Bargain hunter: This trust is on a roll, but remains cheap as chips

These have been a stellar couple of years for shareholders in the Fidelity China Special Situations investment trust, which has enjoyed a resurgence under the management of Dale Nicholls, who took over in April 2014.

Nicholls had big shoes to fill as he replaced star fund manager Anthony Bolton at the helm. Bolton had steered the Fidelity Special Situations fund to annualised returns of around 19 % during his 28 years at the helm before stepping down in 2007.

He moved to Hong Kong to manage the newly launched Fidelity China Special Situations trust in 2010. But he struggled to repeat his success overseas, with FCSS' net asset value return showing a loss of 31.5% in 2011, according to broker Winterflood. Indeed, it was a challenging year for all stock-pickers in the region: the MCSI China index, the trust’s benchmark, declined 17.6%.

By the time Bolton retired in April 2014 he had managed to steer FCSS back into the black, but in the three and a half years since Dale Nicholls took the reins, the trust’s performance has improved markedly. FCSS has produced an NAV return of 87% on a three-year view, and is showing a return of 21% over the past year.

However, despite this strong showing, the trust is today sitting on a discount of 13.7% (as at the time of writing on 20 September) - an anomaly that has caught the eye of Killik, the stockbroker, which has issued a 'buy' recommendation.

In a note to clients Killik notes that "for long-term investors, the development of the Chinese middle class provides a strong backdrop for growth," and that FCSS offers an attractively priced entry point for investors to gain exposure.

Over the past 18 months or so Chinese stockmarkets have enjoyed a fine run of form. Killik puts this down to "clear signs of economic improvement over this period", going against predictions from various gloomy experts who had warned China would suffer from a so-called 'hard landing'.

But, as the more experienced investor knows all too well, those who back China should fasten their seatbelts and prepare for a bumpy ride - the stockmarket has past form for falling sharply in a short space of time. Therefore, those who invest in such a single-country investment trust or fund should be prepared to invest for the long term, at least five years.

"Periods of heightened market volatility are to be expected as China undergoes a challenging rebalancing of the economy. However, for long-term investors, the development of the Chinese middle class provides a strong backdrop for growth," says Killik.

"The portfolio continues to offer attractive high levels of prospective earnings growth, and with the share price having lagged the NAV return year-to-date, the current 14% discount is wider than the medium-term average and looks attractive."

The investment trust broker Winterflood has also recently thrown its weight behind FCSS. In a note at the end of July the broker said the discount at the time - which stood at 12% - was 'attractive', and as a result the trust had been added to the firm’s model portfolio.

"In our opinion, the high level of gearing, single-country mandate and small cap bias make Fidelity China Special Situations a high-risk, potentially higher-return vehicle, particularly at a time when the manager appears to be more cautious on valuations," said Winterflood.

"Having said this, the ability to take short positions provides an opportunity to benefit from overextended valuations and the use of gearing and small cap allocation makes good use of the closed-ended structure. In addition, while we tend to view single country funds as specialist vehicles, we note that if the manager is correct about China becoming a greater part of global indices, there could be a growth in demand for China-focused funds."

Nicholls focuses on 'new China', investing in areas of the market related to China's modernisation, which has paid off. He looks particularly for small and medium-sized companies, where he believes lower levels of research coverage tend to lead to more mispriced opportunities.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.