Beating trade tensions with domestic growth

“Most of the companies we invest in serve domestic consumption,” he explains. “I’ve spoken to their managers, and they’re more concerned about their competitors and getting capital [than US trade tensions].”

Mr Nicholls is focusing on companies serving domestic consumption because China is moving from being an export-led to a domestic consumption-driven economy, and the proportion of its population that can be defined as middle class is growing. These factors mean that companies in the technology, insurance and healthcare sectors are offering new products and services, and new players are entering the market. 

In the technology sector, Tencent (700:HKG) and Alibaba (241:HKG), the trust’s two largest holdings at the end of June 2019, are expanding and buying innovative new names. “Their ecosystems continue to expand and will occupy an even greater share of the Chinese economy,” says Mr Nicholls.

Other technology companies tapping into China's growing middle class’s disposable income include luxury e-commerce retailer Secoo (SECO:NMQ). “It is building strong relationships with well-known global brands yet trades at a significant discount to global peers,” says Mr Nicholls. “Big [ecommerce] companies in China actively manage their relationships with their government very well, and I would argue that they have better relationships than others, such as Amazon (US:AMZN) or Facebook (US:FB), have with their governments.”

Another sector that Mr Nicholls believes is benefiting from China's increasing middle class is insurance. The trust has significant exposure to insurers including China Pacific Insurance (601601:SHH), China Life Insurance (601628:SHH) and China Taiping Insurance (966:HKG). 

Mr Nicholls says that the long-term opportunity insurance companies offer remains attractive because it’s a big market at a nascent stage being driven by domestic competition. "Insurance is really a compelling investment in China at the moment,” he says. 

Healthcare is changing due to government policy. “Most of the pharmaceutical sector is made up of generic companies, but government policy is now supporting ones that are making novel and innovative drugs,” he explains. And Mr Nicholls believes that competition arising from this will lead to significant pricing pressure. For example, Hutchison China MediTech (HCM), one of the trust’s 10 largest holdings, is a Hong Kong-based bio-pharmaceutical company that researches and develops therapies in the areas of oncology and autoimmune diseases. 

But Mr Nicholls thinks that one of the best areas in which to find innovative smaller companies is unlisteds. The trust’s initial allocation to this area was 5 per cent, but it can now invest up to 10 per cent of its gross assets in unlisted companies to allow the trust's manager more flexibility. At present, around 6 per cent of the trust's assets are invested in unlisted companies, most of which focus on technology. Examples include Bytedance, an internet technology company that operates several machine-learning-enabled content platforms. Its core product is Toutiao, a popular content platform in China, and it owns the social media app TikTok, which is available globally. 

“In the space of a few years it has built up a strong position and is now taking more advertising dollars in the internet space than Baidu (BIDU:NSQ) [a Chinese multinational technology company that offers many services including a Chinese search engine],” says Mr Nicholls. “This is due to a news aggregation app that is still strong business, although increasingly live streaming is a strong business in China. The company has over 400m users and is now building up an offshore business."

Mr Nicholls says that unlisted companies have generated more money for Fidelity China Special Situations than listed ones, for example Alibaba, which the trust held before it listed.

“We factor in an expectation of them coming to market at some point, but it's not a priority as long as they’re generating value,” he says. “And this is one of the benefits of [an investment trust] structure – it gives companies time to grow and if they don’t need to come to market [in the immediate future] it’s OK.”

Investment trusts do not come under pressure to sell assets to reimburse investors taking their money out of them because investors cannot ask investment trust managers to give them back the money they put into a trust. Instead, investors have to sell their shares in investment trusts to other investors on the secondary market. So trusts can hold investments for long periods.

Mr Nicholls says that it is more important that the earlier stage companies he invests in deliver high returns to compensate for the higher level of risk investors are taking on with these. When picking such companies, he conducts rigorous due diligence to try to ensure that the ones he invests in will be able to deliver high returns. 

He says: “When investing [in these types of companies] we generally start with small positions, and as we build conviction in their managements our position builds over time. We look at things like what other businesses the company has and who the key players in its industry are, and conduct broader checks on its reputation.”

The recent launch of the Shanghai Stock Exchange STAR Market, which is based on the US Nasdaq market, means that unlisted companies now have another platform through which to come to market. Mr Nicholls thinks it will help with the build-up of debt – a big concern in China. “It’s being addressed, but is still a risk,” he says. “One way to solve the problem is through equity and having another platform for companies to come to market is a positive. It’s a much more efficient way to channel capital.” 

Chinese listed equities have been volatile. But Mr Nicholls says: “The direction of policy is pretty predictive because you’ve got a government that draws up detailed five-year plans and has a pretty good record of meeting them. So you have a pretty clear view of where things are going in many industries.”

Fidelity China Special Situations (FCSS)

Source: Winterflood as at 29 July 2019, *AIC, **Fidelity

Performance

Source: Winterflood as at 29 July 2019

Top 10 holdings (%)

Source: Fidelity as at 30 June 2019

Sector breakdown (%)

Source: Fidelity as at 30 June 2019