Foreign investors start to fear a bubble in the air

Foreign investors are keeping a watchful eye on new opportunities emerging from China's surging stock market; but an increasing number are also starting to warn against the possibility of a growing bubble, in what has become world's fastest-growing stock index.

Their key concern relates to the unreasonably high price-to-earnings multiples of the stocks leading the growth of the A-share market, warning that prices have become detached from fundamental values.

"A lot of these firms already have very high PE multiples, meaning a lot of work still needs to be done to meet their expectations," said Robert Davis, senior portfolio manager at NN Investment Partners.

"The companies could grow fast - but there is a greater risk that they will not grow as fast to justify their valuations."

Davis' views are echoed by Steve Yang, an A-share strategist at UBS Securities.

"A-share prices have grown extremely fast in recent months. But we certainly can't have such high growth every day, because at the current rate we'll have 400 percent growth annually, which is unsustainable," he said.

To put the skyrocketing A-share prices into perspective, China's main stock index, the Shanghai Composite Index, has doubled since July last year. It rose from around 3,000 points in February to around 4,400 in April.

Yang said the A shares are being driven by incremental capital being ploued into the market.

A lot of Chinese mutual funds and hedge funds have raised new capital in the past three months and investors are using the leverage to invest. Individuals too are directing more of their savings into equities.

For over a decade, foreign institutional investors have been tapping the A-share market through the Qualified Foreign Institutional Investor program, although the opportunities broadened at the end of last year when China introduced the Shanghai-Hong Kong Stock Connect program.

The linkage allows both institutional and retail investors that trade on the Hong Kong stock market to purchase a selection of A shares, while allowing investors in the Chinese mainland to buy H shares, or Hong Kong-listed shares, that can be freely traded by foreigners.

Yang said the Stock Connect program has been well received by international investors, and marks an important step in the opening up of China's capital markets.

It is also being seen as healthy because some of the capital from domestic investors can now flow into international stocks as opposed to being concentrated in the A-share market alone.

For international investors such as NN Investment Partners, which has traded on the Hong Kong market for years, the Stock Connect program provides great opportunities to tap into the A-share market.

At the same time, however, the Stock Connect has also caused a degree of nervousness about the quality and transparency of the A shares being offered to foreign investors, as they may not necessarily have the same disclosure standards as H shares.

"There's a feeling that the investor relations departments of some of the mainland companies lack sophistication, as they have not dealt with overseas investors before," said Davis.

"They may not have accounts in English, or may not release their press releases at a timely manner."

These concerns, combined with the relatively unfamiliar landscape of the A-share market for foreign investors, have meant that many Western investors are also cautious about how they tackle opportunities in the mainland market.

"Some Western investors don't know these companies, and they may not have Mandarin teams to communicate with them. But if you are talking long term, this channel presents a big opportunity for overseas investors to tap into China's growth," Davis said.