Is this major market turning a corner?

The second part of our Insider Interview with Fidelity Special Situations manager Dale Nicholls addresses a painful period of performance over the past five years, whether the more favourable three-year figures show a change in fortunes, and reasons for both optimism and caution. 

Other topics discussed include how robotics can be a potentially profitable area for investors, and whether regulatory crackdown risks are now in the rear-view mirror. 

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Kyle Caldwell, funds and investment education editor at interactive investor: Welcome to our latest Insider Interview. Today in the studio, I have with me Dale Nicholls, manager of Fidelity China Special Situations Ord (LSE:FCSS) investment trust. Dale, thanks for coming in today. 

Dale Nicholls, manager of the Fidelity China Special Situations investment trust: Great to be here. 

Kyle Caldwell: So Dale, if an investor bought the investment trust five years ago, they’ll be sitting on some pretty sizeable losses today. However, the three-year performance figures are much more favourable. Does this show that a corner has been turned and that there are now brighter times ahead for investors?  

Dale Nicholls: Yeah, it’s a volatile market, as you say, and there’s definitely been some derating in the market. Part of it over time is earnings. If you’re looking over the last 10 years, we haven’t seen much earnings growth. You’ve seen some earnings declines over the past three years on lower margins, a lot of it on the back of increased investment. 

The seeds are definitely there for better earnings growth going forwards. There’s a few things there. We touched on property earlier [in part one]. That’s actually been the area that’s probably seen the biggest downgrades and the biggest drag on earnings. As I mentioned [in part one], things are coming together that can make that be less of a drag going forwards. 

We’re five years into a property correction. We’ve seen 30% on average price declines. When we study property corrections globally over time that’s the average, a five-year adjustment period and 30% price declines. As I mentioned, you’ve seen the supply side adjust significantly. So, there’s good potential for that to be less of a drag.

At the same time, a lot of Chinese companies are really looking to grow offshore. These companies are hugely competitive. I still believe that many people are underestimating the competitiveness of Chinese companies on the back of scale and the investment in R&D, which has been another drag in earnings over time. 

Chinese companies are definitely gaining share globally. That overseas portion of their businesses will grow, and generally that’s higher margin. It’s a very competitive domestic market mostly for most companies. I do think that can a positive mix shift. The hope is that these really competitive areas, the domestic market as well, you’ll start to see some consolidation.

Obviously, you’ve seen the anti-involution type movement from the government. Whether you think that can be a major driver or not, I think there’s good potential for consolidation across a number of industries. So, hopefully that can improve margins over time. 

At the same time, companies are doing more in terms of capital return. Buybacks, dividends, that sort of thing. So, there’s good potential for that to be a potential re-rating driver for China as well. 

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Kyle Caldwell: How do valuations stack up today for China and the areas of the market that you invest in? 

Dale Nicholls: They’re attractive, so we’re sort of on 10x forward earnings, roughly a standard deviation off historical levels, still a significant discount to global markets, despite, as we’ve talked about, growth rates that are comparable and potentially improving. So, I do think that rerating potential is definitely there in China. 

Kyle Caldwell: Is that the biggest reason for optimism for you, where the valuations are today? 

Dale Nicholls: I think that combination of valuation, plus slowly improving fundamentals and then the potential for people to be more aware of the competitiveness of Chinese companies. 

Within that, one area of the market that can get people more excited is what’s going to happen in robotics.

There’s a very good chance for Chinese companies to lead in the robotics area. Obviously strength in the supply chain is one thing. But when we talk about humanoid robotics, there’s the AI element to it as well. As you know, you see Chinese AI models that are becoming more and more competitive and competing at the top level.

At the robotics level, there’s potential to be even more optimistic in terms of embodied AI. You’re probably going to have less of a reliance on compute, which many companies would be at a disadvantage there. It’s less of an issue. But data is going to be more of an issue as well.

In terms of building those data sets through manufacturing, obviously you’ve got that huge manufacturing base, and you’re seeing companies make significant investment in that area. The companies themselves, probably the factory is going to be the first big application for humanoid robots and big companies are already looking to get that started.

So, there’s good potential for the data sets to build quickly. As I said, it’s a potential massive new market where China has the potential to lead, so that could be a potential catalyst as well. 

Kyle Caldwell: Could you provide an example of a company that you think is ahead of other competitors in terms of robotics? 

Dale Nicholls: It’s an interesting space. There’s not that much listed now to be honest, but you’re going to see a lot of the leading companies in the robotic space come to market in the next year or two. So, if you look at a company like AgiBot in Shanghai, I think they are definitely one to watch. Unitree is one that’s known quite well as well.

