Fidelity China Special Situations Plc (LON:FCSS) have published final results for the year ended 31 March 2023.
Financial Highlights:
- The Board of Fidelity China Special Situations PLC recommends an annual dividend of 6.25 pence per share, an increase of 13.6% from last year.
- The first tier of the management fee will reduce from 0.90% of net assets to 0.85% of net assets from 1 July 2023.
- The net asset value (“NAV”) total return of the Company increased by +2.6% for the year ended 31 March 2023, outperforming the Benchmark Index (MSCI China Index) which returned +1.4% (in UK sterling terms).
- The ordinary share price total return was +0.3% over the reporting year.
- The Portfolio Manager continues to find opportunities fuelled by growing domestic consumption in the region.
CHAIRMAN’S STATEMENT
After more than two years of volatile returns, it was pleasing to see positive net asset value (“NAV”) and share price returns and a return to outperformance for your Company against its Benchmark Index, the MSCI China Index (in UK sterling terms). China’s economic growth rate in 2022 was just 3%, the lowest in decades, but the economy and stock market are now on a recovery path following the removal of the zero-COVID policy.
In the reporting year to 31 March 2023, NAV per share total return of your Company was 2.6% outperforming the Benchmark Index which returned 1.4%. The share price total return was 0.3%. The discount of the share price to the NAV widened to 9.7% at the end of the year compared to 7.5% last year. While we expect the Company to generate its returns primarily from capital, corporate earnings growth in China and the maturing of business models has meant healthy growth in dividends. Our own dividend – which has grown every year since inception – makes an important contribution to shareholder returns and this year grows by 13.6% from 5.50 pence to 6.25 pence.
As our Portfolio Manager, Dale Nicholls, points out in his report, investor pessimism towards China reached a peak in the early part of the second half of our financial year. Encouragingly, the rebound in sentiment since then is borne out by the six-months to 31 March 2023 total return performance figures, with the NAV and share price rising by 12.1% and 11.2% respectively, compared with a return of 7.3% on the Benchmark Index.
While the mood of investors in Chinese equities has swung between extreme bearishness and euphoria over the past year, the current backdrop reflects a more measured outlook. The Board continues to believe that a direct exposure to China – the world’s second-largest economy – is an important constituent of a diversified portfolio. Although economic growth was lacklustre in 2022, the International Monetary Fund expects China’s GDP to advance by 5.3% in 2023, ahead of the 3.9% average for emerging markets and developing economies and well in excess of the 1.3% forecast for advanced economies.
China is at a different point in the economic cycle to the rest of the world; rising interest rates and inflation in the West have meant very constraining central bank policies aimed at slowing economies down, whereas the opposite is the case in China. Inflation is not and has not been a problem and the authorities are taking a more stimulative approach to boost growth. This is being done at a measured pace to reduce unemployment, particularly amongst the young, but at a level which doesn’t fan speculation in the property sector which remains an issue.
Your portfolio has limited exposure to property as Dale prefers to access the housing theme through areas such as home décor and appliances. Consumer spending, which is expected to be the primary engine of growth for the Chinese economy, is an important driver of stock selection, with the consumer discretionary sector containing many of the attractively valued, fast-growing stocks that he favours. Having a large research team on the ground in China is fundamental to seeking out the best opportunities, particularly among medium and smaller-sized companies, where the relatively higher growth potential has yet to be reflected in share prices, and investor awareness is low.
As a closed-ended fund and without the liquidity concerns that would hamper an open-ended fund, the Company is able to invest up to 15% of its Net Assets plus Borrowings in unquoted companies (those not listed on a stock exchange). This allows the Manager to take advantage of the faster growth trajectory of earlier stage companies before they potentially become listed on the public markets. Other than the unlisted shares in Xiaoju Kuaizhi (Didi Chuxing) converting to listed American Depositary Shares, there have been no new unlisted additions or changes to the unlisted companies held in the portfolio in the reporting year. However, the unlisted percentage increased from 13.2% of Net Assets plus Borrowings on 31 March 2022 to 13.6% on 31 March 2023 given changes in the valuations of these companies and changes to the size of the rest of the portfolio. If the Company were to reach the 15% limit in unquoted companies, it does not preclude us from further investment in existing holdings if fresh capital was required by them.
