It's a dogs life

TOP DOG (Long term winners) 
Jing Ning
Portfolio Manager
Fidelity China Fund 
I believe 2018 could be the year when the much-maligned Hong Kong listed large-cap old economy stocks outperform. We are entering the second year of robust and sustainable earnings, which suggests these companies are being better run and the government’s policies to reduce capacity and excess are having an impact. We are seeing many industries, such as coal, steel and cement going through different stages of decapacity, which is improving the supply/demand dynamics of their respective products. These industries are also amongst the biggest culprits for non-performing loans on bank’s balance sheets, so their improvement alongside stricter loan requirements are helping to improve non-performing loan formation. When looking at 2017 share price returns, all returns from these companies were driven by earnings growth - these stocks generally did not enjoy a re-rating. Structurally, it is becoming clear that the biggest companies in each sector has the strongest balance sheet and they are using this strength to squeeze out smaller players, thus gaining market share, generating positive free cash flow and paying a dividend. This improving market position could drive a re-rating.
 
Raymond Ma 
Portfolio Manager 
I see potential long-term opportunities related to State Owned Enterprise reform. So far we have seen little improvement in this area, so market expectations remain very low, but this creates very interesting valuation opportunities. A number of SOEs have a very significant core asset base, whether it be land, licenses, favourable regulations, etc. These assets are generally under-monetised due to a greater focus on volume of production and job creation versus profits and returns. The landscape here could well change with management reshuffles or changes in management incentive schemes. The later has already started to a limited degree, but this is yielding positive results from a shareholder perspective. Generating strong growth from SOEs via fairly simple reforms is relatively low hanging that the authorities are aware of. The key is the government’s appetite to make these changes and this is why they remain at low valuations.
 
Dale Nicholls 
Portfolio Manager 

Investments related to the rise of China’s middle-class consumer remain a core focus for me. These consumers are demanding more from products and services - and some companies are responding with strong offerings on both of these fronts. China Meidong Auto is a long term holding that has done very well over the last couple of years, but I still think it has much more potential. It is a car dealership based in the Guangdong region that continues to grow its network while its excellent management team is highly successful in taking over weaker dealerships and turning them around. Selling cars is core to its business, and its approach has led to partnerships with high quality brands such as Porsche and Lexus. However, what sets China Meidong Auto apart from competition, and how it has been able to turnaround the failed businesses it has purchased, is its approach to services. Buying a vehicle from them is an experience and the management team focuses heavily on offering the best after sales services. Having mechanics the customer trusts or sitting in a luxurious lounge with your tea while your tyres are changed has driven higher and regular income streams from servicing. Other services, such as financing, are also important revenue opportunities that the company is capitalising on. There is scope for more growth as it expands its dealership network across the region and even nationally, which means lots of future potential value in the business. 
 

Lynda Zhou 
Portfolio Manager 
China’s video surveillance industry is still in the growth stage, and Hikvision is leading the way. Hikvision benefits from two areas: demand growth driven by rising domestic security investment, mass scale camera installation in cities (especially new growing cities) and the ongoing shift from analog to digital; and value growth driven by increasingly complex cameras with multiple functions that sell for higher prices and generate higher margins. Hikvision’s market leading position means it has more cash to spend on R&D and technological improvements, which further cements its position as the industry leader. Hikvision is also increasingly looking overseas and its technology and price advantages means this is an additional area for future growth.
 
Hyomi Jie
Portfolio Manager 
Yum China is China’s largest restaurant chain with over 7000 restaurants within its portfolio of brands, which includes KFC, Pizza Hut and Taco Bell. A key driver to Yum China’s long-term potential returns lies within its growing delivery business. The company is using its vast number of offline restaurants as an effective nationwide distribution network to maximize online food delivery sales - a higher margin scalable business versus in-house dining. It also has strong brand recognition, especially within the millennial demographic, which should allow the company to pass on higher raw material costs to consumers and help maintain profits. I also see a potential turnaround situation in its Pizza Hut brand towards the end of 2018, which would add additional value to the company. Yum China trades at a reasonable valuation given its growth potential and execution capability.
 

