Dale Nicholls: China’s special but comes with political risk

China's 'devastating' attack on tuition companies has implications for its healthcare and tech stocks, but provides an opportunity to buy its long-term story, says Fidelity China Special Situations fund manager.

Dale Nicholls, fund manager of Fidelity China Special Situations (FCSS ), has issued a statement on the turmoil in Chinese technology stocks that has seen the trust’s shares fall 7% this week.

Nicholls (pictured above), who held just over 20% in Tencent and Alibaba at the end of June, expressed shock at the ‘devastating’ clampdown by China’s government against after-school tuition (AST) groups last Friday, a move that provoked a wider sell-off in the country’s tech stocks listed on its mainland and in the US.

Fortunately, the manager sold his position in New Oriental Education, one of the hardest-hit stocks, in the second quarter, so the trust avoided the 59% slump in its shares this week after it and rivals were banned from making a profit or being funded by stock market companies.

However, Nicholls did retain a small holding in China Online Education, a platform for foreign teachers to teach students English, whose shares have tumbled 29%.

‘While we have been wary of potential regulatory changes to the AST segment and I exited from other AST stocks earlier this year, I didn’t factor in the likelihood of a ban on overseas teachers - clearly a misjudgement on my part,’ he said.

Building on comments he made to investors in a Citywire virtual event last (see video above) week, Nicholls said it was natural for investors to connect the crackdown on education providers with the string of anti-trust and data security measures against social-media and e-commerce giants such as Alibaba and Tencent, leading to the recent cancelled listing of ride-hailing app Didi Chuxing in New York.

‘This seems likely to drive many more companies back to listing on the mainland and Hong Kong,’ he said.

However, he argued the two were distinct. While the interventions on internet companies were broadly about improving China’s online infrastructure, the assault on the education sector reflected its politically sensitivity as one of ‘three mountains’ where the Communist Party was determined to limit cost pressures on families and curb income gaps in society (a trend that was evident in other countries, Nicholls noted). The other areas are medical services and housing.

‘We see regulation around these three areas becoming more prominent - obviously something we are very focused on as investors. Given our weighting in healthcare [14.5% at the end of June, according to the trust’s fact sheet] we are watching developments closely, but my sense is that policy moves are already quite progressed (for example, most price cuts are focused on generic drugs versus the government’s goal of developing home-grown innovative drugs).’

Nicholls, who has managed the £1.8bn investment trust since 2014, argued investors needed to consider China’s long-term goals. Doubling GDP per capita again by 2035 required a healthy private sector, and developing its capital markets and turning the renminbi into a global currency needed a stable investment environment, hence the efforts by policy makers to reassure foreign banks and financial services companies in the past two days.

He also reminded shareholders this was not the first wave of interventions. Tencent, whose shares have gyrated this week after suspending its WeChat app to comply with new data rules, had seen its stock halve in 2018 when authorities halted new gaming licences on concerns that young people in the country were spending too much time playing on its platform. From that point to their peak in January, Tencent shares had rallied 200%. Falls since then had reduced the four-year gain to 77%, however.

‘While not without some risk, history teaches us that these times can be the most opportune to invest - attractive valuations coupled with conviction in a company’s business model, management team, and the long-term opportunities,’ said Nicholls.

As a result of regulatory fears depressing share prices, Nicholls said many tech companies were now trading at historically low valuations, and at big discounts to global peers. ‘We acknowledge that there is potential for business models to change and are accordingly, adjusting down our expectations around monetisation levels in certain companies,’ said Nicholls.

‘Having said this, investment is all about risk-reward and for many names, this is looking favourable after recent moves,’ he added.

Nicholls concluded that political and regulatory risks were unavoidable in China and something that investors had to accept. ‘Investing at the end of the day comes down to risk reward and with the correction we have seen, this is tipping in our favour. Yes, sentiment is poor, but it usually is at the most opportune times.’

According to Numis data, the value of FCSS investments has fallen 18% in the past three months, more than rivals Baillie Gifford China Growth (BGCG ) and JPMorgan China Growth & Income (JCGI ), which are down nearly 10% and 9% respectively. Nevertheless, its share price rating has held up, with the stock standing at a small 2% premium over their net asset value at yesterday’s close.

Over 10 years its impressive 335% total shareholder return is slightly ahead of JCGI. BGCG does not have a long track record as a China fund, having until last autumn traded as the Witan Pacific investment trust.

For more of Dale Nicholls’ views watch ‘Big Broadcast: How to balance China growth and tech tumult’.

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