The plunge in the Chinese stock market has provided good opportunities to increase exposure to certain stocks, according to China Special Situations manager Dale Nicholls (pictured). 
The manager says the recent volatility in Chinese shares hasn’t affected his consumption theme, despite panic from many investors who are worried about what the impact on the global economy will be.
Between the second half of 2014 and last month, the Shanghai Stock Exchange Composite index returned a stellar 165.45 per cent, outperforming the MSCI World index by 149.27 percentage points.
Performance of indices from July 2014 to June 2015
Source: FE Analytics
However, the market began plummeting at the start of last month and, to date, has lost more than 26 per cent of its value.
While the reasons for the mass sell-off are unclear, it has been suggested that the huge rise before the crash, China’s slowing economy and retail investor’s use of margin debt may have contributed.
“Things have been quite volatile in the A share market – obviously we saw a significant run-up in the market and, in terms of factors I think that drove that, we’re starting a position of very low valuation and quite negative sentiment,” Nicholls said.
“I think the fact that the government has started easing is a factor there. You’ve additionally got factors like [Shanghai-Hong Kong] Stock Connect opening markets up.”
“But I think the unhealthy element is the amount of margin finance that you’ve had behind the rise in the market, and I think the regulator was probably somewhat behind in terms of controlling that. As that’s adjusted, you’ve clearly had some forced selling in the market and you’ve seen some pretty big moves to the downside.”
Launched in November last year, the Shanghai-Hong Kong Stock Connect programme allowed investors in each domicile to trade shares in either the A share market or the H share market through brokers or clearing houses.
This caused large inflows, in addition to the encouragement from the Chinese government for Chinese retail investors to invest in shares. To do this, many people effectively geared themselves through margin debt to buy into the market.
“In response to [the sell-off], you’ve seen quite an aggressive response from the government across a number of government entities,” Nicholls continued.
“On the whole, I’m personally a little disappointed when you think this is happening in the context of the overall reform programme, which is about liberalisation and opening up.”
In an attempt to stop the stock market from crashing, Chinese authorities cut interest rates to an all-time low to increase liquidity and prevented investors holding a large amount of equities from selling them in the near future. Hundreds of companies also suspended trading their shares.
“It may change my view on some sectors such as the securities brokers but it doesn’t really change the core holdings or the core thesis behind much of my holdings, which is really about consumption,” the manager said. “We’re still seeing the economy evolve into one that’s driven by consumption and we’re seeing a rebalancing away from reliance on investment.”
“It’s really just this theme of general development of the middle class. That’s still the core theme, it hasn’t really changed, and this volatility is providing some opportunities to add to some positions in that space.”
One area of the market that the manager has been increasing his exposure to is the electrical appliance sector, which Nicholls has always remained positive on.
In the five FE Crown-rated Fidelity China Special Situations trust’s portfolio, consumer products contributes the largest weighting at 31.46 per cent.
One stock that Nicholls is particularly excited about at the moment is Midea, an electrical appliance manufacturer that specialises in air conditioning and is headquartered in Shunde, Guangdong province.
The group, which has been listed on the stock exchange since 2013, employs approximately 135,000 people both overseas and in China.
“It’s number two in air conditioning in China and is closing the gap with the number one. It’s quite an interesting story, I like the air conditioning space. It’s actually a pretty good business and with room to grow still, as you’ve still got relatively low penetration in the rural areas and in commercial. There is also potential to grow offshore, so [the sell-off] was a good chance to add to quality names like Midea in the A share market,” Nicholls said.
He adds that the H share market also saw a substantial correction and has fallen by 19.98 per cent over the last two months.
Performance of index over 2months
Source: FE Analytics
As such, the manager is increasing his exposure to the smaller cap area of the Chinese market and has added to a company called Dongpeng, which is the largest bathroom tile company in China.
“It’s still only 2 or 3 per cent of the market share but that’s actually part of the story – there’s great potential for consolidation in the industry and I think they’re a very good operator. There’s good potential for them to double or triple their market share in the coming years,” Nicholls explained.
While the manager adds that the majority of the trust is still weighted in private companies, he believes there are some interesting state-owned enterprises (SOEs) that could prove to be stellar investment opportunities.
One example he gives is Shanghai International Airport, which is the trust’s fourth-largest holding and accounts for 2.7 per cent of the portfolio.
“It’s one of the few airports in China that really has growth potential – they have the potential to grow [their number of] runways, there’s actually plans to add another terminal. When you think of the backdrop for growth, obviously outbound travel from China is growing significantly,” Nicholls said.
“Last year there were over 100 million people travelling outbound and that continues to grow strongly. In addition, you’ve got Shanghai Disneyland which is opening next year, so I think that can also boost the growth.”
“I also think there’s pretty good potential to improve [Shanghai Airport’s] returns. Not so much on the aeronautical side, but on the non-aeronautical side.”
“It’s a pretty under-managed retail offering and, as concessions come up for renewal, I think there’s some good potential to generate better returns on that, particularly if we do see some of the SOE reforms come through, which could potentially cause management to be more incentivised to generate higher returns on those types of assets.”
Since Nicholls took the helm of the Fidelity China Special Situations trust from Anthony Bolton in April 2014, it has outperformed its MSCI China benchmark by 8.03 percentage points and returned 31.85 per cent, despite being hit particularly hard by last month’s stock market slide.
Performance of fund vs sector and benchmark over management tenure
Source: FE Analytics
The £767m trust is geared at 24 per cent and has ongoing charges of 1.36 per cent, as well as a 15 per cent performance fee which is charged if it outperforms the index by more than 2 per cent.
