Fidelity China Special Situations lags strong recovery

While the year began negatively, fortunes for the Chinese equity market improved following a significant uplift in sentiment at the end of 2024. This tailwind led Fidelity China Special Ord (LSE:FCSS) to return 31.5% in net asset value (NAV) terms and 35.8% in share price total return terms. Those returns, however, lagged the benchmark return of 37.5% for the MSCI China index (in UK sterling terms).

Domestically focused small/mid-cap stocks contributed most to performance in addition to holdings across financials and innovative companies linked to artificial intelligence (AI) and electric vehicles (EV) themes.

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Reasons for underperformance versus the index included not holding EV producers, BYD Co Ltd Class H (SEHK:1211) and Xiaomi Corp Class B (SEHK:1810), which fund manager Dale Nicholls avoids due to high valuations and immense competition.

The numbers in detail (for financial year to 31 March 2025)

Net Asset Value (NAV) Return: +31.5%
Share Price Total Return: +35.8%
Benchmark Return (MSCI China): +37.5%
Premium/Discount: -7.3% (vs -10.2% at prior year end)
Full-Year Dividend (proposed): 9p (vs 6.4p in prior year)
Gearing: 20.8% (vs 20.9% at prior year end)

Outlook

The looming trade war emanating from the US warrants caution and threatens Chinese GDP growth and corporate earnings, although notably the country is significantly less reliant on US trade than in years prior.

Nicholls and the chair highlight reasons for an improved outlook towards China, including a renewed willingness from the government to support private enterprise, as well as more targeted economic stimulus in the year with scope remaining for further monetary and fiscal support, particularly by way of response to the effects of tariffs.

Discount

The trust’s discount shifted from low double digits at the end of last year into single digits – the board’s target range. Throughout the year the board undertook material buybacks of shares to rectify a double-digit discount, as well as the share rating being helped by a sentiment shift towards Chinese equities at the end of 2024.  

Portfolio

Chinese equities at around 12.2x forward earnings remain at low valuations relative to the US, and FCSS’ portfolio stands at 10.9x. The bias in favour of mid- and small-cap companies remains for FCSS, with over 55% of the portfolio invested in companies under $5 billion (£3.7 billion), versus circa 8% for the benchmark index.

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The trust has c.10% invested in unlisted assets, the largest of which is ByteDance (owner of TikTok), which saw an upwards valuation revision in the year.

From a sector perspective, FCSS has a long-held overweight towards consumer sectors, forming over 40% of the portfolio, with the bulk held within consumer discretionary, and also biases in favour of industrials, where Nicholls finds opportunities across supply chains.

An example of this within the EV value chain is Hesai Group ADR (NASDAQ:HSAI),  a supplier of automotive LiDAR (Light Detection and Ranging) technology, and Precision Tsugami (China) Corp Ltd (SEHK:1651), a producer of lathe machinery.

Dividend

FCSS has proposed a full-year dividend of 8 pence, along with a special dividend, thanks to a portfolio’s company’s (Lufax Holding Ltd (SEHK:6623)) large distribution. Given strong income production within the portfolio, revenue per share covered the distribution and (assuming approval) FCSS will have grown its dividend payments every year since inception in April 2010.

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The year marking FCSS’ 15th anniversary yielded strong absolute performance although the trust lagged its MSCI China benchmark. Given the variable management fee (which rises or falls by 0.2% in relation to NAV performance), this was reflected in a lower yearly ongoing charge of 0.89%.

This performance follows three years of either negative or meagre returns for the trust and for its benchmark as the Chinese market underperformed global indices.

Despite the year’s relative underperformance for FCSS, pleasingly since inception in 2010 the trust has delivered an impressive 7.7% annualised return, outperforming its benchmark index by over 3%. Throughout the now 11 years of Dale Nicholls’ tenure as manager, the yearly return of near 10% on average represents annualised outperformance of close to 4%.

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In the year, the trust benefited from a sharp reappraisal of the outlook for Chinese equities, buoyed both by more business-friendly signals and stimulus from government, as well as the reveal of the DeepSeek AI model that drew reinvigorated interest in Chinese tech-related businesses.

Given FCSS’ focus on valuation, unsurprisingly the avoidance of certain higher multiple names (BYD, Xiaomi) detracted from relative returns.

Still, Nicholls’ use of gearing at a level of just over 20%, which he typically deploys aggressively to capitalise when valuations are weak, added to performance.

It is positive also to see progress within the unlisted portion of FCSS’ portfolio, albeit with returns lagging those of public markets. The private allocation is a differentiator, and another IPO in the period shows there is appetite for exits into public markets, despite a mixed reception to driverless tech firm Pony AI Inc ADR (NASDAQ:PONY)'s IPO.

ByteDance (owner of TikTok) delivered good financial results (despite uncertainty re its US business) and Nicholls continued to fund this top position. This holding has yielded great returns as the fair value of the position now is close to three times FCSS’ book cost, while other unlisted positions, such as smart-city tech provider Venturous Holdings, and drone maker, DJI International, also saw their valuations upgraded.  

A broader positive trend for shareholders is improving Chinese corporate governance. The benefits were tangible during the period, reflected in increased dividend payouts from portfolio companies, including a notable exceptional dividend from Lufax, contributing to a 76% increase in revenue per share for FCSS. Even with the proposed 1 pence special dividend to shareholders, revenue per share will healthily cover the dividend distribution for the year.

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This stellar equity market performance has been somewhat curtailed since the end of the period by the “Liberation Day” announcements, which brought a shadow back over the region even despite a downward trend in China-US trade over the past decade. Regardless of rollbacks and stalling in recent months, the most likely outcome is increased trade friction between the US and China than in years gone by.

In this regard, FCSS’ long-held orientation towards the domestic Chinese consumer, reflected in overweight consumer holdings as well as allocations to healthcare and certain areas of industrials, may provide some shelter from the trade fallout in the long run.  

China is and will continue to be a volatile market. The yet to-be-determined outcome of US-China trade negotiation may only increase volatility in the near-term, while the domestic property market troubles and weaker consumption rate are yet to recover.

Nonetheless, the structural drivers of domestic growth for the country and innovation that rivals the US makes for compelling long-term investment opportunities. FCSS offers a well-managed but suitably adventurous manner to invest in the country and the track record of the strategy and manager are testament to FCSS’ ability to outperform in the long term.

The trust forms part of interactive investor’s Super 60 list of ideas as an adventurous option.