As these companies come to market, we’re going to learn a lot more about them, but really, really significant potential over the mid to long term in these companies. 

Kyle Caldwell: There was a regulatory crackdown in 2020, 2021, which impacted certain educational companies and some technology companies. How does the regulatory backdrop feel now, and which parts of the portfolio are most exposed? 

Dale Nicholls: It’s mixed, to be honest. The whole common prosperity period that we went through, that was probably the biggest period of regulatory tightening that we’ve seen. Definitely, I think we’re past that.

If you follow the rhetoric out of government, there’s a lot more focus on growth. But as I said, it’s mixed. You do see some signs of crackdown in certain areas, mainly focused on areas that clearly the government’s viewing [as] potentially anti-competitive types of behaviours.

But in general, the focus is a lot more on growth. It’s worth looking back at those companies that were impacted by the previous crackdowns. If you look at New Oriental Education & Technology Group Inc ADR (NYSE:EDU) in the education space, that’s a company that’s now hitting new earnings highs. 

So, the point I’d stress is that the regulatory waves are cyclical. Clearly, given a generally weak economic backdrop, I believe the focus from a regulatory perspective is much more on driving growth. 

Kyle Caldwell: Could you talk through how often changes are made to the portfolio, and also the benefits of having a team on the ground to find new ideas? 

Dale Nicholls: In terms of driving changes in the portfolio, it really comes down to that risk/reward balance. I always want to own undervalued companies and companies I think are undervalued. So, if I think something is reaching fair value generally, I’m moving out of a name like that into something that I think is undervalued.

It’s great to have the team on the ground, we’ve got obviously what we think are strong theses on the companies that we own. Sometimes that changes. You don’t always get it right, so sometimes you may need to make those changes.

We’re always trying to allocate capital to the best ideas. So, there can be those types of shifts happening, but it depends on the movement in stocks, it’s a volatile market. You can have periods where the turnover moves up.

But, yeah, we’re very, very lucky to have the team that we have on the ground providing insights. They’re incentivised to always be finding the best ideas and getting them into the portfolio. Again, we are very lucky to have those insights from the ground. 

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Kyle Caldwell: You take advantage of the ability to gear. At the moment, gearing levels are around 22%, which is close to the maximum limit of 25%. What does that tell us? 

Dale Nicholls: It’s actually around 20%. We try to keep it within that level and that’s net gearing. We’re definitely at the upper end of that range. It has moved over time, but generally, what we find is that the gearing moves up at times when things are cheap, and potentially sentiment is bad. That’s the time when we look to capitalise on the opportunities. And that really does reflect the underlying opportunities. So, to be at that upper range where we are now reflects a lot of opportunity in the market that we currently see. 

Kyle Caldwell: You’ve highlighted in this interview lots of opportunities that you’re seeing. If I could ask you for your one reason for optimism for investing in China, what would that be? Also, what are the biggest risks and potential headwinds that concern you? 

Dale Nicholls: It’s a very interesting time. The biggest catalyst will be things gradually improving. We talked about earnings. Some stabilisation in the property market, that being less of a drag going forwards, that feeding into slightly better consumer sentiment, I think will be a driver.

At the same time, we’ve talked about the competitiveness of Chinese companies. Across a range of industries, we struggle to find the industries where Chinese companies are losing market share from a global perspective. There’s just a lot of potential for the market to be more aware of that competitiveness. Obviously, we see the EVs, the electric vehicles, on the ground here, that’s definitely going to continue. So, that greater market understanding can drive a re-rating there. Risk/reward for the overall market looks positive.

In terms of the potential negatives, it would be things like the property cycle, that downturn, continuing to drag on. But as I said, the ingredients are there for that to potentially bottom. So, again, the balance of outcomes looks pretty good in terms of things potentially gradually improving. 

Kyle Caldwell: Finally, Dale, as I’ve interviewed you before, I know that you do have skin in the game. So, instead, I’d like to ask you, when was the last time you purchased shares in Fidelity China Special Situations? 

Dale Nicholls: I’ll say that I’ve definitely capitalised on the opportunity when I can to add to my position. It can be difficult. As you know, the board is pretty active in buying back shares and I can’t compete with them in the market. So, I do try to capitalise on the opportunities to buy when they’re there. 

Kyle Caldwell: Dale, thanks for coming in today. 

Dale Nicholls: Thanks, Kyle. 

Kyle Caldwell: That’s it for our latest Insider Interview. For more videos in the series, do hit the subscribe button, and hopefully I’ll see you again next time.