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Fidelity China gears up for recovery, tackles discount
Dale Nicholls has hiked borrowing on his Fidelity China Special Situations investment trust in anticipation of a stock market recovery.
Fidelity China Special Situations (FCSS ) manager Dale Nicholls is gearing up the investment trust for a recovery in Chinese companies, as they languish at their lowest valuations since the financial crisis.
Nicholls has brought net gearing, or borrowing, on the trust close to its 25% limit, increasing it from its 19.2% level at the end of last year, and having steadily built it up from a recent low of around 10% in June last year, just before China's stock market bubble spectacularly burst.
Nicholls has acted after valuations on the MSCI China index, which is composed of shares in Chinese companies listed in Hong Kong and those listed domestically but traded in foreign currencies, fell to lows not seen since the financial crisis.
Stocks on the index are now trading at a price-earnings ratio of 8.9 times, roughly the same valuation level as during the financial crisis, and a price-to-book ratio of 1.2 times, even lower than during the depths of 2008 and 2009.
Nicholls has responded to the drop in the market by closing some of the trust's 'short' positions – or bets that the shares of a particular company will fall – and used the process to buy more shares, particularly in the country's embattled insurance sector.
'This is the time when markets look most attractive,' he said. 'I've seen less potential gains from the shorts and more from the longs.
'That makes sense when there is a great deal of negativity out there and stocks are near historical lows. What you like to have is good companies that are really cheap and have a good long-term story. Because of this negative sentiment this is what we're having.'
Action on discount
Shares in Nicholls' trust have also been hit with this negative sentiment. The discount on shares in Fidelity China Special Situations versus its net asset value has remained stubbornly high, currently just over 17%, close to its 12-month high of nearly 21%.
That's despite the resilient performance of the trust, whose shares have fallen 8.4% over a year while the MSCI China index lost double that, and are up 29% over three years while the index lost 7.5%.
'There's long been the hope the discount would come in based on the long-term performance of the trust,' said Alex Denny, associate director of investment trusts at Fidelity.
That appears to have been recognised by the board, which after a few months' hiatus as the worst of the volatility hit China, has resumed buying back the shares. Since mid-January it has spent £1.3 million on the trust's shares in its first buy-backs since September last year. Over the lifetime of the trust, it has spent around £23 million of the shares, according to Numis Securities.
'I think they [the board] are going to be more active,' said Denny. 'You shouldn't be too active on the discount when you're not in normal conditions, [but] things have calmed down from where they were.'
Buying more insurers
As Nicholls (pictured) ramps up borrowings, some of that money has gone into Chinese insurance companies. His largest 'overweight' position – owning more than the market – in the trust is in China Pacific Insurance (601601.SS), while another top 10 position, although holding less than the market, is in Ping An Insurance (601218.SS).
'You've got stocks trading at embedded values close to one, which is implying there is no growth,' he said, arguing that there was a strong opportunity for insurers in China, which was 'very underpenetrated' by the sector.
Nicholls has two key themes running through his portfolio – the rise of technology and the Chinese consumer. Consumer stocks overtook technology companies as the biggest weighting in the fund last year.
He said that growth of the Chinese consumer was 'from an investor's perspective, still the big story in China', and that the rebalancing of the country's economy, from export and investment-led growth to consumption, was continuing apace. 'The real growth is below the official perspective, but whatever the final number is, the rebalancing is happening,' he said.
After changes to the MSCI China index, Nicholls now looks less 'overweight' the technology sector than he has been, but that is largely the product of deciding not to increase his technology stake when their weighting in the index swelled in autumn last year. 'Given valuations, I didn't feel compelled to increase that weighting,' he said.
A series of American depository receipts (ADRs), a name for Chinese stocks listed in the US, were added to the index in November last year, including some technology stocks.
Catalyst for recovery
Nicholls still refuses to invest in China's banks, a decision which accounts for his heavy 'underweight' to financial stocks. Heavy lending from China's banks has raised fears the country could be heading for its own financial crisis, although Nicholls is sanguine over that risk, and believes that greater transparency in the sector could help lift the country's markets out of their malaise.
'[In the 2008/9 financial crisis] the markets bottomed when the markets could see the bottom, see how bad it was. It's about transparency,' he said, adding that he did not sense the same levels of investor panic as in the credit crunch and the 1997 Asian crisis.
'My sense about China is that sentiment is not as suicidal as it was during those periods,' he said, adding that the catalyst for a recovery could be 'a realisation the real bear scenario is not going to play out'.
One of the fears gripping investors is that the country's central bank continues to devalue its yuan currency, having shocked markets with cuts last summer. But Nicholls believes heavy devaluations are unlikely.
'Politically, the potential for China to make a wholesale devaluation is tough in terms of its relationship with trading partners,' he said. 'The general sense you hear from policymakers is that's not what is really needed. A wholesale devaluation is something I find hard to picture.'
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by Daniel Grote on Jan 20, 2017 at 13:27