Our unquoted investments are assessed regularly by Fidelity’s dedicated Fair Value Committee (“FVC”), with advice from Kroll, a third-party valuation specialist, as well as from the Fidelity analysts, who look after these companies. An additional resource has been added in the past year in the form of oversight by a newly recruited Chinese unlisted investment specialist. The Board receives regular updates from the FVC, with Alastair Bruce, the Audit and Risk Committee Chairman, also providing expertise in the area, having for many years been involved professionally in private equity investing.
The Board is mindful of the risks of investing in a single emerging market, however large and diverse it may be, and monitors both current risks and our perception of emerging risks. The key risks are set out below. We believe, however, that those risks are outweighed by the opportunities offered by investing in China in general, and in particular in Fidelity China Special Situations. Dale’s focus on consumption and the domestic economy mitigates much of the geopolitical risk which has been heightened in the period under review. We share Dale’s confidence that with the Chinese economy now having fully reopened after the restrictions imposed by the government’s zero-COVID policy, the opportunities for a continued rebound in consumer spending are significant.
ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) INVESTMENT AND CLIMATE CHANGE
ESG factors remain central to the work of both the Board and the Portfolio Manager. Chinese businesses are under increasing pressure to ensure that their activities are environmentally sustainable and demonstrate social responsibility and good corporate governance. Although there is progress in the form of commitments and initiatives across a wide range of areas, much more needs to be done. Fidelity has a sustainable investing approach, which includes engagement and voting principles and its proprietary forward-looking ESG ratings. This ratings system leverages Fidelity’s internal research and interactions with investee companies, where analysts quantify the direction of change of a company’s ESG performance (positive, neutral or negative trajectory) and rate the companies using a scale of A to E. The Board pays close attention to the ratings of underlying portfolio companies and challenges the Portfolio Manager and his team on any stocks with lower ratings. The ratings of the companies within the portfolio are well ahead of the broader market and continue to improve.
The evaluation of ESG factors is a core part of our Portfolio Manager’s investment process and he continues to see progress regarding the level of engagement with and transparency of Chinese companies. Sustainability factors are key topics of conversation with companies and many management teams are looking at ways to generate a more sustainable outcome for their businesses. Although China continues to lag most other major markets in this area, we are encouraged by the rates of improvement the Manager is seeing. China’s regulators are engaging with companies to improve the disclosure of ESG metrics to better align themselves with the required standards. Not only is this a good outcome globally, but we also believe that progress on better ESG practices could be a key driver of performance for the portfolio over the longer-term. Further details of the Manager’s ESG practices are in the Annual Report.
GEARING
We continue to believe that the judicious use of gearing (another benefit of the investment trust structure) can be accretive to long-term capital and income returns, although being more than 100% invested does also mean that the NAV and share price may be more volatile and can accentuate losses in a falling market. Net gearing at the year-end was 21.1%, largely unchanged from a year earlier when it was at 23.5%. The Company recently renewed its loan facility for a period of one year at a fixed interest annual rate of 6.335%. The Board would prefer to have a diversified source of finance in the future, as well as CFDs, and depending on terms hopes to be able to put in place longer-term borrowing when this facility ends.
DIVIDEND
Although the Company’s investment objective is to achieve long-term capital growth, it has paid an increasing dividend each year since its inception, growing from 0.25 pence per share in 2011 to 5.50 pence per share in 2022, which is a compound annualised growth rate of 32.8%.
As indicated earlier, the Board is pleased to recommend once again an increased final dividend of 6.25 pence per share for the year ended 31 March 2023 for approval by shareholders at the Annual General Meeting (“AGM”) to be held on 20 July 2023. This represents an increase of 13.6% over the 5.50 pence paid in respect of the prior year and cements your Company’s status as one of the Association of Investment Companies’ Next Generation of Dividend Heroes. The dividend will be payable on 27 July 2023 to shareholders on the register on 16 June 2023 (ex-dividend date 15 June 2023).
The revenue per share earned by the Company during the year was 7.05 pence, which is an increase of 9.8% over the 6.42 pence earned in the prior year, and this fully covers the recommended dividend.
