Why these cheap shares are ripe for a recovery

Our latest Insider Interview features Dale Nicholls, manager of the Fidelity China Special Situations investment trust. Nicholls talks about the out-of-favour areas of the market he’s targeting to take advantage of low valuations. He also discusses the biggest private company holding, ByteDance, which owns TikTok, as well as the technology sector and artificial intelligence (AI).

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello, and welcome to our latest Insider Interview. Today in the studio, I have with me Dale Nicholls, manager of the 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: Dale, to kick off, could you give an overview of how the investment trust invests and what qualities you look for in a company in order for them to win a place in the portfolio? 

Dale Nicholls: Sure, well, we spread the net very wide, looking for basically the best ideas in China as a whole. As you know, we have a lot of leeway and we can have unlisted investments. We can definitely go down the cap curve, leveraging the structure that we have. 

Like I said, we leverage the big team that we have on the ground to find the best ideas. In terms of any individual ideas, it really comes down to risk or reward for that individual name.

So, thinking about that balance, there’s a few things that we always try to get our head around. One is growth or scale, thinking about how big a business could be in five, 10, 15 years given the opportunity and how they’re positioned.

Second, we think about return, so the quality of a business. We think about the competitive advantage or moat that a company has, and how sustainable that is. There’s a lot of businesses that grow a lot that don’t generate great returns. So, thinking about the competitive edge a company has.

And then management. You can have the opportunity and you can have the business, but you really need a management team that can execute.

The final element is finding something that’s not in the price. So, really just thinking about something the market has missed, or things that we think the market’s not appreciating that’s in the price. We’re always trying to own undervalued companies. 

Kyle Caldwell: You touched on unlisted companies. What’s the current percentage weighting for that part of the portfolio and could you provide some examples of companies that you own? 

Dale Nicholls: Yeah, absolutely. Currently, we have about 14% in private companies. It’s across a range of areas, but tech would be central. The biggest bet we have in the trust is ByteDance, which you may be familiar with as the owner of TikTok, which is obviously a much bigger business for them on the ground in China, but it is expanding globally and continuing to grow very well. It’s one that we’re very positive on.

The valuation of that company has definitely moved up over time, but there’s still a lot of potential value creation there in our mind. As I mentioned, a very strong domestic business is actually very profitable, but the potential monetization of the overseas business through TikTok is something that’s really exciting, particularly through things like e-commerce. So, again, tech is sort of core to the portfolio.

I also have holdings in healthcare, cross-border e-commerce, and drones. China leads the world in drone manufacturing and this is a really growing market as well, both in the leisure space, but also increasingly in commercial drones across a range of areas where there’s agriculture and inspection. The the number of applications continues to expand. So, I’m really positive on the private part of the portfolio. There’s a lot of potential. 

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Kyle Caldwell: How often do you revalue the unlisted companies? And is it all done in-house or do you also use a third party?

Dale Nicholls: Obviously, if there’s a significant event that changes the valuation, the team will act. There is a fair value team that meets regularly, looking at the valuations of the companies. And there’s the third party as well that provides their view that feeds into that process as well. 

Kyle Caldwell: The MSCI China index has big weightings to two companies, Tencent Holdings Ltd (SEHK:700) and Alibaba Group Holding Ltd ADR (NYSE:BABA). How do you approach investing in China against that backdrop? You hold both stocks. They are the two biggest positions in the investment trust, but you are slightly underweight. Is it the case that you have to own both those companies given the dominance they have in the index? 

Dale Nicholls: I don’t think you have to own them. Every investment needs to be there on the basis of its own merits. We’ve got significant positions in those businesses. I definitely think they’re undervalued. We’re underweight relative to the benchmark, but those underweights have been closing.

It’s been an interesting time in markets, and I’m sure we’ll talk about tech and things like AI, but we’ve been through a time where...the market is focused very much on the companies that are benefiting from the AI spend, and the spenders themselves have been pretty significantly derated in the market. 

You’d probably put Alibaba and Tencent into that category. But my sense is that’s sort of overdone. What really matters is clearly, as we’re seeing globally, everyone is increasing their spend. The question is the returns that they can generate on that investment. And I think the signs are actually pretty positive.

It kind of feels like the market is over-punishing those companies. So, to me, they look undervalued. As I said, they’re underweights in the portfolio, partly because in China, there’s so much opportunity.

As I mentioned earlier, we can really go across the whole market cap spectrum. Being underweight, those companies could be drags on performance, but I would hope that other names that we have in the portfolio would offset that and we can drive our performance there. 

Kyle Caldwell: You’ve touched on technology. Could you provide an overview of how you invest in that sector and how you’re also gaining exposure to artificial intelligence? 

Dale Nicholls: When we say technology, it’s actually very broad. Overall, it’s fair to say that we’d be overweight technology as a whole. But as I said, there’s different parts to it, and probably our biggest bets are, at least sector-wise, in industrials. I know that’s kind of a broad category, but there’s a whole range of companies that are benefiting from that spend. And as you know, one of the key bottlenecks in rolling out AI is power.

