DALE NICHOLLS had never managed a closed-end fund before being appointed manager of the Fidelity China Special Situations investment trust in 2013. He followed one of Fidelity’s most successful fund managers, Anthony Bolton, whose original idea it was to launch a trust specialising in China-related equities. After four years at the helm, which has seen the value of the trust’s shares more than double, he reflects on what he has learnt so far and the prospects of investors in China.
How did you work with Anthony before you took over this job?
When he was in Europe, he was spending a lot of time looking at China. I was managing Asian equities in my open-ended fund. We would spend time talking about different ideas. We’d find ourselves ending up in the same meetings, being in the same company, and I think we just developed a pretty good dialogue about our thoughts on different stocks. The relationship was really just sharing ideas and thoughts.
Then when the decision was made, I think it was a well planned transition. It was announced, I think, a year before. We were working really closely together ahead of that. And in the last quarter, before the actual changeover happened, we agreed that we’d agree on all trades. So we were pretty well aligned. There wasn’t a huge amount of trading that we needed to do upon the actual handover.
How would you describe your style compared to his? Was there more in common than differences?
I think definitely more in common. I think that’s why we found ourselves in the same meetings, looking at similar types of companies, and definitely in terms of looking at the small and mid ends of the market – more off the beaten track in terms of the types of names that we’re looking at. In terms of background, obviously his being in Europe and me being in Asia, we’re influenced by that. I spend a lot of time in Japan so was probably a little bit more familiar with things like the tech areas. It’s hard to say.
In retrospect, it looks like you took over at a pretty good time. Is it fair to say you’ve always been bullish about the opportunities in Chinese and China-related equities?
I think so. China has been a great stockpicking market from a number of perspectives. As an individual stockpicker I try to let the stockpicking drive portfolio construction. It’s a big market and a very diverse market, and a big and diverse economy. You’ve got great variances between different parts of the economy. There’s a great amount of structural change.
We’re talking about a market where there’s been a lot of macro concerns, some of them pretty well justified – most obviously, the concern about slowing growth and the buildup in credit. But from a bottom-up stockpicking perspective, if you’re selective, you’re benefiting from those macro concerns bringing down valuations and you can focus on the companies that are benefiting from structural change. There has also been a huge amount of fear and negative sentiment. For a bottom-up stock picker, that’s a pretty good environment.
I think that general sentiment is starting to adjust somewhat. The collapse that a lot of people have been predicting hasn’t happened. Don’t get me wrong, some of the concerns are valid. The build-up in credit is clearly a concern, but as far as the people that were thinking that it could lead to a Lehman-style financial crisis are concerned, I have always found it really hard to understand how that would actually play out in China.
What are your reasons for saying that?
There has been a very rapid expansion in credit over the last 17 years. Since the global financial crisis, credit per GDP has increased a lot. History teaches us that you’re going to have credit issues as a result of that. I have no doubt that China has those problems as well. It’s part of the reason why I continue to own none of the Chinese banks. Amazingly, the top banks are reporting non-performing loans of just 1.8%. I suspect the real number is higher and needs to be going higher.
But then, when we talk about financial crisis, what really defines a financial crisis? One thing that tends to define it, based on the work that I’ve done, is a lack of liquidity. When you think about what happened during the global financial crisis, you had the banks stopping lending to corporates and also stopping lending to other banks. That’s when you have real liquidity problems. In the China context, first of all, for better or worse, the banks all have one big shareholder – the government – who’s shown that it is quite willing to drive lending when it needs to, but you’ve also got good deposit support in the system. The fact that you’ve got a very strong consumer base and a high savings rate has been what has driven high levels of bank deposits.
So when we think of loan to deposit ratios, you need to think about it in a broader context, not just the formal banking system but the informal banking system. A lot of credit has grown off the balance sheets of the banks. Even when we bring that back onto bank balance sheets, we still get a loan-deposit ratio of below 100%. Compare that to where you’ve had real problems in the past, where you generally have pretty highly wholesale-funded banking systems in which credit can disappear quickly. In China you’ve got this deposit support in the system.