DISCOUNT MANAGEMENT
The Board believes that investors are best served when the share price trades close to its NAV per share. However, we recognise that the share price is affected by the interaction of supply and demand in the market based on investor sentiment towards China, as well as the performance of the Company’s portfolio. A discount control mechanism is in place whereby we seek to maintain the Company’s discount in single digits in normal market conditions. Historically, shares bought back were held in Treasury and could be issued at a later date should the share price move to a premium to NAV per share. As the number of shares held in Treasury equated to 15% of the issued share capital by 11 May 2023, shares bought since then have been cancelled. There is an annual 14.99% cap in place that limits the Company’s ability to repurchase its own shares in the market.
The Company’s discount widened from 7.5% at the start of the reporting year to 9.7% on 31st March. To combat slightly tricky and volatile market conditions during the year, the Board authorised the repurchase of 25,631,781 shares into Treasury at a cost of £57,249,000, representing 4.5% of the issued share capital of the Company. These share repurchases have benefited remaining shareholders as the NAV per share has been increased by purchasing shares at a discount. Since the year end and as at the date of this report, the Company has repurchased a further 2,900,696 shares into Treasury and 2,238,726 shares for cancellation. The graph below shows the movement of the Company’s discount during the year.
FCSS – Discount to NAV
At the forthcoming AGM, the Board is seeking to renew the annual authority to repurchase up to 14.99% of the Company’s shares, to be either cancelled or held in Treasury, as it has done each year previously.
ONGOING CHARGE
The Ongoing Charge (the costs of running the Company) for the year was 0.98% (2022: 0.94%). The variable element of the management fee (due to outperformance of the Benchmark Index) was a charge of 0.20% (2022: 0.20%). Therefore, the Ongoing Charge, including this variable element, for the year was 1.18% (2022: 1.14%).
The largest element of those running costs of the Company is the management fee paid to Fidelity.
MANAGEMENT FEE
The Board has agreed a revised fee with the Manager, FIL Investment Services (UK) Limited, with effect from 1 July 2023. The revised fee will be 0.85% (reduced from 0.90%) on the first £1.5 billion of net assets. It will remain at 0.70% on net assets over £1.5 billion. The variable element of the fee of +/-0.20% remains unchanged.
CHANGE OF BROKER
Following a review of broker services provided to the Company, we changed our corporate broker in March this year from Peel Hunt to Jefferies International, who now acts as sole corporate broker and financial adviser to the Company.
BOARD OF DIRECTORS
This is my first annual report as Chairman, having taken over from Nicholas Bull at the conclusion of the last AGM. Nicholas had served on the Board since Fidelity China Special Situations PLC was launched in April 2010, and as Chairman since 2016, and we thank him for his wonderful stewardship of the Company.
Given my new position, Alastair Bruce, who joined the Board in July 2021, has taken on my former role as Chairman of the Audit and Risk Committee.
We have welcomed three new non-executive Directors in the past 12 months. Georgina Field, whose appointment was announced in the last annual report, and who joined the Board on 1 July 2022, is an investment marketing specialist and founder and CEO of White Marble Consulting. She was subsequently elected by shareholders at the AGM on 20 July 2022.
We were sad to say goodbye to Linda Yueh who resigned and stepped down from the Board on 31 December 2022 in order to concentrate on a new role as a non-executive director of Standard Chartered plc. Linda’s role as Senior Independent Director is now undertaken by Vanessa Donegan. We are very pleased to have added not one but two China experts to the Board as non-executive Directors in recent months. Edward Tse, a pioneer of management consulting in China, was appointed to the Board on 24 November 2022. As well as acting as a consultant to hundreds of companies on all critical aspects of business in China, he has also advised Chinese government organisations on strategy, state-owned enterprise reform and Chinese companies going overseas, as well as advising the World Bank and the Asian Development Bank.
Gordon Orr, who moved to mainland China from the UK in the early 1990s, founded McKinsey’s management consulting practice in the country, and led McKinsey in China and subsequently Asia until 2015. Gordon was appointed to the Board on 1 January 2023. He currently serves on the boards of Hong Kong-listed companies Lenovo, Meituan and Swire Pacific, and is the Vice Chairman of the China Britain Business Council.
