For a number of years professional investors have been keen to get access to Chinese shares listed on the mainland, for better exposure to domestic growth. Read more on this
These include Anthony Bolton, the outgoing manager of Fidelity China Special Situations Fund (FCSS), who likes to invest in privately-owned medium and small companies, in particular consumption and services. "The big infrastructure spend days are over, and there is a large focus on growing the domestic economy," he says.
The fund is massively overweight consumer discretionary shares (25.1 per cent as opposed to 5.6 per cent for the benchmark), and healthcare (10.5 per cent in contrast to 1.3 per cent for the benchmark).
Although the fund has a quota under the Qualified Foreign Institutional Investor scheme to buy mainland shares, Mr Bolton says that the Chinese mainland is not necessarily the cheapest place. "Local investors in China like small high-growth companies so much that some of them trade on excessive valuations of 60 to 70 times earnings," he says. "Hong Kong is the opposite: local investors like big companies, so smaller companies have particularly low valuations. I saw a smaller Hong Kong company a few weeks ago and it has a valuation of about a quarter of that of its main competitor which is listed on a mainland exchange.
"But over time I expect mainland investors to be allowed to invest more freely into Hong Kong listed shares, and the opportunity to buy into smaller companies there will be a serious consideration for them. Although Hong Kong listed Chinese medium and smaller sized companies sell on much lower valuations than their mainland listed peers, I would expect this valuation difference to close, with the Hong Kong shares being re-rated."
Mr Bolton adds that H shares (companies incorporated in the People's Republic of China but listed in Hong Kong) are only just off their 10-year lows so are "pretty attractive as they are still well below their long-term average."
Smaller and medium companies shares helped the trust outperform over the six months to the end of September. "It is good to see the factors that hindered performance in the past, the exposure to smaller private companies and the portfolio's borrowings, are now working to shareholders' advantage," he said.
Fidelity China Special Situations did not get off to a good start, but over one year it has massively outperformed its benchmark, MSCI China.
Mr Bolton also invests in mainland shares which account for around fifth of the fund's assets. "These have been more highly valued but this is a highly inefficient market with a wide range of companies so you can find lots of opportunities," says Mr Bolton. "For example, I own one of the cheapest car companies. If you are investing in China you don't want an index tracking fund because they provide exposure to large state owned enterprises, rather than small and medium privately owned companies with domestic exposure that I believe will lead China's growth over the next few years.
"The index is weighed down by many large state owned enterprises where policy support is likely to be less favourable than in the past. I expect a number of them will face headwinds as cheap finance is cut off, as the government opens up selected industries to competition and as some businesses suffer from the ongoing anti-corruption campaign."
US listed
Nearly a quarter of the fund's assets are in Chinese companies listed in the US. Chinese companies listed in the US and Canada experienced reputational problems after in 2011 a research company accused Canada-listed Sino-Forest of committing fraud. Ensuing doubts about US-listed Chinese companies' book keeping and disclosures meant that the entire sector, whether implicated or not, experienced massive share price falls, including companies held in Fidelity China Special Situations' portfolio.
This has also proved to be a problem for other UK funds such as RENN Universal Growth Investment Trust (RUG) (read more on this), while Mid Wynd International (MWY) investment trust had a small exposure to Sino-Forest (read more on this).
Fidelity China Special Situations had owned companies which were listed in the US as a result of a reverse merger, whereby a shell company is listed in the US and is acquired by a Chinese business allowing it to bypass the scrutiny of an initial public offering. "I thought most of these were all right but I got that wrong," admits Mr Bolton. "I don't hold any reverse merger companies today - only full listings."
Exposure to fully US listed Chinese companies was increased materially last year, when Mr Bolton said: "The poor performance of Chinese shares and particularly those listed in the US has led to the opportunity to buy some companies at what I believe will prove to be attractive valuations."
His contrarian stance was proved right this year when these companies experienced a bounce back: over the six months to 30 September Fidelity China Special Situations' outperformance was helped in particular by Chinese internet companies and US listed Chinese companies. "This year these have done very well, especially technology companies," he said. "US listed Chinese companies are a very interesting area because there are lots of technology and internet related names."
The trust is overweight IT shares: 25.2 per cent of assets in contrast to 9.3 per cent for its benchmark.
However, as a result of the fall in the share prices of US listed Chinese companies some of these have opted to delist via management buy-outs at low valuations. "Two good companies have been bought off us which is frustrating," says Mr Bolton.
One of investors' key mistakes is making predictions for China based solely on their western experience, says Mr Bolton.
"The likelihood that the economy will collapse in a western style banking crisis any time soon - something that several international commentators predict - is extremely remote in my view,” he says. “To my mind, the real challenges are medium-term social and political ones. A particular worry focused on this year by the China bears is the rising level of debt in China relative to gross domestic product (GDP)."