So a real liquidity driven financial crisis I find hard to imagine. What concerns me more is a Japan-type scenario where you’ve got bad loans that just sit on the balance sheets of the banks and that doesn’t get worked out. Then you get poor allocation of capital and that can affect growth. That’s why I spend more time focused on how fast the non-performing loans are being dealt with. I think progress is being made there; but it could be faster.
I’m also more encouraged, particularly in the last six months, by the rhetoric that I hear from the government. At the very top, there’s more awareness of the risks and less of a focus on growth, which I think is positive and shows that things are moving in the right direction. I think there will be less of a focus on growth and more focus on the quality of growth.
Growth definitely will slow. I think that’s natural and necessary. Why? Mainly because you have so much investment-driven growth funded by credit. There’s a real awareness that there needs to be a shift in the structure of the economy towards consumption and away from investment. It’s happening. Consumption is the key thrust of the portfolio. Regardless of what the final GDP number is, whether it’s 6.5%, 6.25% or even 5.0%, you know that consumption is going to be growing faster.
I’d be pretty disappointed as a bottom-up stockpicker if I couldn’t find some decent ideas in an economy that’s undergoing a lot of structural change and has still got a decent consumption growth story. It’s always good when you’re investing in China to think about what the government wants to achieve. You generally want to be aligned with that. The broader growth driver is really just the natural development of a middle class. Across a range of sectors, people want their appliances and their cars, there’s real aspiration. That just seems like a really strong theme that you can invest in, on a five-, ten-, fifteen-year basis.
How much of the portfolio is driven by the Chinese domestic economy?
The majority of the portfolio is about the domestic economy in China. Obviously, I am concerned about trade policy and that sort of thing going forward. If you look at the revenue exposure of the companies that I’ve invested in, you’re looking at over 90% in Greater China. You can invest in that theme across a range of different exchanges and different countries. So I have holdings in Singapore, Taiwan, the US through ADRs (American Depositary Receipts) – these companies that may be listed in different markets, but their prime exposure is China.
Has that percentage changed at all over your tenure?
Only marginally. The proportion of US-listed companies has definitely increased, with the listing of companies like Alibaba and the fact that the ADRs are now coming into the index. The other big change is A-share exposure. There was a lot of negative sentiment around the A-share market when I took over. In many cases the dual-listed companies were trading at a discount to the H-shares. So I shifted a fair bit of exposure into the A-shares. In the last 12 months the market has become more rational. The exposure to the A-share is still relatively high at 10% of the portfolio now, but it’s come down, though it is still above where we started.
More institutional flows, I imagine, are inevitable now that China has been included for the first time in the MSCI world index?
I invest on fundamentals, but when you step back and think about the dynamics around flows, China represents a percentage of global GDP which is in the teens, compared to its share of global markets which is less than 3%. I think that gap is going to close over time. Obviously, MSCI inclusion is clearly a movement in that direction. A lot of global investors could afford to ignore China in the past, but that’s going to become that much harder for them to do.
The A-share market is a fascinating market. For me, it’s one of the most inefficient markets that I’ve seen. It’s not a great surprise when you think that the majority of traders are retail. You have a lot of small, fast-growing companies that are trading on huge multiples, and larger caps – generally pretty good businesses generating strong cash flows – that are largely ignored and really cheap. That structure is clearly going to change over time. You’ve got greater foreign participation in the market and that will increase.
Before you took on this job, did you have any experience with closed-end funds?
No. I was completely from an open-ended background, so this is a new departure for me. It’s definitely been positive. It allows me to reflect the opportunities I see in the market. When things are looking really cheap, when sentiment is negative, or when I am feeling more bullish about the holdings of the portfolio, it is a time to increase gearing, and vice-versa. When we talk about gearing, we should probably distinguish between gross and net gearing. The structure of the trust gives me the ability to go short as well. I can make bets against companies. That obviously gets included in the gross gearing, but is deducted when calculating net exposure. I focus more on net exposure.
