Long/short investing in Chinese equities

How has the Chinese equity market evolved?

Since I started managing investments in China in the mid-1990s, a great deal has changed. Back then, China was a very cyclical market, known for being the world’s primary source of cheap manufactured goods – from toys to shoes – supported by a growing petrochemical industry. Today, it has embraced higher value-added sectors, such as tech, and has become one of the biggest consumer markets in the world, with disposable incomes almost doubling in the past decade.

From a handful of listed companies, China’s stock market has ballooned to thousands; the Shanghai and Shenzhen stock exchanges now both rank in the top 10 globally by market capitalisation.https://www.msci.com/documents/10199/113f7338-90a7-47ce-bed9-f51e67ee0a44

And the investment opportunities are much more diverse – tech companies, for example, now account for 42% of MSCI’s Golden Dragon index, compared to 21% in 2011. https://www.msci.com/documents/10199/113f7338-90a7-47ce-bed9-f51e67ee0a44 A more diverse market, in turn, increases the need for deep fundamental analysis. To make the most of China’s opportunities, you now need a team of experts and an active, bottom-up approach.

Then there are the regulatory changes. From a totally closed system to foreigners, the domestic A-share markets have opened up to international investors. Thanks to the “connect programme”, they can now access the Chinese domestic A-share markets in Shanghai and Shenzhen via the Hong Kong Stock Exchange, under the same rules for Hong Kong-listed stocks.

While China remains a policy-driven market sensitive to changes in government regulation, corporate governance and accounting transparency have improved greatly, compared with even 10 years ago.

Why does the long/short approach work particularly well in China?

We have already seen major structural shifts in China, but it continues the transition to a diversified and consumption-driven economy. Naturally, such seismic changes will create winners – but also losers. A long/short strategy can find opportunities on both sides.

As the economy transitions, growth has slowed. After growing by an average of 10% a year for three decades – and being one of the fastest growing economies in the world – China is now expanding at half that pace. As a result, some sectors have encountered difficulties in terms of growth and profitability.

State-owned enterprises (SOEs) still dominate in some industries, such as upstream materials and energy. But elsewhere, the private sector is thriving, with many dynamic, world class companies.

By taking a long/short approach, we can capture China’s growth while limiting any downside risks stemming both from the country’s own transition and from the general volatility that prevails in emerging markets.

Where do you see the best opportunities?

Some of the best long opportunities can be found in industries that Chinese authorities consider to be strategic priorities. Biotech is a good example, across both research and manufacturing. China has overtaken the US as the biggest location for early-stage drug testing https://www.ft.com/content/ad55ee0c-ae32-42df-8e64-a2690454be8d?syn-25a6b1a6=1 and dynamic Chinese companies are attracting the attention of big multinationals, such as Pfizer and Merck. Revenues from drugs originating in China are forecast to reach USD34 billion per annum by 2030 and could climb as high as USD220 billion by 2040, according to Morgan Stanley.https://www.morganstanley.com/insights/articles/china-biotech-boom-generics-to-innovators

AI is another growth area. The DeepSeek AI assistant sent shockwaves through the global tech sector a year ago, underscoring China’s two key advantages in this space: cost and speed. Whether in large language models (LLMs), such as DeepSeek, or in other areas, such as semiconductor equipment, Chinese companies can compress the time to market to a fraction of what their competitors in the developed world can achieve, and they can deliver at a fraction of the cost. This is a crucial advantage in a world moving towards cheaper but more capable technologies.

We are thus long on industries where China is on a strong competitive footing globally, and on companies that offer improving earnings alongside reasonable valuations.

Conversely, we see short opportunities among businesses that are struggling with economic headwinds, heightened competition and overcapacity. Some sectors face rising costs of essential components; these include the automobile industry and consumer electronics, such as smartphones and PCs. We are also cautious on some more traditional sectors, such as real estate.

Why is now the time to focus on alpha rather than beta in China?

The economic conditions in China are still quite tough. Growth may have stabilised at around 4-5% per year, but pricing pressures are eroding company revenues. The authorities have been proactive, but we believe their aim is to prevent any economic crisis rather than administer extensive fiscal largesse. We expect to see relatively modest earnings growth for the broader Chinese market, averaging around 7% per annum over the next five years.

Investors who want the opportunity of higher returns will need to look beyond broad market exposure (or beta) and to focus instead on active bottom-up stock selection (alpha). Through detailed analysis, we can find the companies that are well insulated from pressure on input prices and margins.

How does Pictet AM's Mandarin strategy stand out from its competitors?

Pictet’s Mandarin strategy has been running for nearly 20 years. Our focus is on generating alpha. We use deep fundamental research to construct a high-conviction portfolio of liquid stocks, and we actively manage gross and net positioning to achieve the best possible upside-downside capture ratio.

Since inception, we have a track record of mitigating downside risk by limiting our exposure to beta. Our positioning tends to be more defensive than many of our competitors.

As China continues its transition, our approach puts us in a strong position to identify the winners and losers and to deliver attractive risk-adjusted returns for our investors.