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Challenging the China consensus

John Baron reflects on 2014’s performance and, in reminding readers of the constant need to question consensus, again recommends China.
January 9, 2015

Looking back at performances over 2014, the Growth portfolio is up 8.01 per cent and the Income portfolio 9.07 per cent. By comparison, their Wealth Management Association Growth and Income benchmarks were up 6.47 per cent and 7.70 per cent. The FTSE All-Share index was up 1.17 per cent. All figures are total return.

More relevantly, last year’s modest outperformance by both these ‘live’ portfolios has further contributed to their good long-term record. Since their inception in January 2009, the portfolio returns are 147.29 per cent and 120.95 per cent compared to benchmark figures of 81.79 per cent and 67.64 per cent respectively.

These are pleasing performances, but I am never complacent. One should always be questioning assumptions and positions. A benchmark cannot be beaten if it is simply copied and the investor takes comfort from the company of crowds. In order to outperform, the consensus must be challenged – and China is a case in point.

 

The longer view

While it is helpful to beat benchmarks over the short term, I highlight longer-term performances as any meaningful benchmark comparisons require a minimum five year period. This is because, in order to outperform, investors should always be seeking value in unpopular sectors and regions, which can then take time to come right – but more than make up for lost time when they do.

My last three monthly columns have focused on individual ‘special situations’, where sentiment has unduly trailed a trust’s fundamentals and which has been reflected in their wide discounts. My next series of columns will now focus on broader regions and themes which are unpopular but which I believe represent good value, and on identifying the trusts which are well positioned to benefit from an expected improvement in sentiment.

A key favourite is China, and with it Fidelity China Special Situations (FCSS). I first introduced FCSS into the Growth portfolio in the spring of 2014 (‘Buy China’, 6 June 2014), when sentiment was especially negative. Since then, it has returned over 35 per cent at the time of writing. I topped up in November and again in December – space in last month’s column not allowing me to explain why.

Fidelity China Special Situations

The market is concerned that China’s growth rate is slowing. Growth of around 7.5 per cent, already the lowest since 1990, is set to slow further – perhaps to around 6 per cent. There are also concerns about the banking sector and possible credit bubble, about an overheating housing market, and about the number of inefficient state-owned monopolies. High levels of corruption and poor corporate governance have added to the nervousness.

As a result, and despite a strong run in recent months, China remains one of the cheapest markets at around 10 times 2015 earnings, which are expected to grow at around 11-12 per cent. By comparison, Japan costs 14 times for similar growth, the US is more expensive whilst offering lower growth, whilst most emerging markets are more expensive.

Many of the market’s concerns are not warranted. China is in the process of rebalancing its economy away from export-led and infrastructure engineered growth and towards domestic consumption. This will produce volatility and a slowdown, but the resulting growth will be of a much better quality. Markets will anticipate this achievement – preferring to travel than arrive.

Meanwhile, the importance of reforms introduced by the Communist Party’s Plenum in 2013 is being underestimated. This is particularly the case regarding plans to limit state socialism and allow the market a much bigger role in the economy in order to encourage a more efficient allocation of resources, and raise productivity and living standards.

China observers will testify this has been quietly happening for some time, but the Plenum has increased the momentum. The Party understands the perils of failing to meet the economic expectations of its increasingly aspirant people – and events elsewhere have reinforced this focus.

Linked to this is the Party’s renewed mission to combat corruption and improve corporate governance. This rising middle class will be more questioning of blatant ‘unfairness’ and inefficient practices which, if not addressed, could also lead to political instability. All things are relative, but the clamp down is under way.

This bodes well for foreign investors who tend to shun corrupt economies as market forces get distorted and minority interests sidelined. It is no coincidence that, in the years prior to the financial crash, China’s CAPE (Cyclically Adjusted Price Earnings) multiple rose markedly when corruption was being tackled, but retreated when reform faded.

Investors in China over the last decade know better than most that fast-growing economies do not necessarily result in good performing markets. However, progress in tackling corruption could significantly raise the market’s rating, almost regardless of any economic slowdown.