Is this a decision that you make? Does the Board delegate that to you?
They’re obviously kept informed about everything that I’m doing, but it’s really my decision within the parameters that I operate in. On a formal basis, every quarter I explain how I’m looking at things, but also on an informal basis as well, I let them know pretty regularly how I’m looking at things and roughly where the gearing is running at.
What other advantages have you found in the closed-end structure?
Not having to worry about flows is a huge positive for me. I have a mid to small-cap bias in the trust, so liquidity [how easily shares can be bought and sold in size] is always something that’s at the back of my mind. Not having to worry about flows gives me more freedom. When there were discussions about my taking over the trust, that was a very positive factor for me.
How much overlap is there between the trust and the Fidelity Pacific fund you also run?
Significant. Obviously, China being a sub-set of the Pacific region, I definitely wouldn’t own a Chinese stock in my Pacific fund and not own it in China Special Situations. So, everything that’s in China, in Pacific, is part of China Special Situations. The overlap is pretty significant. With the trust, again I just get a little bit more flexibility, particularly around liquidity, and probably more exposure in the small-cap space.
The discount widened steadily for quite a period and then started to reverse. How much of that do you think is due to the share buybacks and how much to improving sentiment?
I think it’s improving sentiment, to be honest. It’s quite hard to control the discount. Part of the recent closing of the discount is just a recognition that the doomsday scenario that some people were predicting for China just hasn’t played out and now doesn’t seem likely to play out. I think it’s also a recognition that there’s actually just some great companies in China – the likes of Tencent, Alibaba – which continue to execute and have really strong management teams.
Corporate governance is not always a great strength of emerging markets. You get a lot of semi-state-owned or family-controlled businesses that aren’t particularly shareholder friendly. How does China fit into that category?
As you said, corporate governance is a challenge in any emerging market. It just takes time for the systems to develop. China’s no exception. It’s a challenge for a lot of companies. We’ve spent a lot of time doing as deep research as we can, building relationships with management and building a conviction over time about the management teams. There’s still a pretty significant proportion of state-owned companies.
I don’t ignore the state-owned companies, but the focus for me really is on the private companies. I think that’s where so much of the growth is coming in the economy. And obviously, they’re the biggest investors, the biggest employers, particularly from a growth perspective.
Looking at any company, management is a big factor in how they’re incentivised and the fact is there are a lot of state-owned companies whose goals are not necessarily aligned with ours as minority shareholders. The way the banks have grown since the crisis, obviously there’s government policy behind that. When I think about the big energy companies, I could come into the office tomorrow and there’s been an acquisition made somewhere in the world which may be more about energy security than economics. So, that’s something that’s in the back of your mind all the time.
The state-owned companies I focus on are the ones that have really good assets. I’m a pretty big investor in the airports in China, for example. I think that really fits in with the consumption theme. The growth in travel in China just continues to march along at a good rate – double-digit growth both overseas and domestically. I look at something like Shanghai Airport, which has hub status. Shanghai Disneyland is being built as well, which will continue to drive traffic. You’ve got pretty good expansion prospects.
There are good opportunities to improve the returns on those assets as well. I don’t know if you’ve been through Pudong Airport, but it’s not the most exciting retail offering that you’ve ever seen. If you benchmark against the likes of Heathrow, there’s pretty good potential for even better returns. Valuations also compare well globally.
Looking at the risks as well, what do you think are the major risks that you face in having this big exposure to the Chinese economy?
The development of the middle class is a very strong trend that’s hard to see reversing. When we think about the goals of the government, they want to see that trend happen, they want to see full employment, they want to build welfare, healthcare, and so on. That’s something that’s definitely a strong underlying driver.
In terms of the risks, I’m somewhat concerned at the margin. From a political perspective, you think about censorship and that sort of thing. I don’t think that’s a problem in the short term but if you think about things in the mid-term, obviously as people get richer, I think they’re going to want to have more of a voice. They’re travelling more, they see things that are happening overseas. And so there’s potential for people wanting to have more of a voice over time.
