Fidelity China Special Situations plc (LON:FCSS) is the topic of conversation when Hardman & Co’s Analyst Mark Thomas caught up with DirectorsTalk for an exclusive interview.
Fidelity China Special Situations is a large British investment trust dedicated to long-term investments in Asia. Hardman & Co have now published a report on the company entitled China Growth Story + Market Beating Style. Joining me to discuss the report is Mark Thomas, Analyst at Hardman & Co.
Q1: As mentioned you called your report on Fidelity China, China growth story + market-beating style. What is your brief summary of the report?
A1: FCSS offers investors a one-stop shop, providing their portfolios with a diverse Chinese exposure across stocks, sectors, market capitalisations and unlisted companies, all based on the underlying value of each investment.
China offers superior GDP growth, a growing middle class and modernisation. FCSS has a flexible mandate, and the closed-ended structure can make high-return, illiquid investments. It has scale, and the shares are liquid.
Fidelity’s stock-picking and gearing have led to total returns ca.3x the market since launch. Regulation is a risk and an opportunity. Other risks include sentiment to FCSS’s style and volatility, the latter often affected by sentiment.
Q2: You say it’s a style that has generated 3x market returns since launch. Can you tell us more about that?
A2: FCSS, being a closed-ended fund, can invest in small and unlisted illiquid investments, including unlisted ones, as it does not need to hold cash against redemptions – as open-ended vehicles do. This structure also ensures good corporate governance, with its directors usually spending a week a year in China.
From 2011 to 2021, Fidelity’s stock selection and use of focused gearing have nearly doubled the MSCI China Index’s annual contribution to NAV growth, adding, on average, 9.6% p.a. Compounding these higher returns then delivers even more value over time. FCSS’s focus is value in structural growth businesses with competitive advantages and strong management teams.
Research by a long-established, large, local team is a competitive advantage over many global players (some have had local presences for less than two years), while access to Fidelity’s global analysts, and the manager’s regional experience, give a perspective that is unavailable to many domestic competitors.
Q3: Your report goes into detail on its flexible mandate. What can you tell us about that?
A3: FCSS’s investment policies allow optimal investment choice, and include i) a broad mandate with flexibility to take the best opportunities available, ii) an active approach, typically turning over the portfolio every two years, with even higher turnover when opportunities are the greatest (e.g. FY’21), iii) unlisted investments accounting for 9% of net assets (immediate peers nil), allowing FCSS access to value created in the run-up to IPOs, and iv) an active use of derivatives, which delivered £267m of gains in FY’21 (peers nil).
Q4: And what about the risk of regulatory intervention?
A4: A series of announcements since November 2020 have hit a range of large-cap Chinese companies. The 2021 effect has been so dramatic because China has taken action more rapidly than many other countries, and there remains uncertainty as to what will be affected next. However, by understanding why the regulations are changing, one can appreciate future risks.
We have identified three distinct drivers, each likely to affect different stocks. They include i) concerns on social inequality – most affect the largest companies and those with poor consumer/worker protections, ii) data protection and related national security – mainly affecting technology and tech-enabled businesses, and iii) preservation of Communist Party power by limiting the development of potential rivals – the greatest impact being on largest companies.
Putting the risks into this context makes them manageable, and it creates a number of opportunities for FCSS, including i) a general market sell-off creates value opportunities in unaffected businesses, ii) ESG regulations will create new markets, with respect to factors like EV, where Fidelity’s global research can best identify local opportunities, iii) research can help identify the real risks and not be driven by sentiment, and iv) FCSS’s bias to small/medium cap is likely to be less affected than funds invested in large-cap names.
Q5: And other risks – like Evergrande?
A5: There are a range of other risks, including i) geopolitical risks, such as tensions between the US and China, where the direct portfolio risk is limited, with just 3% of investee company revenue coming from the US, ii) Chinese market volatility, with notable corrections in 2007, 2009 and 2015 (but, unlike during those periods, we do not see the speculative bubbles that built ahead of these corrections), iii) a range of economic risks, including the level of private debt and the exposure of the banking system to stress scenarios (this is where Evergrande comes in), iv) the shadow-banking market, v) localised rapid house price appreciation, and vi) an ageing population. However, it is a single party state and, while the authorities appear to have levers to manage these risks, which they have done successfully in the past (e.g. in 2020).
Fidelity China Special Situations is a large British investment trust dedicated to long-term investments in Asia.