Technology, e-commerce and privately-owned companies further down the cap spectrum offer the best stock opportunities in China at the moment, according to Fidelity’s Dale Nicholls.
The manager, who took over from Anthony Bolton to run the five crown-rated China Special Situations trust in 2014, says that there are indeed attractive growth prospects in the region, despite high levels of negative sentiment.
Year-to-date, in fact, the Shanghai Composite index is down 6.95 per cent compared to the MSCI AC World’s return of 17.15 per cent.
Performance of indices in 2016
Source: FE Analytics
“The constant battle you have when you’re running a China fund and you’re a bottom-up stock picker is that there’s always such focus on the macro about China,” Nicholls (pictured) said. 
“This is a good thing in a way because a lot of the macro has a lot of fears around it, so it can bring stock prices down and, on a company level, [individual stocks] can be doing quite well.”
China is a region that has warranted particular focus from investors over the last 18 months or so, given the extreme choppiness of its market sparked by a growth slowdown, experimental monetary policy and an economic shift from a manufacturing to a consumer-led economy.
The composite index rallied during the first half of 2015 and abruptly fell following growth fears following a currency devaluation, which led to a global sell-off that has since been dubbed ‘Black Monday’.
Following this collapse, the market has remained volatile as a result of mixed sentiment based on commodity prices, growth forecasts and other macro-led indicators.
Nicholls says that this has led the discount of his £1.3bn trust to continue widening. While its one-year average discount is currently 16.78 per cent, it is now on a 19.14 per cent discount.
“The move in the [trust’s] share price has not kept up with the NAV. That probably reflects the immediate sentiment around China but we’re hoping that, as long as we can continue to show we can grow NAV despite the concerns that are out there in the general market, that gap can close over time,” he continued.
Over the manager’s tenure, the trust has outperformed its MSCI China benchmark by 22.42 percentage points with a total return of 48.91 per cent.
Performance of trust vs benchmark under Nicholls
Source: FE Analytics
Nicholls says that the best investment opportunities in China at the moment are those that are focused on China’s domestic consumption story, although he does hold a small number of exporters that are particularly competitive in their area of the market.
“The structure of our portfolio is very much about the new China and where China is going, so the core part of the portfolio is about consumption. I still believe that is a significant theme for China over the next five to 10 years,” he said.
“This is the change in the model that the government is trying to bring about, a shift away from reliance on investment and exports to consumption.”
In terms of China’s slowing GDP growth, the manager says that this shouldn’t be a major concern for investors given that it is a natural adjustment and that consumption is likely to grow faster as a result of the region’s economic shift.
However, he is particularly concerned about the credit growth trajectory in China which he says is likely to lead to an increase in non-performing loans. As such, Nicholls completely avoids Chinese banks and will only focus on areas set to benefit from a consumption-led economy.
One area the manager particularly likes is ecommerce and any stocks that take advantage of the global shift to online products and services.
“Ecommerce penetration in China is already higher than that of the US despite the fact that internet penetration there has just passed 50 per cent,” he explained.
“You’ve seen that across a range of areas and it makes sense if you think about the fact that China just hasn’t had that retail build-up that you’ve had elsewhere.”
Examples of stocks that Nicholls holds in this area include Baidu, Tencent and NetEase.
Another important feature of the Chinese stock market, according to the manager, is the extreme divergence between the performance of different market areas, which has partially been caused by the region’s economic shift and the fact that growth drivers are changing.
For example, he points out that while Alibaba’s year-on-year mobile revenue growth was 149 per cent in 2015 and Chinese tourists travelling to Japan rose by 108 per cent, the country’s largest department store operator Parkson fell by 7 per cent over the same time frame.
“That data point on tourism is interesting – just travel alone is an area that has held up amazingly well despite an overall slowdown. You’ve seen travel both domestically and overseas growing double digits,” Nicholls said.
“In terms of what’s driving consumption, some of it is just the general development of the middle class and you see penetration across a whole range of categories that is just so low relative to what you see in the West.”
“As the economy grows, you’re going to get that natural development of the middle class. If you look at the auto area, it’s by far the biggest auto market globally now but, in terms of penetration, it lags significantly and maybe the US is not the best comparison because it is probably one of the highest-penetrated auto markets.”
“I’m not saying that we’re going to go to those types of levels, obviously in China you’re going to have issues with congestion and things like that, but there are a lot of potential areas of consumption where things are clearly going to pick up and they are the areas I tend to be focused on and am investing in the trust.”
An advantage that the manager has when investing in the volatile market area is that he is able to hold both long and short positions within the portfolio and can leverage the trust – it is currently 26 per cent geared.
He used last year’s rally as an opportunity to add to his short book and sell some of the long positions that had performed particularly well, while at the start of the year when the market slumped, he increased his long holdings and reduced his number of short positions.
Nicholls says that this bodes particularly well for the trust, given that he adopts a bottom-up stock-picking process that focuses on smaller and often overlooked companies.
“Due to the macro concerns, you have valuations that are very attractive versus historic levels and very attractive versus other markets, despite the fact that earnings growth has been comparable. If you look at ROE [return on equity], that looks quite attractive as well,” he explained.
“In the context of long-term performance, it’s been a rewarding market at the moment relative to others.”
Fidelity China Special Situations yields 1.2 per cent and has an ongoing charge including a performance fee of 2.27 per cent.
