Concerns over the Chinese economy and the impact on company valuations have helped create a stockpickers’ market in the country, according to Dale Nicholls, manager of the Fidelity China Special Situations trust.
The five crown-rated closed-end fund was launched in 2010 under veteran investor Anthony Bolton, who had previously managed the Fidelity Special Situations trust.
Fidelity China Special Situations was launched to focus on the perceived long-term growth potential of China. However, the fund struggled initially, returning just 7.08 per cent under Bolton before he handed the reins to colleague Dale Nicholls in 2014.
Since taking over the trust from the veteran investor in 2014, Nicholls’ portfolio has returned 114.07 per cent compared with a 73.32 per cent gain for the MSCI China benchmark.
Performance of trust vs sector & benchmark since September 2014
Source: FE Analytics
Nicholls said the trust structure of the Fidelity China Special Situations was part of the attraction in taking it over, noting its flexibility and ability to gear the fund when opportunities present themselves.
However, Nicholls noted that it is a longer-term strategy and investors considering the trust should be prepared to hold it for the longer term.
Investors have been bearish on the Chinese market more recently as concerns have grown over indebtedness levels. But the outlook has changed more recently.
Debt levels have rocketed in recent years, with Chinese authorities encouraged to take greater action to support banks in the event of a financial crisis.
Nicholls said that he does not own banks or Chinese property in the fund, limiting exposure to any potential fall-out.
Recent policy announcements and other measures have done much to allay fears, however, and the economy has begun recover.
Yet the International Monetary Fund recently upgraded its Chinese economic growth forecast by 0.1 percentage points to 6.7 per cent for 2017, in line with 2016, reflecting a stronger-than-expected first quarter.
Indeed, while concerns over economy had been noted, Nicholls said the Chinese market was good for bottom-up stockpickers, noting the many drivers of change in the economy.
“Macro concerns aren’t focused on individual companies and bring down overall valuations. It’s a great place to be, you can really focus on individual stocks,” he explained. 
The planned rebalancing of the MSCI Emerging Markets index to include a greater proportion of Chinese stocks is also likely to have a positive effect on the market, said Nicholls.
He said that the move was recognition of the importance of China to global markets and addressed the gap between the size of the economy and the underrepresentation of the market in global indices.
One of the more significant changes to the trust more recently has been the increase in the portion of the portfolio he is now able to invest in unlisted companies. The trust’s board increased the limit from 5 per cent to 10 per cent at the annual general meeting in 2016.
“It’s a reflection of the opportunities that are out there: more and more companies are coming to market now,” he explained.
One example of an unlisted stock held by the manager which later listed was Chinese e-commerce giant Alibaba.
Indeed, e-commerce is one of the areas where Nicholls said the country leads its global peers, highlighting levels of innovation and ability for retailers and other service providers to bypass traditional structures.
Demand has been fuelled by growing disposable income, which in turn have driven earnings for many retailers and other service providers.
Nicholls said new online retailers have been able to grow quickly without being hindered by underperforming branch networks, while mobile payments has also taken off.
Elsewhere, the manager remains more bullish on state-owned enterprises (SOEs) than many other investors.
SOEs have been among the main culprits of the borrowing surge that China has seen in recent years, with some investors arguing that they have been mismanaged. Some of the worst-affected SOEs have been banks, which have facilitated this borrowing.
However, Nicholls said that there are some interesting opportunities in the sector, highlighting top 10 holding Shanghai International Airport. The service provider can benefit from the greater growth in passenger traffic through the airport, which has become a growing financial hub.
Other opportunities have presented themselves in the life insurance sector, where Nicholls has invested in insurers China Pacific and China Life. Life insurers are well placed to take advantage of ageing population and the need for greater retirement provision, as well as greater dependence on provision of private healthcare services.
Since the launch of the trust in 2010, the trust has returned 129.22 per cent, compared with a 74.88 per cent rise in the MSCI China, as the chart below shows.
Premium/discount over 5yrs
Source: FE Analytics
Winterflood Investment Trusts analyst Kieran Drake wrote of the fund in March that it was “certainly not for the faint-hearted”, noting the high level of gearing and single-country focus.
The trust’s share price is trading at a 12.2 per cent discount to NAV and has gearing of 24 per cent, according to data from the Association of Investment Companies.
However, Fidelity believes the discount has now stabilised, while gearing has come down as the MSCI China index has rallied in recent months.
The trust has ongoing charges of 1.2 per cent.