Stepping into the shoes of one of the most highly regarded fund managers of the past few decades is a tall order, but when Anthony Bolton announced last year that he was retiring from managing Fidelity China Special Situations (FCSS) investment trust, someone had to step up to the challenge.
The chosen candidate, Dale Nicholls, already has a good performance record with Fidelity Funds Pacific Fund (LU1033664373), beating the MSCI AC Pacific Index over one, three, five and 10 years. And although Mr Nicholls officially took over in April he had been working closely with Mr Bolton since June last year – attending more company meetings together than previously. Since Mr Nicholls relocated to Hong Kong in January, no trade in Fidelity China Special Situations portfolio was made without his agreement.
Fidelity says Mr Nicholls' contrarian value style is very similar to Mr Bolton's.
"I focus on three main things," he says. "Companies with good long-term growth prospects; cash generative businesses, because some grow but do not make high returns; and companies controlled by strong management teams. The latter quality is especially important for small and mid-sized companies.
"Ideally, these three factors are not reflected in valuations, which I think about relative to these three things."
Mr Nicholls has a bias to smaller companies because they tend to be less well researched and therefore more mispriced. He says risk management is key, and meeting companies is essential to understand them and monitor their progress – a reason he has been building a mainland team in Shanghai.
Smaller companies are more volatile but Mr Nicholls mitigates this with more discipline on valuation, so focuses on balance sheet strength and earnings stability.
Corporate governance is also particularly important in this area. "But corporate governance is an issue in all emerging markets, and something you have to deal with and incorporate into your analytical process," adds Mr Nicholls. "In China we use third party resources – people on the ground – to do background checks on managements and look for reputational red flags. As well as areas such as forensic accounting this includes really basic checks: for example, if a company says it has 1,000 stores, how many does it really have?"
Dale Nicholls CV Dale Nicholls has been manager of Fidelity China Special Situations since 1 April and Fidelity Funds Pacific Fund since September 2003. He managed Japanese sector funds between 1999 and 2003, and has also run regional small-cap funds. He joined Fidelity as a research analyst in 1996, before which he worked at Bankers Trust Asia Securities in Tokyo. |
Changes to portfolio
Although he shares a similar investment style with Mr Bolton, Mr Nicholls has already made some changes. "The stocks that will deliver over the long term are the 'new China' private companies as there is a shift away from investment and exports to consumption," he says. "I have increased the trust's allocation to consumer discretionary shares – there are a number of names I liked and have added to – and reduced financials, which mainly resulted from selling Wing Hang Bank."
In fact, Mr Nicholls does not hold any Chinese banks. "These look cheap on paper but face headwinds, most notably non performing loans which are increasing. They are reporting levels of around 1 per cent but I don't think anyone knows what the true number is – though I think it is north of that. This is not a great environment for bank stocks to outperform."
By new China, Mr Nicholls refers to areas and themes such as domestic consumption and services, private companies (which have been outperforming state owned enterprises driven by rising profits), value added manufacturing and deregulation and faster reform.
"The government wants to change the economy to a more consumer-led model and is committed to improving the living standards of the population," he adds. "This would cover areas such as consumer goods and services, health care, anti-pollution and the internet, and I think private companies in particular are likely to benefit. These new industries should grow faster than the overall economy, and the companies within these areas should thrive.
"That said, one must be mindful of all sectors in the market and investors cannot ignore China's state-owned enterprises, some of which trade at attractive valuations and will likely see improvements driven by reform."
He believes consumer goods and services are unpenetrated in areas such as insurance and cars, with Chinese motorists trading up, and holdings include SAIC Motor, which manufactures Volkswagen and GM automobiles via a joint venture.
Mr Nicholls has also deployed cash in higher quality technology shares, for example, internet, mobile and telecoms provider Tencent. This increased from 5.8 per cent of assets at the end of March to 9.8 per cent at the end of June, making it the trust's largest holding.
"We have seen a decent correction in software and internet shares, and Tencent was a good opportunity given the sell-off," he says. "There is significant value in its social network and it has probably one of the best records in the internet space, which it is finding ways to monetise."
China has more than 500m internet users – well in excess of the US. Online consumption is rising significantly and mobile internet has huge growth potential, where companies like e-commerce group Alibaba are leading the way. This is the trust's second largest holding accounting for 4.6 per cent of assets.
Overall market valuations are compelling, with MSCI China at historically low price-to-earnings ratios which price in many of the risks. There is a divergence in valuations between markets, with the same companies' Chinese mainland-listed A-shares around 10 per cent cheaper than their Hong Kong listed H shares. Among large caps the differential is maybe 20 per cent.
Fidelity China Special Situations has around 15 per cent of its assets in A shares.
"Among A-shares we see lots of value in larger-caps as these gaps have strong potential to close," he says. "A shares will be a great stock picking market in years to come because there is such a diversity in valuations."
