The growth of the consumer sector, regulatory changes for state-owned enterprises (SOEs) and increased connection between markets means there is a wealth of opportunities among Chinese equities, according to Fidelity International’s Dale Nicholls. 
The manager (pictured), who heads up the four crown-rated Fidelity China Special Situations investment trust, wrote in his latest annual report that the gap between China’s share of global markets and its share of the global economy is likely to close over time.
While he admitted the country still faces challenges, he is positive in terms of finding new investment opportunities for the £1.2bn portfolio as he believes its market and economy will remain dynamic.
“Ultimately the investment returns for the company are an outcome of the companies in which we invest,” Nicholls explained, highlighting his bottom-up stock selection process.
“The growth of the consumer sector along with changes in the way that people consume have been key investment themes throughout my tenure.
“It will continue to be an important economic driver over the next five to 10 years supported by the natural development of the Chinese middle class and the government’s policy of moving from an investment and export led economy towards an economy led by domestic consumption.”
Not only is China experiencing increasing domestic consumer demand across various sectors, the manager said there is now increasing demand for higher quality and service.
Performance of indices since start of data
Source: FE Analytics
As product development and marketing in the country continues to become more innovative to meet these demands, Nicholls said a prime beneficiary of this is condiment manufacturer Yihai, which floated onto the Chinese stock exchange in July last year.
“Yihai manufactures condiments for hot pot, a popular style of cuisine in China, and has a strong market position in the mid-to-high end segment,” he explained.
“It is the main supplier to the Haidilao hot pot restaurant chain, one of China’s fastest growing restaurant chains, so it also benefits from the expansion of this business.
“In addition, Yihai is using its brand recognition at Haidilao to develop a retail business that enables customers to enjoy the same experience at home.”
The trust’s portfolio is positioned to benefit from the increase in consumption of services through exposure to education, restaurants, travel and financial services.
Within this, Nicholls said e-commerce in China has already surpassed western markets as internet penetration continues to rise. He pointed out that this is a prime example of the structural change China’s economy is undergoing.
“We are seeing new business models emerge exemplified by growth in online businesses such as flash sales, live video streaming, and a range of education services,” he continued.
“The Company holds a position in Ctrip, China’s largest online travel agency. China tourism, both domestic and outbound, is a huge market with significant growth potential.
“Online booking is growing at an even faster rate, and Ctrip is the best positioned business to take advantage of this with over 60 per cent market share. Following its acquisition of Qunar, Ctrip covers all markets from mass to luxury.”
Another area the manager is seeing more opportunities in is SOEs. While the portfolio remains focused on private companies and SOE reform has been “disappointing” relative to the Third Plenum’s agenda, he believes there are signs of progress.
“A number of SOEs have the potential to benefit from changes in regulation especially around more market-oriented pricing in areas like transportation,” Nicholls said. “The company’s holdings in the airport sector have benefited from recent tariff adjustments and I believe there is good potential for progress in other areas such as railways.
“Elsewhere, there are also encouraging signs of supply-side reform in certain old economy sectors reflected in falling steel and coal output.”
One state-owned stock Fidelity China Special Situations holds is China Petroleum and Chemical, which it has an 80 basis-point overweight to relative to its MSCI China benchmark at 2.6 per cent.
The manager said the company is considering launching a spin-off and IPO of its garage forecourt business and is exploring the possibility of developing the existing business further – two factors he believes are not reflected in the company’s valuation.
Generally speaking, the trust relies on seeking individual firms that are further down the cap spectrum and are therefore under-researched by the broader market.
This approach has clearly stood the trust in good stead over the last year. As its annual report highlights, it has returned 38.8 per cent over the last 12 months to the end of March. Its dividend has also increased by 38.9 per cent to 2.5p per ordinary share.
Given its 8.2 percentage-point outperformance over this time frame, its discount has narrowed from 17.2 per cent to 13.2 per cent over 12 months to the end of March this year.
Performance of trust vs sector and benchmark over 1yr to April 2017
Source: FE Analytics
“Hutchison China Meditech (HCM), a longstanding top 10 position in the portfolio, returned over 70 per cent,” Nicholls explained. “HCM is a Chinese pharmaceutical company listed on the UK AIM market with a strong traditional Chinese medicine business generating strong cash flows for the company to support its R&D efforts.
“The company continues to develop its exciting pipeline including a number of advanced oncology drugs where it is teaming up with global multi-nationals like Astra Zeneca.”
Elsewhere, the manager said China Sanjiang Fine Chemicals was a significant contributor to the trust’s strong performance as price spreads widened across a range of chemical products.
Car dealership China Maidong Auto also stood the trust in good stead over the last year as its share price more than doubled over this time frame.
In contrast, the vehicle’s holdings in financials were the largest detractors from performance. China Pacific Insurance, for instance, is Fidelity China Special Situation’s largest individual overweight relative to the MSCI China index.
Despite this, the manager believes it offers significant long-term growth potential as there is still a low penetration of life insurance products in China.
“I look for investment ideas across a range of different markets and find significant value in many of the Hong Kong-listed small caps,” Nicholls explained. “With increased connection between markets such as the Stock Connect Program (which allows mainland Chinese investors to buy Hong Kong listed names via the Shanghai and Shenzhen exchanges), I think there is good potential for valuation discrepancies between the market to normalise which could act as a tailwind for these names.”
Looking over the medium to long term, the manager believes China will remain a dynamic economy and market with huge variations between the winners and losers. As such, he said it will remain a particularly fertile ground for bottom-up stock-pickers.
“While the market has moved up, valuations on the whole remain compelling in a global context. One wonders if what has become a relatively stable and predictable policy environment compared to much of the West might also start to get reflected in valuations,” he reasoned.
“The gap between China’s share of the global economy and its share of global stock markets remains significant, and I remain confident this will close over time. It is a matter of time before A-shares move into global indices.
“The prospects for an acceleration in the reform process are also improving. Looking back, it has been an exciting, interesting and ultimately fruitful three years in charge of the company’s portfolio. I very much look forward to capitalising on the opportunities in the market to deliver further growth in NAV and the share price.”
Over Nicholl’s tenure, Fidelity China Special Situations has outperformed its MSCI China benchmark by 40.11 percentage points with a total return of 106.43 per cent.
Performance of trust vs benchmark under Nicholls
Source: FE Analytics
It is currently trading on a 13.7 per cent discount, is 26 per cent geared and has ongoing charges including a performance fee of 2.22 per cent.