Dale Nicholls has long earned the right not to be compared to his starry predecessor, but the history of the Fidelity China Special Situations investment trust still merits a mention. When Nicholls took over the reins of the trust, it had had an uncomfortable start. In spite of having one of the UK’s leading fund managers, Anthony Bolton, at the helm, it had performed poorly and a number of stock picks had backfired.
Nicholls’s three years at the helm have been a very different story. Although he has been operating with a tailwind, he has still beaten a competitive sector. Over three years the trust is up 111 per cent, almost 30 per cent ahead of the AIC Asia Pacific sector average. It is also comfortably ahead of its peers over one and five years.
This is in spite of – seemingly – not doing anything very differently from Bolton. The fund is still focused on small and mid-cap stocks, still has a large technology weighting, still seeks out undiscovered value and places considerable emphasis on root-and-branch stock analysis. It may just be that markets have shifted.
When considering an investment for the portfolio, Nicholls examines its long-term growth potential. If all goes well, how big could it be in five to 10 years? He is a long-term investor and happy to wait as long as it takes. There are companies in the portfolio that have been held since the trust’s inception in April 2010.
He is also concerned with the quality of a business. The fast-growing China economy tends to throw off plenty of businesses with high growth, but not all will be high-quality. Nicholls wants companies that are also generating a good return on the capital they invest, have fluid cash flow and offer a sustainable competitive advantage over their peers.
A third factor – and particularly important in China – is the quality of the management. Nicholls needs to be reassured that it has a strategic vision, and that it can deliver on that vision. He adds: ‘When meeting management for the first time, we talk very big picture, looking at the company’s history as far back as possible. In the early days, all we really have is the management’s track record. From there, we can look at what has gone well or badly and how the strategy has evolved, building a deeper understanding of the market position and where it is trying to get to. Beyond that, we are checking on those assumptions.’
Valuations are also important. Nicholls wants to ensure that he is not overpaying for the quality of the business and its management team. The closed ended trust structure affords him greater flexibility: ‘It allows us to have a natural mid/small cap bias. These companies tend to be less well-covered, with less information and more mispricing. We are in the business of owning mispriced stocks, finding ideas early and staying on top of them. We wait until liquidity picks up and they come onto the radar of other investors.’
Alibaba and Tencent are biggest holdings
However, this valuation sensitivity hasn’t seen him shy away from the technology behemoths of Alibaba and Tencent, which make up the two largest holdings in the portfolio. He also remains positive on the consumption story in China. He says: ‘The development of the middle class still has momentum. At the moment, there is low penetration across a range of categories, but there is a strong aspirational feeling. People want cars, appliances and so on. This is a thematic bet for five to 10 years or longer.’
In some areas, notably in its IT development, China is outpacing developed economies. ‘We are seeing things move online globally, but in China, things are moving ahead so quickly,’ observes Nicholls. ‘Alibaba is now worth $450 billion, with almost 50 per cent revenue growth. In an area such as e-commerce, there aren’t a lot of legacy bricks-and-mortar shops and buildings, so the shifts are happening faster – from ride-sharing to mobile payments.’
This growth in consumer numbers is unlikely to be derailed by the problem of Chinese debt. Nicholls admits that debt is his greatest concern, but says the impact is unlikely to be felt in the consumer economy. ‘There has been a significant increase in debt and history teaches us that it doesn’t always end well. There are non-performing loans within a number of the banks and the real number is probably higher. We don’t own any Chinese banks as a result – optically they look cheap, but there are problems,’ he comments.
Nevertheless, he believes some of the problems have been overplayed: ‘The bears would say that this is China’s Lehman’s moment, but that I find hard to see. There is pretty good liquidity support. This is not a whole sale funded banking system where that funding can disappear. Consumers are strong and have savings, so there is good deposit support. It is hard to see a liquidity-driven crisis.’ He believes that the worst effects will be poor allocation of capital around the economy.
Consumer debt in China remains relatively low
Concerns about debt don’t affect China’s consumer economy, because the credit issue is not with the consumer. Indeed, consumer debt remains relatively low. Although the Chinese are moving slowly into areas such as mortgages, the trend is starting from a very low base. As such, Nicholls believes the outlook for consumers is relatively positive.
He adds: ‘There has been a significant build-up in credit and that needs to change. The government’s priorities reflect that. It may have an impact on growth in the shorter term, as the government reins in spending.’
The ‘new’ economy in China is the focus for many investors, but Nicholls is one of the few among his peers who still sees some strength in ‘old economy’, which includes infrastructure-related companies. He admits that the driver of the economy and employment growth is unquestionably the private sector, but state-owned enterprises will occasionally have high-quality assets that can be exploited. He holds Shanghai International Airport, for example, pointing out that travel is seeing dramatic growth, with the Chinese travelling more and more.
Economic growth in China continues to surprise, though there is a danger that some of this was engineered to give an artificial boost ahead of the Communist Party’s 19th Congress this autumn, and the transition of power. Nicholls had been invested in more cyclical areas in order to harness this growth, but has been moving into steadier growth companies as high valuations have reduced the valuation advantage of economically sensitive companies.
Governance considerations proved to be a problem for Nicholls’ predecessor. At the end of his tenure on the trust, Bolton delivered a blistering attack on the standards of corporate governance standards in China, famously concluding that the ‘Chinese are great liars’. Nicholls admits that there is a range of governance standards in China, and that proper governance remains a challenge. He says: ‘As investors, we have to do an extra level of work to get comfortable with the management team and how the company is run. That said, developed markets have similar problems.’
It can be a particular challenge in the state-owned enterprises: ‘We are minority shareholders and the company management might not have the same priorities. Private companies are much more aligned with the longer-term interests of investors.’
The trust remains at £1.3 billion in size and as of mid-November traded on a 12 per cent discount to net asset value. Having delivered investors almost double their money in three years, Nicholls has proved himself worthy of the very big shoes he had to fill.
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