The government at the same time is very focused on that. I don’t think it’s something that we need to worry about in the next five years. But if you think on a longer term basis, I would like to see things politically moving more towards a freer approach. Obviously we need to think about geopolitical risks as well, things that are happening in North Korea now. That’s a risk as well.
From a policy perspective, when you think about the direction the government has set, it’s pretty positive in terms of the way they want to transform the economy. When you think about the predictability of policy, we’re talking about a government that has a five-year plan that’s extremely detailed about what they want to achieve and has a pretty good track record of hitting it.
When I compare that to policy predictability in some of the Western economies, from a policy perspective you know what the government in China is trying to achieve and the direction that’s been set. Yet China has lagged and continues to lag in terms of valuation.
It’s closed some of the gap versus the Western markets, but it’s still a pretty big gap. And at some stage that might start to get reflected in valuations for the markets.
You haven’t mentioned currency so far. How do you manage the trust from a currency perspective?
I think purely in local currency terms. I’m thinking about companies that are trying to grow their business as much as they can in local currency. I’m not overly concerned about the Chinese currency. I think there was probably some concern 12 to 18 months ago when the US was hiking interest rates and other markets were cutting. You saw that reflected in some pretty significant capital outflows out of China. That’s clearly changed now. It’s under control and the reserves are building again. I don’t think you’ll see any significant rate cuts in China. Obviously, the government keeps a pretty firm hand over rates. That will change over time. The clear goal is to free up the capital accounts over time. But it’s going to be a slow process, I think.
How do you see the trust developing?
We’re really committed to China, we continue to build the research team and we’re out there focused on the best ideas. We’ve been looking at the A-share market for quite some time. I think a lot of our competitors were late in getting to look in depth at a lot of the A-shares. I think the commitment that we’ve made to building research is crucial. The fact that we can invest in unlisted companies as well gives us exposure to a broader part of the economy in China. There’s so much happening in the unlisted private space. There’s a great amount of entrepreneurial activity there. It takes a fair bit of time in terms of looking at the companies but it’s really valuable as well. You can find some great ideas and it gives you a sense of what’s coming down the road as well, in terms of companies when they do list.
How much value have the unlisted holdings added?
Pretty significant. Obviously, it’s hugely biased by our investment in Alibaba. But if I look across the other holdings as well, we’ve had pretty significant uplift post our initial investment. We’ve got four holdings now, we’ve had uplifts across three of those. The biggest holding in the unlisted now is Didi, which is effectively the Uber of China. They’re delivering more rides in China than Uber does globally, to give you a sense. This is what I was trying to get to earlier about the pace of structural change. In a lot of industries, it just happens to be faster in China. The penetration of e-commerce has already surpassed the West, surpassed the US. You don’t have legacy retail bricks and mortar investment in third and fourth tier cities. So it makes sense that the transition happens faster.
The Chinese stock market has always looked cheap compared to other markets. Where do you think Chinese equities should trade relative to the US amd other markets?
The growth prospects are clearly stronger. As an emerging market, it still trades at a discount, but when we’re looking at the price to earnings, when the US is close to double China, I think that gap should be closer, particularly when you think about the structural change that’s happened. Now that you’ve got the likes of Alibaba and Tencent – which I think are definitely comparable to the big internet names, your Facebooks, Amazons etc. of the world – with those representing 25% of the index, I think that gap should definitely close. I think you can argue that the growth prospects are at least as good as the US-listed peers for better valuations.
As I said earlier, I think China is going to become harder to ignore. The fact that we’re seeing some great companies coming through, really delivering on their strategies, it’s going to become more of a mainstream market. We have some big investors who like the fact that the trust is big and liquid, unlike a lot of the other options out there. If you put those things together, I think there’s pretty good potential for the discount to close over time and for us to bring in new investors, and as you said, more institutional money.