Fidelity China Special Situations offers growth at a discount

Despite this, the trust is trading on a discount to net asset value (NAV) of 13.4 per cent. But if investors recognise its long-term growth potential this could tighten. The trust's discount has followed a narrowing trend for more than a year, according to analysts at Edison, coming in from 19.5 per cent in July 2016 to its current level of around 13 per cent. "Since launch in 2010, Fidelity China Special Situations shares have traded between a 13.2 per cent premium and a 23.4 per cent discount, suggesting significant scope for the discount to narrow further should investor sentiment towards Chinese equities continue to improve," they explain.

The trust's manager, Dale Nicholls, invests mainly in companies he thinks will benefit from China's long-term structural shift from an investment-driven to a consumption-led economy, mainly listed on the Hong Kong and domestic China stock exchanges. These include luxury goods and services companies that should benefit from China's growing middle class, and state-owned enterprises that are benefiting from reforms.

Mr Nicholls invests in some of the most illiquid and under-researched areas of the Chinese market, giving him the potential to exploit mispriced stocks. He can invest up to 10 per cent of the trust's assets in unlisted companies, which could offer access to some of the fastest growing entrepreneurial areas of the market.  

Investment trusts such as Fidelity China Special Situations can be a good way to invest in illiquid areas such as unlisted stocks because they do not have to sell holdings to pay investors taking their money out of the fund. If investors want to dispose of their holding in an investment trust they have to sell their shares on the secondary market.

The trust's largest sector exposures are information technology and consumer discretionary. It is underweight financials, with 12.7 per cent of its assets in this area, in contrast to MSCI China's 23.5 per cent weighting to it, because Mr Nicholls is worried about the levels of debt on bank balance sheets. 

The trust has underperformed MSCI China index over one year. And although its ongoing charge is currently 1.16 per cent, in years when it out performs its performance fee means that this can be much higher, for example, 2.22 per cent for its financial year to 31 March 2016. 

Chinese equities are high-risk and prone to spells of volatility, for reasons including that country's high level of debt and state interference in domestic markets, and Mr Nicholls' focus on smaller companies means that risk is amplified. And the trust has a relatively high level of gearing (debt), which can exacerbate losses in falling markets, though also greatly enhance returns if things go well.

Although the trust has underperformed the index over one year it still made a double-digit return of 24 per cent. And analysts at Edison say the short-term underperformance has largely occurred during the past three months, which Mr Nicholls attributes to a rally in cyclical stocks triggered by inflation returning after a deflationary period during the first half of 2017. "This rally has seen MSCI China Small Cap index underperform MSCI China index by around 18 per cent in 2017 to the end of August," they explain. "Fidelity China Special Situations has a bias to small and mid-caps and provides highly differentiated exposure versus the benchmark, meaning periods of diverging performance should be expected."

Analysts at Killik add: "Periods of heightened market volatility are to be expected as China undergoes a challenging rebalancing of the economy. However, for long-term investors, the development of the Chinese middle class provides a strong backdrop for growth. The portfolio continues to offer attractive, high levels of prospective earnings growth, and with the share price having lagged the NAV return year-to-date the current discount is wider than the medium-term average and looks attractive."

So if you are willing to take on the trust's risks  this could be a fund worth paying for. It is run by an experienced manager and its discount to NAV could tighten because it invests in high-growth areas that could handsomely reward you over the long term. Buy. 

Fidelity China Special Situations 

Source: Morningstar as at 18.09.17, *Fidelity 

Performance 

Source: FE Analytics as at 18.09.17 

Top 10 holdings as at 31.07.17 (%)

Source: Fidelity, as at 31.07.17

Sector breakdown as at 31.07.17 (%)

Source: Fidelity