There are lots of Chinese companies that play a part in that power infrastructure, whether it’s batteries or just various parts of the infrastructure that goes into providing power. Obviously, China is a leader in a lot of areas about power, particularly in renewables. Many companies are benefiting from that trend. So, I’d say in technology overall, we’d be overweight, but probably a greater weighting in the industrials.

There’s a number of industrials where the market hasn’t fully appreciated how these companies are benefiting from some of these trends. They have parts of their business that have exposure to these fast-growing areas. Perhaps in some cases, that’s not fully recognised in the market. We think there is good potential for all these companies to rerate as people become more aware of the exposure they have to these growth areas. 

Kyle Caldwell: We’ve seen certain companies that are listed in Korea and Taiwan benefit from the AI trend. Why hasn’t the rally for Chinese companies related to AI happened yet?

Dale Nicholls: Well, it has. The semiconductor names have definitely had big moves. But I guess the starting point in terms of that exposure to semiconductors is just smaller in the market. You don’t have the big memory companies. Well, actually, you do have the emergence of big memory companies now. In fact, you’re going to see some listings coming up of a pretty significant size. That part of the market is growing, but again, compared to the likes of Korea or Taiwan, they’re smaller parts, but growing fast, growing pretty quickly. 

Kyle Caldwell: Moving back to industrials, could you provide an example or two of an industrial company that’s tapping into AI that you think the market’s underappreciating the potential of at the moment?

Dale Nicholls: There’s a company called Weichai Power Co Ltd Class H (SEHK:2338), and its a significant producer of diesel engines. The market’s had this perception that if you’re a diesel engine provider, particularly in the commercial space, there’s not a lot of growth, and you’ve got the challenge of the shift to electric over time. It’s been priced as a company that’s going to be disrupted, and yet they’re very strong in motors. 

As you know, that’s one of the key components that’s going into AI data centres. One is originally as back-up motors, but now they’re becoming prime motors in both diesel and gas. And you’re looking at a company that’s one of the market leaders in this area.In the West, you’ve seen the likes of Caterpillar Inc (NYSE:CAT) and how they’ve done. Someone like Weichai is growing really strongly in this area with a lot of capacity very quickly. 

So, that data-centre exposure in their business is growing rapidly. We’re looking at probably going from a teens exposure to perhaps 40% of profits by the end of the decade. There’s good potential for one of those old industrials to be re-rated as a company that’s having exposure to these fast-growing areas. 

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Kyle Caldwell: Greater consumer spending power underpins many of the investments held in the portfolio. Could you highlight a couple of examples of companies that you own in that space? 

Dale Nicholls: This has been the part of the market that’s really lagged and we can get into the reasons for that. What’s happened in the property sector over the years has definitely been a factor, and been that drag on consumer sentiment.

But a lot of the drivers that were there when the market was so excited about the Chinese consumer are there. You’ve still got rising penetration in areas like sportswear. That per capita spend in China is growing, but it’s still a fraction of the levels that you see in the West. These trends towards athleisure and that sort of thing is an underlying driver.

A key example of a holding for us in that area would be ANTA Sports Products Ltd (SEHK:2020). They’ve got a portfolio of brands. They’ve got the core Anta brand, which has been a great growth driver over time, but you’re actually seeing faster growth in some of the smaller brands, like Fila, Descent, Arc’teryx.

The whole outdoor trend, that’s been a growth area globally and China is an example of that. You’ve got these niche brands that they’re managing very well. If you look at how Anta has managed brands over time, it’s very impressive how they’ve been able to nurture brands through their understanding of the Chinese market. 

So, that’s a company that continues to grow and you can buy it at a low teens-type multiple. Over time, it has a pretty exciting story still. 

Kyle Caldwell: Given that it’s been a trickier backdrop investing in consumer-related companies, have you been readjusting your exposure to that sector?

Dale Nicholls: It’s been out of favour, but we have significant exposure in the consumer space. As I mentioned, it’s been quite a bifurcated market. Those growth areas, particularly anything AI-related, has re-rated pretty strongly, and yet these consumption-related areas, particularly versus history, are almost historical lows in terms of the multiples.

We talked about risk/reward. The risk/reward in these areas looks pretty positive, particularly if we can see that stabilisation in property pricing. There’s a pretty good chance that that can happen. I think this is actually a positive for the overall market, because it’s definitely been one of the things that I think has kept the market back.

If you look at the property market itself, the supply adjustment has been significant. You’re looking at housing starts at an 80% or so adjustment on the supply side, and demand is definitely there. Demand has probably undershot as consumer categories in China have, the consumer is underspent. But with some stabilisation in pricing, and there’s signs that that’s happening, I think you can see a slow recovery in the consumers. So, definitely adding to positions. I think it’s going to be a slow process for that re-rating to happen.  

Kyle Caldwell: And those hot areas related to AI, have you got much exposure to the likes of the semiconductor companies that have seen their share prices rise significantly?

Dale Nicholls: I’ve had some. As I said, I’m obviously trying to stay disciplined around valuation. So, I’m probably more in those niche areas, like the power-related areas. I do have some exposure. But there’s some pretty, I won’t say stretched, but pretty full valuations and high expectations in those areas. So, again, thinking about risk/re-award, I think there’s other parts of the market that are potentially more interesting from that risk/reward perspective right now. 

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.