FCSS is well placed to benefit from these encouraging developments. Dale Nicholls, the manager, has a strong track record in the region with Fidelity’s other funds, and the trust has outperformed the market – returning around 35 per cent and 105 per cent over one and three years.

The economic slowdown does not worry Nicholls. Gearing of over 20 per cent reflects his positive view. The switch from infrastructure investment to consumer spending offers huge potential. Wage growth is feeding demand for consumer goods and services, particularly in sectors such as insurance and autos.

Technology is another favourite sector given internet usage is small compared to the developed world. FCSS is hoping to harness the changing way people use the internet to socialise, communicate and purchase goods.

Furthermore, as the state gradually allows the market to assume a greater role, it will be the nimble and entrepreneurial companies that will disproportionately benefit. FCSS’ focus on smaller companies therefore bodes well.

China remains a command economy with strong vested interests. There will be volatility. The reforms will take time. But one should not underestimate the Party leadership which has already taken steps to rein in the property bubble and overstretched banks. Meanwhile, its recent interest rate cut and decision to allow foreign investors to access the market, together with falling oil prices, are modest positives.

A cheap market with improving fundamentals, a government actively promoting a pro-growth environment, a good fund manager, and a geared exposure to smaller companies and rapidly growing consumer market, all suggest it’s not too late to buy FCSS if you missed out first time – the 11 per cent discount adding to the attraction.

 

Other portfolio changes

This purchase has been funded by various sales. I have sold BlackRock Frontiers Investment Trust (BRFI) in both portfolios when standing at a small premium, partly because these markets are now more expensive than emerging markets.

Within the Growth portfolio, I have also sold Templeton Emerging Markets Investment Trust (TEM) and added to Henderson Far East Income (HFEL) given the latter’s strong focus on dividend-payers in China and Hong Kong.

Within the Income portfolio, I have added to Perpetual Income & Growth Investment Trust (PLI).

 

Growth portfolio

Bonds
IShares Corp Bond Fund ex-Fin[£] ETF7.5%
New City High Yield IT2.5%
UK Shares
JPMorgan Mid Cap IT6.0%
Murray Income IT5.5%
Finsbury Growth & Income IT5.0%
Henderson Smaller Cos IT5.0%
Strategic Equity Capital IT4.0%
Hansa Trust 3.0%
International Shares
Fidelity China Special Situations IT6.0%
European Assets IT 6.0%
JPMorgan Japanese IT5.5%
Baillie Gifford Japan IT5.5%
Henderson Far East Income5.0%
Oryx International Growth Fund4.0%
Themes
International Biotechnology IT6.5%
Herald IT4.0%
The Biotech Growth IT4.0%
Utilico Emerging Markets IT3.0%
Ecofin Water & Power Opportunities2.0%
City Natural Resources IT1.5%
Commercial property
TR Property IT4.0%
Standard Life Property Income IT3.5%
Cash1.0%
Total100%
Holdings are rounded to the nearest 0.5%

 

Income portfolio

Bonds
IShares Corp Bond Fund ex-Fin[£] ETF9.0%
IShares Corp Bond Fund [£] ETF8.0%
New City High Yield IT7.0%
Invesco Perpetual Enhanced Income IT5.5%
City Merchants High Yield IT5.5%
UK Shares
Perpetual Income and Growth IT6.0%
Temple Bar IT5.5%
Murray Income IT4.5%
JPMorgan Mid Cap IT4.5%
Henderson Smaller Cos IT4.0%
International Shares
European Assets IT6.0%
Henderson Far East Income IT5.0%
JPMorgan Japanese IT3.5%
Themes
International Biotechnology IT5.5%
M&G High Income Inc shares IT4.5%
Utilico Emerging Markets IT3.0%
Herald IT2.0%
BlackRock Commodities Income IT1.5%
Commercial property
Standard Life Property Income IT6.0%
TR Property IT 3.0%
Cash0.5%
Total100%

 

Portfolio performance Jan 2009-Jan 2015

Growth (%)Income(%)
Portfolio Total Return147.3120.9
WMA Total Return81.867.6
Relative Performance65.553.3
Yield2.54.2
The WMA (formerly Apcims) Growth and Income benchmarks are cited (Total Return)