We are pleased that your Company’s Board includes a real diversity and balance of relevant skills and experience, covering China itself, accountancy, investment management, including private equity and private equity valuations, and marketing expertise. Owing to the changes in its composition during the year, the Board no longer meets the target of 40% of FTSE 350 board members to be women as set by the FTSE Women Leaders Review. Our Board composition currently has a 33% women representation, however, it should be noted that from 1 July to 31 December 2022 the Board exceeded the 40% target. In the period from 24 July 2019 to 31 December 2022, at least 40% of the Board consisted of women. As all the current Directors have served for less than five years, the Board wishes to take due care in making the next appointment in order to meet the 40% target and to space out succession planning. The present plan is to recruit a female director before the AGM next year.
In accordance with the UK Corporate Governance Code for Directors of FTSE 350 companies, all Directors are subject to annual re-election at the AGM on 20 July 2023. I, together with Alastair, Vanessa and Georgina will stand for re-election and both Edward and Gordon, being newly appointed, will stand for election at the AGM. The Directors’ biographies can be found in the Annual Report, and, between them, they have a wide range of appropriate skills and experience to form a balanced Board to support and oversee the Company in the best interests of shareholders.
ANNUAL GENERAL MEETING
The Company’s AGM is at 11.00 am on Thursday, 20 July 2023, and the Board and I hope to see as many of you as possible on the day. Details of the AGM are below.
OUTLOOK
After a year in which China’s economic growth was hampered by lockdown restrictions, the current picture looks much brighter. GDP growth is forecast to come back in line with longer-term trends at above 5% in 2023, and the authorities are willing to stimulate where needed to ensure sustainable growth is in line with the government’s Common Prosperity agenda. ESG standards continue to improve, and as Western governments experiment with increasingly protectionist policies and try to tame inflation, opportunities increase for China to move up the value chain in manufacturing and services.
Against this improving backdrop, valuations in the stock market, and in particular those of small and mid-cap companies in China, remain relatively modest, with arguably the best opportunities to be found among the less well-known companies that may be overlooked by funds that lack a solid on-the-ground research presence. Added to this, Dale’s flexible approach to portfolio management allows your Company to adapt to changing conditions, helping to ensure a profitable future.
While the Chinese stockmarkets are always likely to be volatile, we are encouraged that all the building blocks remain in place for continued healthy returns. There will be slips along the way and we remain mindful of geopolitical issues such as the relationship with the US and the status of Taiwan, however structural trends such as the growing middle class and on-going innovation support our positive medium to long-term view.
All the Directors on your Board, other than newly appointed Edward and Gordon, are also shareholders in the Company, and we remain committed to its future success.
Meanwhile, we hope to see you, in person or virtually, at our Annual General Meeting on 20 July 2023, details of which are below.
MIKE BALFOUR
Chairman
7 June 2023
PORTFOLIO MANAGER’S REVIEW
QUESTION
It has been an extraordinary period for investors over the past year, both in China and globally. What are the main factors that shareholders should understand?
ANSWER
Not too long ago, in fact after the 20th National Congress of the Chinese Communist Party in October 2022, sentiment towards Chinese equities was probably the lowest I have witnessed since I started managing Chinese and broader Asian equities. This bearishness was further fuelled by weakening macro data and off the back of the country’s zero-COVID policy.
Then just before the end of 2022, there was an unexpected pivot towards the country’s reopening and the end of China’s zero-COVID policy. This caused a sudden shift in investor sentiment, as the market started pricing in the benefits of reopening. The National People’s Congress at the end of March 2023 clarified the government’s focus on quality growth, primarily underpinned by growth in domestic demand. As I write this year’s annual review, questions are once again being raised about China’s economic recovery, which is likely the main factor behind recent market weakness. While growth rates on the whole have clearly tempered in the second quarter, the government’s GDP target of 5% for the year looks achievable. This will make China one of the few large economies that will see accelerating economic growth in 2023. Corporate earnings should follow suit and see accelerating growth, which again compares favourably to other markets. In terms of corporates, messages are mixed, but we are seeing clearer trends and distinctions between winners and losers, with the stronger players confirming that operations are returning to normal and are painting an optimistic picture of recovery. Valuations as a whole remain towards the lower end of historical levels, and remain attractive versus global peers, despite what is mostly a stronger growth outlook.