 

PUPS (Emerging ideas) 
Jing Ning
Portfolio Manager
Fidelity China Fund 
My style is to look for value and take a contrarian view. Therefore, it may come as a surprise that this approach is leading me towards A-share growth stocks (defined as those with +20% p.a. earnings growth). Over the last 18 months A-share market sentiment has favoured high quality blue-chip companies as they offer stable growth and have the potential support of foreign inflows on the back of future A-share inclusion in market indices. These companies did offer value, but now I believe sentiment may have shifted too far. In the meantime, high growth stocks have lagged during this hunt for high quality growth and now offer relative value. It is important to find those companies who can deliver on their promise, but as the A-share market becomes more institutional and a destination for foreign investment, we could see a greater focus on relative value, which would put this segment of the market in a favourable position.
 
Raymond Ma 
Portfolio Manager 
I see emerging opportunities within ‘Old’ China names that would be direct beneficiaries from tighter supply. I expect to see a flat to modest demand-side pick-up in 2018, so the majority of changes in supply/demand dynamics should come from the supply-side, where government controls generally dictate. We have seen supply-side reform success in certain industries over the past 12-18 months and I can see this trend continuing in the near term. These reforms generate higher average selling prices, which will help improve margins. I am looking to get exposure in my portfolio to this through names in gold, copper, steel and cement. The risk is worse than expected demand, but I do not foresee this over the next 6-9 months.
 
Dale Nicholls 
Portfolio Manager
I am constantly looking for investment opportunities in the health care sector given the strong mid-term growth prospects, and pharmaceutical distributors have emerged as an interesting area. The pharmaceutical distribution industry has been consolidating for the past decade, but will accelerate following the recent ‘two-invoice’ reform. This policy cuts out layers of middle-men so there are now only a maximum of two invoices for drugs sales - one from manufacturer to distributor; another from distributor to hospital. The impact has been significant consolidation within provinces this reform has been trialled in. This is also a capital intensive business in China as distributors extend credit to hospitals ranging from 1-6 months, and the receivable days are increasing as distributors look for new opportunities in more remote cities. As a result, the biggest and best run are growing market share. I own Sinopharm, China Resources Pharmaceutical and Shanghai Pharmaceutical in this space due to their extensive distribution network and comparatively deeper pockets. Given the regulatory changes and subsequent change in industry structure, this area has been neglected by the market and thus valuations look relatively attractive. 
 
Lynda Zhou 
Portfolio Manager 
Foreign interest in the mainland A-share markets is an increasingly emerging theme that may offer some support to A-shares and will help increase institutional ownership. In a few months’ time A-shares enter MSCI indices for the first time. Initially this will be at an artificially low ‘5% inclusion rate’ and will only be for ~225 stocks. However, over time the inclusion rate for these stocks will increase and more A-shares will be included (note there are ~4000 listed companies in Shanghai and Shenzhen). This will lead to the A-share market being too big for international investors to ignore. As a result, I expect to see greater foreign focus on A-shares and the first batch of investors will predominantly be institutional investors who have a robust investment process, rather than the generally more speculative nature of the A-share retail investor. Companies with strong business models, good corporate governance and robust balance sheets will likely see the most foreign interest, but as investors gain more confidence in investing in A-shares we could see shift down the market-cap curve where the companies are generally less well  covered.
 
