financial crisis but I think those chances are fairly low, given the liquidity that supports the system and the fact that the government is really supporting the banks as their major shareholder.”
The second major concern, according to the manager, is China’s real estate market as he admits the property sector is clearly going through an adjustment after a period in which supply has outpaced demand.
House prices have been falling in China since the summer. However, Nicholls thinks the possible ramifications of those dropping prices have been overdone as the falls have now started to slow.
“I think that adjustment process is well under way and I don’t think you will see significant price declines given the fact that underlying demand is still there. You’ve got a consumer that is relatively under-levered and affordability – in most cities – remains pretty reasonable.”
Since Nicholls took over the Fidelity China Special Situations investment trust in April 2014, the closed-ended fund has returned 36.55 per cent, beating its benchmark – the MSCI China index – by close to 10 percentage points.
Performance of trust vs sector since April 2014
Source: FE Analytics
Those returns mean that since Bolton originally launched the trust back in April 2010, it is now considerably up against the index with gains of 44.41 per cent.
Performance of trust vs sector since April 2010
Source: FE Analytics
That performance, as the manager has already built up a decent track record on his Fidelity Pacific fund – which sits in the offshore universe and has considerably beaten its MSCI AC Pacific benchmark over the long term – and the flexibility of the trust’s mandate means Cantor Fitzgerald’s Charles Tan says it is the ideal holding for investors who want exposure to China as it can deliver “exceptional returns”.
“Fidelity China Special Situations is the largest single-country specialist trust with close to £1bn in gross assets and a strong track record of outperformance,” Tan (pictured) said.
“With its flexible mandate and the ability to leverage, the trust has generated an NAV total return of close to 60 per cent since inception –and ranks it as the top performing China strategy across both open- and closed-ended funds.”
“In light of the tremendous longer term potential of the Chinese economy, but bearing in mind the macro challenges it faces in the short term, Fidelity China Special Situations is, in our view, the ideal structure with which to access the growth and nascent liberalisation of the Chinese equity market.”
Nicholls currently holds 63 per cent of his portfolio in mainland China and 33.6 per cent in Hong Kong.
His top 10 holdings include the likes of Tencent, China’s largest social networking site, Citic Securities, China’s largest financial services firm and Alibaba, China’s largest e-commerce portal, as well as various small caps.
Fidelity China Special Situations is currently trading on an 11.53 per cent discount to NAV, which is wider than its one and three-year average discount, according to the AIC.
It is quite highly geared, however, at 23 per cent and has a relatively high ongoing charges figure of 1.46 per cent which also doesn’t include a performance fee.