Consumption will most likely be the prime driver of the recovery, supported by strong household balance sheets with deposit levels increasing significantly over COVID. Property still remains a significant component of these balance sheets. On the back of ongoing loosening measures, we are seeing increasing signs of the residential property market bottoming in terms of both volumes and pricing. This all bodes well for spending to continue to recover, similar to the post COVID recoveries we have seen in other economies.
Geopolitics is another factor that continues to dominate headlines and can cause turmoil in markets at times. As I have said before I believe that strategic competition and related tensions between China and the US will be with us for decades and investors should expect this. It is important to remember that these two economies are heavily intertwined and this is recognised by the respective governments. The key thing we need to evaluate as investors is how policies have the potential to impact the fundamentals of individual companies. In the past year, we have seen the US government further restrict sales of leading-edge semiconductors and related equipment to China. I believe there is potential for such restrictions to tighten further – these are the type of risks that we build into our analysis. For most companies, such risks are not a factor. Consequently, the team and I continue to find many attractive opportunities across the market.
QUESTION
How has the Company performed in the year under review, and how have things changed since China’s zero-COVID policy was removed?
ANSWER
The Company’s NAV delivered a total return of 2.6% for the financial year ended 31 March 2023, outperforming the MSCI China Index (the Benchmark Index) which returned 1.4%. Robust stock picking in the Chinese consumption space (both discretionary and staples) and in materials contributed positively to performance. An overweight allocation in industrials also added value. In contrast, selected names in financials and communication services weighed on returns, as did an overweight exposure to the information technology (“IT”) sector.
As discussed above, the biggest change post-COVID is the outlook for the consumer. While the recovery is bumpy and varies somewhat by sector, the path to recovery is clearly there. Having said this, the obvious beneficiaries of reopening – particularly travel and certain consumer stocks – saw a significant upswing as the zero-COVID policy was lifted. However, this has made the investment case less compelling for some companies and overall I have reduced exposure to such names.
Clearly the resumption of normal business operations and supply chains is another important change. As a result, we will be looking for signs of recovering business confidence and related indications of a pick-up in capex. Recent credit growth data is encouraging. As the recovery broadens, I would expect companies in other sectors such as industrials and financials to benefit. At the same time, one needs to be wary of global trends – many other economies may slow significantly, which can impede a return in investor confidence and sentiment.
QUESTION
Which stocks have performed well during the period and why?
ANSWER
Macroeconomically, sensitive names in the consumer discretionary space have fared well as faster than expected reopening led to an accelerated consumption recovery in China. Among the top contributors in the portfolio were positions in branded variety retailer MINISO Group Holding and home appliances manufacturer Hisense Home Appliances Group. MINISO’s recent results were better than expected, demonstrating good execution in brand and product upgrades, overseas expansion and solid efficiency gains. Hisense’s profit recovery remains well on track, led by robust overseas growth and solid ongoing profitability from its joint venture with Hitachi. In addition, retail jewellery player Luk Fook Holdings International has enjoyed a rerating in the market, driven by pent-up post-pandemic demand and market share gains as a result of channel expansion. Also, within the consumer discretionary sector, a short position in an auto manufacturer, known for their design in electric vehicles (EVs), added to performance as the stock declined owing to concerns of consumers favouring other brands. The risk of lower market share was a key aspect of our investment thesis for shorting the stock.
A holding outside the consumer sector that also proved rewarding was the position in COSCO Shipping Energy Transportation (“CSET”), the largest global oil tanker operator. CSET benefited from tailwinds associated with a recovery in oil demand as air and road traffic regained momentum.
Conversely, the lack of exposure to Chinese online retailer PDD Holdings and an underweight stance in internet and gaming giant Tencent Holdings held back relative returns. Tencent’s share price was further boosted as it received new game licenses from the Chinese regulator at the start of this year. This type of news, such as the issuance of new gaming licenses, has been another signal that regulatory pressures on the internet sector have eased.