Hyomi Jie
Portfolio Manager 
I have become increasingly interested in China’s Software as a Service (Saas) industry, where Kingdee International stands out as an interesting opportunity. I think China’s SaaS market is at an inflection point: better cost performance, high internet penetration and booming start-ups will increase SaaS penetration from 5.7% of total software revenue in 2017 towards 15% in the next few years (the current US penetration rate). Kingdee offers software to small and mid-sized enterprises (SME) for services such as accounting, inventory and customer relationship management. Historically they have offered this software as a package, but they are teaming up with SME cloud providers such as Ali-Cloud to move this in to the cloud via a monthly subscription model. While this will lead to a short-term loss, it will generate higher and more stable long-term margins. Kingdee has the advantage of being the earliest mover in the China SaaS market, while it holds a competitive advantage over foreign competitors due to the desire to keep potentially sensitive data ‘onshore’. Price-to-Earnings valuation numbers look high, but considering the nature of Saas industry (increasing losses during the rapid customer addition period), I think EV/sales is a better valuation method, which leaves room for further upside. 
 

 

STRAYS (Areas of concern) 
Jing Ning 
Portfolio Manager
Fidelity China Fund 
Tier 3 players in each industry are coming under increasing pressure and an area to avoid. While they may offer strong potential gains should they capture market share, the chances of this have diminished as the largest companies in each industry have been able to establish even deeper moats over the last few years. Big banks have solid capital positions vs. lower tier banks; large-cap industrials have deeper pockets and better contacts to meet increasing regulations (e.g. anti-pollution measures); Tencent and Alibaba have almost impenetrable online platforms. However, you do not have to be large-cap to succeed, but being the dominant player in their industry is key.
 
Raymond Ma
Portfolio Manager 
I think RMB appreciation will have an impact on exporters through higher RMB costs and lower revenues from slower overseas demand. In addition, a general global slowdown will also impact demand for exporters. The technology hardware sector is potentially a key loser from this, especially as the new Apple product cycle is behind us and we are already entering a period of slowing demand in this area.  
 
Dale Nicholls
Portfolio Manager 
Property developers face a tougher environment going forward. After a few years of favourable policy and a general pick-up in demand we have seen a strong residential property market. However, all cycles end and after seeing prices more than double in some cities the government is clearly tightening policy, whether through tougher mortgage rules or restrictions around people buying additional properties. This is staring to hit the property market through lower transactions and higher inventories, which will impact developers. The developers have seen their share prices rise significantly over the last two years, but they are now at relatively high valuations, while leveraged balance sheets may make it a rocky period for the smaller and less disciplined players. I must stress that I do not think this will have a meaningful impact on the consumer story as much of the incremental demand for property units has been coming from investors rather than property owners - and if policies do start to bite, then the government will look to reverse them. 
 
Lynda Zhou 
Portfolio Manager 
Rising valuations amongst high-quality growth stocks is a key concern for me this year. The market has focused its attention on more sustainable growth, but sentiment in this area is very high which has pushed up valuations. Therefore, I am wary of overpaying for what is perceived as near certain growth. I am also cautious on the relatively low volatility environment we have been going through, and that this is becoming the norm. A bout of increased volatility could easily spook the A-share market and lead to a downturn.
 
Hyomi Jie 
Portfolio Manager 
I am fairly bearish on the outlook for China’s auto sector. The sector has had a well-publicised boom with veI am fairly bearish on the outlook for China’s auto sector. The sector has had a well-publicised boom with very strong cars sales growth making China the world’s largest automobile market. However, as the market has grown alongside rising incomes and tax benefits over the last two years, its ability to maintain strong sales growth has diminished and I expect a downturn in 2018. The strong automobile cycle has led to high margins, helping the sector re-rate, but I would expect valuation de-rating if the cycle doesn’t continue its fast trajectory. Although I am underweight autos, I do own Dongfeng Motor as it is a deep value opportunity and Guangzhou Auto due to its improving product cycle and cheap valuation. Both companies have not produced market leading models and are relatively unfashionable brands, which means they have lagged the sector but offer the best value.
 

 

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Investments in overseas markets can be affected by currency exchange and this may affect the value of your investment. Investments in small and emerging markets can be more volatile than investments in developed markets.

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