Fidelity China Special Situations bets on consumer growth

While he acknowledges that certain numbers such as freight volumes and energy consumption are not looking good, other aspects of the economy - in particular consumption-related areas - are pretty strong. This includes services and retail sales, which continue to grow in the double digits (the internet is a significant driver), as well as domestic and overseas air travel.

"The shift away from reliance on investment and net exports is happening, so you can be safe in the assumption that consumption, at least, is growing fast. And that for me still is the big story for China in the mid term - consumption and general development of the middle class," Mr Nicholls says.

Despite the better prospects for certain areas, the market has sold down across the board, so Mr Nicholls has been able to buy companies he thinks have potential more cheaply.

"When you look at valuations for the market you need to distinguish between old and new China as a big part of the index in China is brought down by the big state-owned enterprises, particularly in energy and banks," says Mr Nicholls.

Fidelity China Special Situations is heavily weighted towards consumer discretionary shares, which account for 37 per cent of assets, in contrast to 6 per cent for its benchmark MSCI China, followed closely by information technology, which accounts for a quarter of the trust's assets.

Its level of debt, or gearing, currently stands at a relatively high 27 per cent and has been achieved via a combination of debt and contracts for difference (CFDs).

"While we note Fidelity China Special Situations has a strong record of outperformance against the MSCI China Index, we would also highlight that, with close to 30 per cent gearing and a focus on smaller companies, this fund is certainly not for the faint-hearted," say analysts at Winterflood. "Nevertheless, these factors position the fund well for a recovery in the Chinese equity market and, for contrarian investors willing to accept shorter-term volatility, now may prove to be an attractive entry point."

The gearing has risen partly because Mr Nicholls has increased his investments in what look like promising companies and reduced his 'shorts' - bets on the price of a share falling.

"We have had some big [market] declines so there is less potential upside from shorts on some names," he explains. "A lot of the bad news is priced in. But we have also added to the longs so net gearing for the portfolio has picked up. To me that makes sense when there is great negativity out there and when stocks are near historical lows in terms of valuations. That is the time to be increasing the ones where I am really confident about the fundamentals."

Mr Nicholls does not hold any banks at the moment because he is concerned about China's rising debt, but does like insurance companies. "All financials have pretty much underperformed so that's been an opportunity to add to particular holdings in the insurance space," he says. "China Pacific Insurance Group (601601:SHH) continues to be the biggest financial holding in the portfolio as life insurance is still an interesting area. You have got stocks that are trading at embedded values close to 1, which are implying there is no growth, and yet China is a very under-penetrated story in terms of insurance."

Fidelity China Special Situations is mainly focused on private companies, but one exception is Shanghai International Airport (600009:SHH). "I focus on state-owned enterprises that have really good assets, and an area where I have found value is airports," he says. "Shanghai International is one of the few within the region with expansion potential. It has recorded strong earnings due to underlying passenger growth and this is a trend that looks set to continue as the Chinese consumer increasingly aspires to travel. Passenger traffic is also likely to grow with Shanghai Disneyland opening later this year.

"There is also great scope to grow its retail-related revenues and margins. And the airport falls within the Shanghai free-trade zone, which could see it expand its cargo operations."

Fidelity China Special Situations has beaten MSCI China and peer JPMorgan Chinese (JMC) over one, three and five years – as well as the broader Asian index. However, over the past year that has been with a negative return, albeit a slight one.

Fidelity China Special Situations' share price has not done nearly so well as its net asset value (NAV), in part due to investor sentiment towards China, so the trust trades on a discount to NAV of about 18 per cent - around the widest since launch. But Mr Nicholls hopes that as the share price is now so far away from the value of the assets that the discount is close to the bottom. The trust has recently been buying back shares to try to stem the discount widening.

Performance

Source: Morningstar as at 7 March 2016

Top 10 holdings as at 31 January 2016

Source: Fidelity