Within financials, shares of credit facilitator Lufax Holding declined, triggered by concerns over fintech regulation, deteriorating asset quality and heightened risks about a de-listing of its American Depositary Receipts (ADRs) shares. Nonetheless, we feel Lufax remains substantially undervalued and provides upside potential given its leading position in small and medium-sized enterprises’ (SMEs) online lending. Further, it is likely we will see an easing of regulatory headwinds, albeit they will not completely disappear. Challenging market conditions and weak sentiment in 2022 also negatively weighed on the performance of third-party wealth management company Noah Holdings. Despite these challenges, Noah’s assets under management remain resilient. It continues to grow its client base, positioning itself for robust growth. Its strength is underpinned by structural tailwinds from growth in the wealth management sector in China amid rising household assets and its shift into alternative capital market products.
Within the IT sector, a position in Chinese data-centre operator VNET Group detracted from returns amid some corporate governance concerns – notably, privatisation offers and then the forced selling of the founder’s pledged shares by a large shareholder. The company remains undervalued from a fundamental perspective and its core business remains resilient as evidenced by its recent huge order win from a new, sizable and well-regarded client. Finally, it is worth highlighting that the holding in AI (artificial intelligence) software maker SenseTime weighed on performance owing to issues over a higher loss ratio and a lack of standardisation in scaling up the business. We closed out our position in the company in the third quarter.
QUESTION
What is your approach to gearing, and what impact has it had on returns during the year and over the longer-term?
ANSWER
The Company has the ability to gear (borrow in order to invest) with the view that in the long-term, the judicious use of borrowing can enhance capital returns for shareholders. Given the weak market sentiment and broad-based corrections experienced after the Congress meeting last October, many stocks with lower regulatory risk were sold-off indiscriminately, and this presented interesting opportunities to use gearing in order to add to some long positions.
As at 31 March 2023, the Company’s Net Gearing, which nets off short positions and hedges was 21.1%. For the year as a whole, gearing slightly detracted from returns (gearing impact of -1.5%). However, in the long-term the effect of gearing has been positive, adding a cumulative 12% to total returns over my tenure as Portfolio Manager.
Over the past few years, the portfolio’s net market exposure bias has been predominantly long, fluctuating between 110-120%. I dynamically manage gearing based on opportunities I see in the market – generally gearing moves up when valuations are lower and vice versa.
QUESTION
What areas of the economy are you particularly looking at? Are there any sectors that you are specifically interested in?
ANSWER
Further development of the capital markets, which could become an asset allocation choice for domestic households given that property is no longer viable for ‘investment purposes’, could give rise to some interesting opportunities in the financial services sector. For example, brokers are benefiting from increased trading and the opening of new accounts. Noah Holdings is also benefiting from decent structural tailwinds seen from the growing wealth management/asset management industry, which as previously highlighted, should see the shift in growth from household assets into alternative and capital market products. While there is large potential for increased market share gains for Noah, especially in the area of high-net-worth assets, we are cognisant of intensifying competition.
Within the property sector, the Company remains underexposed to developers due to the avoidance of private developers. However, a position is maintained in state-backed China Overseas Land and Investment (“COLI”). Given continued expectations of consolidation within the segment, COLI stands to gain market share. We have strong conviction in:
· COLI’s high quality land bank (it has the highest proportion of land bank in ‘Tier 1 and Tier 2’ cities versus other national developers) – an important point, as it benefits from ongoing urbanisation;
· Its product quality, which is well-known and well-recognised by homebuyers;
· It has maintained solid profitability due to discipline and pricing; and
· Its land acquisition kept pace during 2022, which should ensure sufficient new sellable resources as demand continues to recover.
Urbanisation continues to support rising consumer purchasing power. Throughout my tenure as the Company’s Portfolio Manager, I have been focused on the rise of the Chinese consumer, and that remains the case, with approximately 43% of the portfolio invested in consumer stocks at the year end, mainly in stocks within the consumer discretionary sector.
