Fidelity China Special Situations trust: two of my favourite shares

Dale Nicholls, manager of the Fidelity China Special Situations (LSE:FCSS) investment trust, explains how he is seeking to profit from two big trends – the rise of the middle class and China’s shift towards a more consumption-driven economy. Nicholls, who seeks to find the “best ideas”, picks out two favourite shares from the tech and industrial sectors. He also explains why investors should be backing China and reveals that he has upped his own ‘skin in the game’ over the past year.

Fidelity China Special Situations investment trust is a member of interactive investor’s Super 60 investment ideas.

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Kyle Caldwell, collectives editor at interactive investor: Hello and welcome to our latest Insider Interview. Today in the studio I have with me Dale Nicholls, fund manager of the Fidelity China Special Situations Investment Trust. Dale, thanks for coming in today.

Dale Nicholls, fund manager of the Fidelity China Special Situations Investment Trust:Thanks, Kyle. Great to be here.

Kyle Caldwell: So, Dale, the trust invests in both listed and unlisted businesses, and it seeks to profit from the rise in the middle class in China and also China's shift towards a more consumption-driven economy. How do you narrow down the universe to invest in a selection of companies that are seeking to profit from those trends?

Dale Nicholls: I don't know if there's an easy answer for that. We're constantly on the ground looking for the companies that are going to be the leaders over the long term. So, following consumption trends, [and] looking at the sales numbers that are coming through. And to be honest, just constantly meeting with companies, understanding a company's strategy and, I guess, really understanding the competitive advantage, how sustainable that is, and how that feeds into the growth prospects over the middle term. So, it's really about the team on the ground, working away, finding the best ideas.

Kyle Caldwell: I can see there's a couple of unlisted stocks in your top 10 holdings. What's the overall exposure and how do you manage risk?

Dale Nicholls: Our exposure to unlisted [businesses] right now would be around 15%. We really try to employ the same approach when we're looking at the unlisted companies. I think, the only thing that's different is the risk/reward prospects are generally different. So, I think generally with earlier-stage companies, the risk is probably higher. And therefore, we expect higher returns to really compensate for that. Oftentimes, there’s probably not the same level of information you can [get] for listed companies. So that requires more work from the analyst team to gain comfort around the fundamentals for a business. But outside that, I think the approach is pretty much the same.

Kyle Caldwell: Two sectors that you have notably more exposure to than the index are industrials and technology. Could you talk us through the attractions of both those sectors and name a couple of stock examples?

Dale Nicholls: Yeah, sure absolutely. So, in the tech sector, it's broad. So, you're going to have the consumer element in terms of consumer tech. You've also got, in many cases, a more business-focused B2B type business. But there's good growth prospects on both sides. Thinking about consumption in general, we know that's going to occupy a bigger part of the economy over time. It's clearly a focus for the government to be focused on quality growth driven by consumption. So that will naturally expand.

But it's just that the natural development of the middle class is a really strong underlying theme in China. There are many companies out there that are going to benefit from that. I'd also say that it's a unique time in tech because obviously we've been through harsher regulation, which has really impacted valuations in the sector. So, valuations are lower. That's offered an opportunity to increase the weight in the sector as well, particularly now that I think the regulatory storm is starting to ease.

Then, elsewhere in tech, as I mentioned, you've got the business side as well, [and] a lot of businesses have really good prospects there as well. If you look at things such as cloud penetration, the potential for software to grow, there's some good growth opportunities there.

Then, in industrials, there's a pretty clear broader economic recovery under way. I think there's good potential for the overall economy to accelerate from here, there's a lot of industrials that I think are set to benefit from that. Again, it's a broad sector. So, you'll have areas like building materials that I think will benefit from an improving property market. It's obviously been through a tough time and a lot of the stocks have been weak on the back of that. But I think the prospects are there for that to improve. But I also see just generally a lot more quality industrials in China, companies that are really investing in R&D and bringing out quality products, and in many cases taking share from international players. So, there's a pretty strong story around import substitution in China as well for a lot of the industrials.

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Kyle Caldwell: Are you able to pick out one example for each of those sectors?

