Dale Nicholls, manager of Fidelity’s £700m China Special Situations investment trust, is facing tough questions on the fund’s track record. The share price is down 30 per cent since its peak last May and its discount to NAV has widened out to nearly 20 per cent.
Nicholls looks across his audience and says calmly: “China’s economy will be the biggest in the world in five years’ time. And people are saying they can’t find investable ideas? That’s mad.”
Nicholls is not a macro-man, but you can’t help but talk macro-economics when it comes to the behemoth that is China. “The country is already 12-13 per cent of the world’s GDP, but it is just 3 per cent of world market cap. It simply has to go higher over time,” he says.
He shares the distrust of the official GDP figures as much as any other fund manager. No one thinks China will record 7 per cent growth this year – not when the electricity consumption or the throughput figures at the ports tell a very different story. “I’m by no means a GDP bull. The real growth will be below the official figures. But the re-balancing in the economy is happening, with a shift from a reliance on exports.”
The period of heavy industrialisation in China may be closing. Steel-making capacity may be cut by as much as 100 million tonnes over the next few years – for context, that’s three times more than Britain’s entire steel industry produced at its peak in the late 1960s. What’s evolving is an economy that will continue to dominate global industrial production, but which is tipping towards consumer consumption, and with a much reduced dependence on exports for growth. It justifies why the biggest weightings in Nicholls’ portfolio are consumer discretionary stocks.
But if it’s economic worries you’re looking for, China has them by the basketload. Nicholls doesn’t think they will overwhelm China, but acknowledges they are there. Chief among his concerns is the banking system.
Since the global financial crisis, China’s banks have been on a lending binge aimed at keeping the growth engine going. Since 2007 there has been a 100 per cent increase in China’s debt relative to its GDP. How much of those loans are being properly serviced? Nobody knows for sure, but the numbers are probably scary. “The recognition of the non-performing loans problem is still ahead of us. That’s the reason why I don’t own any of the banks,” he says.
Nicholls is more relaxed about the other issue that he says concerns investors most, which is the prospect of a deep devaluation of the renminbi. Yes, there are large capital outflows from China, but he says that is partly offset by how the Chinese are dumping dollar-denominated loans in favour of loans in local currency.
What’s more, countries tend not to go through deep devaluations when they are running a large surplus on their balance of payments, which was more than $600bn in 2015.
What should be exciting people is not the figures for GDP growth or capital outflows, but the numbers for share valuations. “The MSCI China index is on just eight-times forward earnings and one-times price to book. Even if you exclude the banks, you are on 11 times earnings and 1.3 times book. Valuations are close to historic lows.”
Nicholls is so convinced that recent volatility represents a prime buying opportunity that he has closed many of his shorts, has added to his long positions and increased the trust’s net gearing. But the central thrust of the portfolio remains the same in its focus on consumer discretionary stocks and companies in the consumer IT and e-commerce sector.
The proportion of personal income spent online in China has already outstripped that in the US, says Nicholls. The largest stock in the portfolio is internet portal Tencent, at 9.2 per cent of the fund, although he has sold down his holding in Alibaba, China’s answer to eBay and one of the 20 most visited sites in the world. On China Singles Day last November 11, it reported sales of $14.3bn alone. But it has had a very poor start to 2016, falling from $84 to $66.
Nicholls also likes life insurance, in a country where the welfare state is still in its infancy and if families need protection, they have to buy it privately. China Pacific Insurance and Ping An Insurance are both in his top 10 holdings.
Both have also suffered a hard landing since the start of the year and are substantially below their pre-financial crash peaks, but Nicholls is confident they will recover. China Pacific is trading on an enterprise value of just one, which implies no growth at all in its business.
The state-owned enterprises are a thorny issue for any investor. Few fund managers like stocks where the government is the controlling shareholder, subject to political vicis situdes. But it hasn’t put Nicholls off Shanghai Airport, which unlike the many new airports in remote locations in China is enjoying spectacular traffic growth. Management, he believes, should be able to squeeze much more out of the retail offering. As someone just back from visiting the Angkor temples in Cambodia, I can confirm that the age of mass Chinese tourism is well and truly upon us.
The bad news on China is largely priced into the market, says Nicholls. Brave investors don’t need to wait for good news, just for an absence of bad news. He points to the property bubble. It was the story that obsessed China bears last year, but has largely gone off the radar, with a property slump no longer expected. All that it needs is for the bad news not to be as bad as expected, and Chinese markets could recover swiftly. “There’s a slow realisation that doomsday hasn’t happened. The spark for investors will be if the bear scenario doesn’t actually play out.”
Nicholls is not perturbed by the current negativity in China, saying there are a large number of opportunities in the nation that will be the world’s largest in five years’ time. He is focusing on consumer discretionary stocks and the e-commerce sector but also sees value in the life insurance industry. However, with the fund trading at a 20 per cent discount not everyone is as optimistic.
£700m Assets in the Fidelity China Special Situations trust
20% Current discount to NAV on the fund
100% Increase in China’s debt relative to GDP since 2007
9.2% Largest position in the portfolio, in Tencent
$66 Stock price of Alibaba, falling from $88 at the start of the year
8.2% Annual price return of the trust in 2015