JNBY Design is a leading player in the designer fashion apparel industry. Its differentiated ‘fashion forward’ product offerings are backed by a strong and stable local design team. Valuation-wise, JNBY is trading on a price/earnings (P/E) multiple below 10 times, which is very attractive for a company with a solid growth profile and track record. It also leverages its strong cash flows to pay a healthy dividend. Encouragingly, within the consumer discretionary sector, China’s jewellery market is expected to see attractive growth, owing to higher per capital disposable income growth. We expect the company Lao Feng Xiang to gain market share and be a long-term winner in the country’s jewellery sector, which is around RMB800 billion and growing at a compound annual rate of between 7 and 8%. Similar to JNBY, the company has strong brand equity and maintains a group of powerful and loyal distributors. Further, with continued industry growth, it is in a position to accelerate the pace of new and expanded stores. We are also pleased that from a governance perspective, Lao Feng Xiang’s management team has been improving its management incentive plans.
We are continuing to witness a rapid pace of innovation in China. This, combined with the ‘domestic substitution’ trend and ongoing consolidation across a range of industries, has underpinned our significant weighting in industrials. The core thesis around industry consolidation remains very much in place – i.e. industries such as building materials are very fragmented relative to more developed markets but are expected to consolidate, seeing the bigger and better players taking further market share. Although some of our paint companies have lagged given ongoing property concerns, we maintain a high level of conviction in the future upside potential as their fundamentals normalise – notably they should benefit from an increase in infrastructure investment (albeit these projects are expected to be very targeted compared to the spending we saw back in 2008).
QUESTION
What are the major domestic developments that investors should be aware of?
ANSWER
In terms of external perception, there was a world of difference in the reactions to the October 2022 Congress versus the National People’s Congress in March 2023. However, in reality they were both on the same page in terms of the government’s direction and emphasis on various policies; of note, innovation, consumption and the quality versus the quantity of economic growth (a GDP target of 5% was announced for the year).
The overhaul of Alibaba Group Holding – China’s second-largest listed company – is a major event. Designed to drive greater autonomy and agility for each of its businesses, it has also forced the market to consider the value of each business. This includes the financial business Ant – the potential float of this business should be taken positively by markets as a sign of progress beyond the peak of regulatory tightening.
Also, within the internet space, ByteDance (an unlisted holding) made headline news overseas after its TikTok app was banned on government-owned devices in the US, UK and EU. Fortunately, its domestic video-sharing app, Douyin, has seen more attractive growth. The Chinese market accounts for 82% of ByteDance’s $70 billion total revenues, and domestic revenue growth remains strong year-on-year amid a tepid economic environment overseas. Focusing again on its overseas operations, in order to address concerns over unauthorised access to US user data, ByteDance has launched Project Texas, a comprehensive system to protect data privacy. This, in turn, could result in a lower probability of a complete ban. Even under the worst-case scenario of a full ban, it would likely take a considerable amount of time and negotiation before anything was enacted. Given all this, we continue to be supportive holders of ByteDance.
QUESTION
Environmental, social and governance (“ESG”) themes are very topical among investors. How do you approach ESG, and can you outline specific examples where engagement has resulted in good outcomes for stakeholders?
ANSWER
All Fidelity managed funds have had ESG considerations embedded in their investment process for a number of years. Our research analysts consider ESG as part of their fundamental stock assessments, using Fidelity’s proprietary Sustainability Rating and Climate Rating frameworks. As well as this research, we are active owners of our holdings and engage with companies on a regular basis where we feel ESG practices could be improved.
During the period under review, we engaged with optics manufacturer Sunny Optical on the subject of board diversity. Fidelity International (“Fidelity”) became a member of the 30% Club HK Chapter in 2022, and in September the Group sent letters to 26 companies with all-male boards to encourage greater gender diversity. Sunny Optical was one of them.
This engagement is part of a 30% Club initiative that Fidelity is involved with along with other investors. The company was responsive and shared that a new female director will be joining the board in 2023. While this still falls short of FIL’s standard, it means that Sunny Optical will have its first female director, and also that the level of board independence will rise significantly.
As well as gender, broader labour management for contract workers was also mentioned. The company has been outsourcing frontline manufacturing worker positions since 2018, and the recent controversy over Foxconn’s use of agency workers on less favourable terms than permanent staff has brought this topic into the spotlight.