Dale Nicholls:I'd say in the industrial space, there's a company called SK Shu in the paint sector, which may not sound so exciting, but I think is actually a pretty compelling story over the mid-term. We talked about the potential for the property sector to improve, but across a lot of areas of building materials, you've got very fragmented markets. We're talking about markets where your top three players can be, maybe, 20% of the market, whereas in the West it's more like 80%, just given the tough times that we've been through, consolidation is very much under way and we're seeing the winners emerge in that space.

So, someone like SK Shu, which is the number two player, a foreign player being the biggest, has good potential to significantly grow over time, both in the B2B side of the business, but also in the consumer side as well, directly to the consumer. The paint business is quite a good business. You can develop a brand, get pricing power, and thus generate pretty good returns on capital. So, I think that's a good example of a company that can be much bigger over the mid-term given their prospects and their positioning in the market.

To offer an example in the tech space, it's somewhat consumer-related as well, but there's a company called Autohome Inc (SEHK:2518), which is really a leader in the auto advertising vertical. So, they're a dominant player in that space. I think the prospects are pretty good for improvement in the auto market, with reopening. I think demand probably picks up there. At the same time, you've got pretty good prospects for increased competition. You've got new players in the electric vehicle space. The incumbents are bringing out new products in that space as well. So, as competition increases, advertising will be important. They've got quite a strong position in that market, so they're set to benefit from that.

They've also got a pretty strong business in the used car market, and that's a market that has pretty good prospects to grow in China - it has lagged. It's been much more driven by new cars. But I think the used car part of the market has pretty good prospects to grow there as well. It's another name that I think is being brought down by the overall tech sell-off with concerns around regulation. But it's clearly a good business generating good cash flow and set to benefit from improving fundamentals.

Kyle Caldwell: The trust makes active use of gearing. Have those gearing levels been increased recently to take advantage of the lower valuations?

Dale Nicholls: The gearing really did pick up when the market was weaker because I was definitely putting more capital to work late last year when things got really cheap. Gearing levels now have come down. So, I have taken some money off the table in the names that have done well. I'd probably cite the more obvious reopening plays, things like travel, travel-related stocks, and that sort of thing, where clearly, they're the natural beneficiaries of reopening. In many cases, a lot of the improving fundamentals is being reflected in stock prices. So, we've taken down the gearing, [but] it's still relatively high. I still think the prospects are pretty good, but maybe not as compelling as it was a few months back.

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Kyle Caldwell: There's a team of on-the-ground analysts. How important is it meeting company management face to face?

Dale Nicholls: It's very important, it's a core part of our process. I think it's important to go to company headquarters, see factories, that sort of thing. We've been through a period where that's been made difficult. It is still important. We're very lucky that we've had a team on the ground through the pandemic. So, they've been able to meet with companies, whereas I think a lot of companies have struggled to get that real on-the-ground flavour through not having that on-the-ground team. So, it's great that we've had that team on the ground.

Kyle Caldwell: For investors considering exposure to China, how would you convince them to pick a single-country strategy like yourself, over an emerging market or an Asia-Pacific fund, when typically, they do tend to have quite a bit of exposure to China?

Dale Nicholls: I think pure China exposure when I think about the Chinese market, it's unique in many ways. It's a market that tends to get driven a lot by the headlines, whether it's geopolitical or economic, it tends to be in the headlines and that can really create volatility in the market. As an individual stock picker, that can create a lot of opportunity in the market. So, it's quite a good stock picking market in that sense.

It will continue to grow and probably out-grow global growth. At the same time, if you look at investor positioning, it's still clearly underweight. Definitely the weighting is minuscule compared to if you think about China's weight as a percentage of global GDP. So, there's good prospects for investors to be owning more of China over time. So, I think that's likely to be a tailwind as well.

Kyle Caldwell: Finally, do you eat your own cooking? Do you have personal investments in the trust? 

Dale Nicholls: I do, absolutely. And it did increase over the past 12 months when we saw things really sell-off.

Kyle Caldwell: Well, that's good to hear. Dale, thanks for coming in today.

Dale Nicholls: Thanks, Kyle.

Kyle Caldwell: That's all we have time for today. You can check out the rest of our Insider Interview on our YouTube channel, where you can like and subscribe. Hopefully, see you next time.