10-year track record offers comfort for out-of-form investment trust

It’s been a tricky time to be invested in China, which is why it’s no surprise to see that Fidelity China Special Situations (LSE:FCSS) was heavily in the red in both share price and net asset value (NAV) terms in its latest financial year (to 31 March 2024).

However, FCSS held up better than the MSCI China index, which helps to further improve fund manager Dale Nicholls’ outperformance. Over the 10 years to March 2024, FCSS has returned an annualised 8.5% for investors, over twice that of the benchmark index.

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While it is too early to call, there are signs of optimism for this out-of-form region (explained in the ii View section).  

The numbers in detail (for financial year to 31 March 2024)

Price Return: -16.4%
Net Asset Value Return: -16.3%
Index Return: -18.8%
Discount: -10.2% (vs -9.7% prior year)
Dividend: 6.4p (vs 6.25p prior year)
Gearing: 20.8% (vs 21.3% prior year)

Performance

The investment environment in China throughout the year to March 2024 was torrid, with stress on the property sector and geopolitical tension weighing on consumer and investor sentiment.

The MSCI China index declined near 19% and in this context Fidelity China Special Situations produced some small relative outperformance, falling a lesser 16.3% and 16.4% in NAV and share price terms respectively.

This marginal outperformance is attributed to stock selection across typically overweight sectors for FCSS: consumer discretionary and industrials.

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However, in terms of negative contributors, the decision to avoid state-owned banks (China Construction, Bank of China) drove underperformance across financials. The trust’s selection in the materials sector also detracted, as did the small allocation to real estate.

Discount

Share price returns were little affected by movement in the trust’s discount, which was relatively stable. It started the year at -9.7% and ended at -10.2%. In accordance with the trust’s goal of maintaining a single-digit discount, 3.5% of share capital was bought back in the period.

Outlook

There are signs of improvement for the sluggish Chinese economy, but consumer sentiment has been poor, reflected by resistance to spend the abundance of savings built up during Covid.

While the cheapness of valuations in the market presents a strong investment opportunity, the most notable risk is that of the forthcoming US election, which could see US/China relations deteriorate.

Portfolio

While there was a higher level of turnover in the period, the trust’s profile looks largely consistent, still exhibiting a notable bias in favour of mid-cap and overweight across consumer sectors and industrials.

Changes are more notable in the unlisted portion of the portfolio, where holdings fell from nine to six positions (now 12.8% of assets) on account of three IPOs.

This gives fund manager Dale Nicholls more space under the 15% unlisted limit to finance these positions if desired, however it is noted that the compelling cheapness of public market valuations inclines the management team to keep adding to new or existing listed holdings, rather than private.

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Gearing is being utilised readily. The level of 20.8% was a detractor from performance in the period given the downward market trajectory. The trust typically increases leverage when sentiment is weak and opportunities are afforded by valuations, and therefore gearing has been maintained around this level through the past year.

Dividend

While not a focus of the portfolio, a dividend of 6.4 pence was recommended for the year, grown from 6.25p. Revenue per share fell 18%, no longer covering the distribution, but this was mostly due to the increased cost of gearing. Despite being utilised in the period, a substantial revenue reserve is maintained.

ii View

Dale Nicholls’ 10th year at the helm of FCSS was a torrid market environment to navigate. Adverse consumer sentiment in China, fuelled by the property sector’s continued decline, as well as foreign and domestic political tensions, produced another bad year for China’s markets.

Nonetheless, while the year was one of the most negative in a decade for the trust on an absolute basis, FCSS’s small relative outperformance added to Nicholls’ strong long-term track record of generating alpha.

Over the 10 years to March 2024, FCSS has returned an annualised 8.5% for investors, over twice that of the benchmark index and Nicholls has been able to outperform through periods of growth or value outperformance.

A notable event in the year was the integration of abrdn China with FCSS in March 2024, bringing the trust’s total assets to over £1.2 billion. The assets and cash have been put to work in the manager’s high-conviction ideas. Moreover, the extra scale has provided scope for a reduction in the fee from 0.7% to 0.65% as and when assets rise above £1.5 billon. This will be positive for investors if the trust continues to grow through that level.

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For most of the year, markets continued their fairly indiscriminate discounting of Chinese companies that began in 2021, and aggregate valuations hovered at depressed levels. Nicholls continued to be proactive in viewing this derating as a chance to find valuation-driven opportunities to buy or add to quality companies, while utilising the trust’s gearing facility to position for a rebound in sentiment.

FCSS is coiled to capitalise on a reversal, and we’ve seen this materialise in the short term as markets rebounded, with a positive return of 13.4% that was 4% more than the benchmark in the three months to June (most of which was post-reported period).

While it’s too early to say if the acute uplift across Chinese equities we’ve seen so far in 2024 is the start of a lasting reversal of the past two years of negativity, or something more transitory, some consumer trends (a key focus of FCSS’ positioning) have begun to show signs of recovery from a dearth of consumer sentiment.

Further, it is hard for investors to ignore early signs of improvement in the country’s production and trade data, an emerging culture of rewarding shareholders through buybacks/dividends, and the authorities’ targeted but prudent fiscal and monetary policy measures. Of course, the geopolitical outlook adds a great degree of uncertainty.

As the last year has reinforced, China is a volatile region for investors to navigate. Investors should also be aware of the heightened risk profile that FCSS levies on account of high gearing levels, discount volatility, private company exposure and allocation to smaller companies.

However, Nicholls’ own expertise and knowledge of the region, as well as the wider resource of Fidelity’s analyst team positions the trust well to benefit from China’s structural growth and the ultimate rise of the Chinese consumer.

A long-term track record under Nicholls of outperformance is testament to the trust’s capacity to generate superior returns over time through its adventurous strategy.