An investment trust taking advantage of China's reopening

The Chinese equity market has provoked strong views in recent times. An early lockdown strategy saw Chinese stocks tear ahead in 2020, delivering big gains for many an Asian equity fund. That was turned on its head in the following two years: first a fierce regulatory crackdown on the internet majors and sectors such as real estate spooked investors. Some dubbed the region uninvestable and even Scottish Mortgage Investment Trust's (SMT) managers have rowed back on their enthusiasm for Chinese tech majors. Alongside this were the challenges posed by the countries zero-Covid policy and rolling lockdowns.

Moving into a new year, sentiment appears to have shifted again. The reopening of the Chinese economy is now widely viewed as a promising investment theme, with Bank of America’s global fund manager survey for February even identifying ‘long China’ as one of the most crowded trades in the eyes of professional investors. Chinese shares have bounced back so far this year, along with many other markets. Any optimism is yet to fully feed into the investment trust space, however, where three of the four dedicated China trusts trade on high single-digit or double-digit discounts to net asset value (NAV).

Regulatory uncertainty has not abated and investing in China continues to come with the many unknowns of buying into an emerging market. But China trusts may offer an interesting way in and a look at the biggest name in the sector can tell us something about the opportunities and risks on offer.

Fidelity China Special Situations (FCSS) is much larger than its three peers and, as our table shows, its share price performance has held up better than those of its rivals over one and 10 years, although JPMorgan China Growth & Income's (JCGI) is ahead over five years. That trust also trades on a much narrower discount to NAV than its three peers.

The managers of these funds have, unsurprisingly, made the case for continuing to invest in China and stocks such as the internet majors on the grounds that they look cheap in a time of apparent turmoil. But with the region seemingly ready to turn a corner once more, it’s worth looking at how Fidelity China Special Situations is positioned and how this compares with its competitors' positions.

The big beast

Dale Nicholls, manager of Fidelity China Special Situations, has put an emphasis on holding stocks that should do well if the u-turn in China's zero-Covid policy drives greater consumer spending. “While consumer sentiment currently remains weak, with challenges around weak economic trends and the property sector, we think the prospects for improvement are strong, supported by significant household savings built up over the past three years, which should help accelerate consumption and boost economic growth,” he wrote in a note published in January.

This is reflected in some of the trust's sector overweights, such as the 35.7 per cent allocation it had to the consumer discretionary sector compared with 30.3 for its benchmark, the MSCI China index. Nicholls wrote in January that over a period of 12 months he had added to “macro-sensitive discretionary names” such as retailer Miniso (HK:9896) and retail jewellery play Luk Fook (HK:590). “Within consumer staples, China Foods (HK:506) is positioned to benefit from a reopening-driven sales increase and an upgraded beverage product mix,” he added.

Nicholls and his team have tended to be big backers of internet giants Tencent (HK:700) and Alibaba (HK:9988), which have long maintained a major presence in China, Asia and emerging market indices. But these stocks also took a big hit in the crackdown that gathered momentum in 2021. Fidelity China Special Situations has large allocations to these stocks, roughly in line with those of the MSCI China index at the end of December, with Tencent making up 11.7 per cent and Alibaba 8.2 per cent of its assets.

The problems facing such shares have been undeniable, with Chinese authorities cracking down on seemingly monopolistic behaviour. But Nicholls has started to take a more upbeat view on their prospects. “Regulatory and policy headwinds in the China internet space over recent years have made it very difficult for tech giants to maintain market share and return to strong margins, which has been reflected in low valuations. However, with an improved earnings outlook and easing regulation, we see an increasingly attractive risk-reward payoff amongst the likes of Tencent and Alibaba,” he says.

Nicholls and his team have also made some investments in the property space, another area battered by regulatory measures. These include adding to a position in state-owned property developer China Overseas Grand Oceans (HK:81). “The company looks well placed to benefit from the decline in privately owned developers in China’s lower-tier cities, while its solid balance sheet and compelling valuation offer a decent margin of safety,” Nicholls noted.

The trust’s investment team has also slightly trimmed positions in Macau gaming stock Galaxy Entertainment (HK:27) and travel names such as Trip.com (HK:9961), following a sharp uptick in valuations. Elsewhere, another focus in the portfolio is the “long-term structural growth opportunity of China’s underpenetrated insurance industry”, with the team continuing to hold names such as China Life Insurance (HK:2628) and China Pacific Insurance (CN:601601), and recently initiating a position in Ping An Insurance (CN:601318). In terms of other themes, they are on the lookout for ideas that could benefit from government support. “The accelerating development of domestic industry and supply chains is being clearly supported by the Chinese government and is a trend we are watching closely,” says Nicholls.

The trust looks especially focused on the reopening trade. It recently had a chunky level of gearing (debt) of 22 per cent, according to Association of Investment Companies (AIC) data, so it is positioned for amplified wins and losses depending on how the relevant holdings work out. At the end of November, Nicholls said that the level of gearing was due to the value opportunities. “I am finding a plethora of buying ideas and opportunities and this is reflected in rising net gearing levels for the company,” he explained.

By contrast, Abrdn China Investment Company (ACIC) and Baillie Gifford China Growth Trust (BGCG) have minimal gearing. But JPMorgan China Growth & Income has a higher level, at 18 per cent, and the other trusts have reasonable levels of exposure to sectors such as consumer discretionary – if not as high as Fidelity China Special Situations and the MSCI China index. JPMorgan China Growth & Income also stands out for its policy of paying a dividend equivalent to 4 per cent of its NAV each year, via quarterly payments. That’s a boost for investors and sets it apart from its less income-orientated peers.

JPMorgan China Growth & Income has also ridden some high points for the Chinese market especially well. It made an enormous 97.5 per cent share price total return in 2020 compared with Fidelity China Special Situations’ lower but similarly impressive 68.6 per cent share price total return. Both trusts’ share prices tanked in 2021 and 2022, with JPMorgan China Growth & Income faring slightly worse, and so far this year Fidelity China's share price total return has rebounded more fiercely.

Fidelity China tends to focus on smaller companies at times and can have a fairly sizeable exposure to unlisted companies too, which made up 16.1 per cent of its assets at the end of 2022. Although JPMorgan China Growth & Income can invest in unlisted companies it states in its literature that it tends not to make such investments.

Baillie Gifford China Growth Trust's unlisted exposure includes a position in TikTok owner ByteDance, while Abrdn China had a very small exposure to unquoteds of 0.4 per cent at the end of 2022.

As with some other single-country trusts, the investment opportunities targeted can take notably different forms, although all have plenty of inherent risks – reopening trade or not.