We also had an in-depth engagement with Tuhu Car (an automotive services company, which is yet to list) in order to better understand its ESG performance and provide advice. The company confirmed it was the first time it had engaged extensively with investors on ESG. As a private company, Tuhu Car does not publish an annual ESG report. However, we have put together an ESG profile for the company based on our engagement, which showed that the company’s direct environmental impact is limited to the energy consumption and carbon emission associated with its warehouses and logistic fleets. While Tuhu Car is still at a very early stage of measuring and managing its direct environmental footprint as well as that of its franchisees, we expect these disclosures to improve as the company becomes more mature, and particularly once it has listed.
Our engagement with state-backed logistics company Sinotrans centred around its capital allocation. Regulators have called on State-Owned Enterprises (SOEs) to improve the efficiency of their capital allocation and we are optimistic that Sinotrans’s efforts in this area could help drive a re-rating of the company. We first sent a letter to the company on the subject, and then discussed the suggestion in a face-to-face meeting. In the past few months, we have continued to supply the company with peer analysis and case studies for their internal assessment on the matter. Given our suggestion that the company should increase its cash payout, we were pleased to see it achieved a 45.2% full-year cash payout ratio (dividend plus buyback) for its 2022 financial year. We believe this should serve as a good starting point for further capital allocation discussions with Sinotrans and we will continue to engage with the company on this subject.
QUESTION
How has the portfolio’s exposure to unlisted companies changed during the year under review?
ANSWER
There has been no change in the number or names of unlisted companies held in the portfolio in the year other than the unlisted shares in Xiaoju Kuaizhi (Didi Chuxing) being converted to listed American Depositary Shares (ADS). The percentage of the portfolio in unlisted companies has moved around due to changes in the value of the individual holdings as well as the value of the overall portfolio. The process of valuing the Company’s unlisted investments is set out in the Annual Report and as example of its oversight, the Manager’s Fair Value Committee has revalued ByteDance three times since October. As at the end of March 2023, the Company had nine unlisted investments valued at £192,878,000 being 13.6% of its total Net Assets plus Borrowings (2022: ten unlisted investments valued at £194,650,000 being 13.2% of Net Assets plus Borrowings). Of the nine companies held during the year, three rose in value, five fell in value and one was unchanged. The largest contributor to performance was Pony.ai, with the biggest detractor being DJI International.
QUESTION
Investment performance in the year under review has been volatile. What lessons have you learnt over the period and what are your expectations for the coming months?
ANSWER
This has been a period that reminds me of just how much sentiment can swing in the Chinese market, and how short-term focused it can be. Policy clearly remains a key focus for the market, but the market often gets overly focused on short-term moves while losing perspective of longer-term goals and historical cyclicality. We now see policy returning to a greater focus on growth – this should not be a surprise. The lesson that is reinforced is the importance of staying calm and focusing on risk/ reward. While we added to positions that were under pressure and capitalised on our capacity to increase overall gearing, we could, arguably, have been more aggressive when some were labelling China as “uninvestable”.
Furthermore, the past year has once again underlined how important it is for us to have people on the ground in China; even when overseas market participants were most bearish, we were still finding investment opportunities and were able to capitalise on the input from our locally-based analysts to make decisions on companies based on fundamentals.
Chinese onshore equities (i.e., A shares) have one of the lowest correlations – of any major market – with the US S&P 500 Index and, consequently, can be viewed as a good diversifier in a global portfolio. Economically, China is at a different point in the policy and economic cycle compared to most developed countries currently. In fact, we would argue that it is possibly one cycle ahead of other economies. In its April 2023 World Economic Outlook (“WEO”), the International Monetary Fund has forecast China’s GDP growth to be 5.3% in 2023 and 4.5% in 2024, both unchanged from the January WEO update, but with the 2023 figure showing a 0.8 percentage point improvement on the last full WEO in October 2022. Some analysts expect the 2023 forecast to be even higher given the strength of the domestic economic data. Household finances are very healthy; the savings rate is 35% and has been in the 30s for many years, compared with around 9% in the UK. Consumption growth hinges on both the ability and the willingness to spend; the ability to spend is clearly there given there is effectively no household debt, but the willingness to spend is dependent upon improved sentiment, and we are now witnessing that too.
I continue to have a confidence in both the Chinese market and the underlying companies we are invested in. As such, I maintain a personal holding of 113,036 shares in the Company.
DALE NICHOLLS
Portfolio Manager
7 June 2023
