Fear and greed overshadow the H factor

IS THE CURRENT bull market in H shares any more sustainable than previous rallies? It is certainly turning a few heads after a 136 per cent gain last year.

This kind of gain means those oldest of emotions - fear and greed - are hard to keep at bay. Navigating that middle path between jumping in at the top of the market or missing out on the early stages of a multi-year bull rally is the tricky task ahead.

H shares have seen improvements in corporate governance over recent years. Some even pay dividends as well as earn profits. Yet the bull case still comes back to the opportunity to get on board what is potentially the world's biggest economy as China makes its transition to a full market economy. Also, this time the stampede towards deregulation has less chance of going into reverse as WTO-related commitments open the mainland economy to a deluge of foreign investment.

It is easy to see how foreign fund managers gaze upon China and see only a string of positive headline macroeconomic numbers. And while some H shares tripled or quadrupled in value last year, the price-to-earning ratios of many still trade in low teens. Do some extrapolations for the potential market and it is not difficult to generate some very positive scenarios.

It is also easy to raise the spectre of a bubble, but less easy to tell how big it will get or what will eventually prick it. When Fed chairman Alan Greenspan famously warned investors of the dangers of 'irrational exuberance' back in 1996, the Nasdaq did not peak for another three years.

Portfolio mangers not in this market - or bubble - face the dilemma of having to explain how they missed out on potentially a generational lift-off in the Chinese economy.

To date, the majority of the existing H shares are in heavy or commodity industries which offer a relatively transparent play on China's underlying industrial growth. Concerns about management or disclosure can be put in perspective as selling oil, aluminium and other raw materials into a market of rising prices should not require any Enron-style accounting to make the numbers looks good.

Perhaps Warren Buffett put it best last year when he disclosed his prescient acquisition of a 13 per cent stake in PetroChina. He did not claim to understand China, but he could understand how the oil industry worked.

When you have two million new cars taking to the road, owning part of the company filling up these thirsty vehicles is a good strategy.

After years of false dawns, China's car market is now a lucrative one. Its growth rates are upwards of 60 per cent and make 8 per cent GDP growth look comparatively pedestrian. Projecting ownership levels is haphazard, but with new financing packages available it could be a costly mistake to underestimate the market's potential.

The worry on the horizon is that the Chinese government might put the brakes on an overheating economy as early signs of inflation appear. But is it good inflation or bad inflation? When property prices rise and the prices of manufactured goods decline, it is at least positive for many consumers' balance sheets.

Beijing also looks reluctant to aggressively raise interest rates, especially as this might only succeed in attracting more hot money flows into the economy.

Deregulation has also loosened the government's tight grip on the economy, and flows of foreign direct investment, equity financing and regional spending mean China's growth momentum will be harder to slow.

Ultimately, it is impossible to accurately predict what lies ahead this year. The best strategy to temper the market's emotional highs and lows is to adhere to the old rule of diversification. You will at least be in the good company of many foreign money mangers who find China and its new stream of H shares a hard story to ignore.