Playing the gyrating mainland stock markets was a game of nerves last year for individual investors, eaving many disappointed with their returns.

The Shanghai Composite Index ranked as the world's third worst performing market in 2010, with a drop of 4.3 percent. In January, China's most widely watched index fell a further 1.23 percent.

So what does 2011 have in store for investors?

Yan Ji, who helps oversee about 11.2 billion yuan (US$1.71 billion) at HSBC Jintrust Fund Management Co in Shanghai, shared his views on the stock market's direction with Shanghai Daily.

Q: The Shanghai stock index has been fluctuating between 2,700 and 2,800 since late last year. What's preventing a rally?


A: Fears among investors over more monetary tightening in the future. In particular, it's the worry that liquidity in the market will be tightened.

I'm not saying liquidity is tight now. In fact, liquidity is so excessive that we are now facing inflation. However, investors in stock markets are always jittery toward any sensitive changes. When you read every day the rhetoric flowing from authorities who pledge to do something to curb inflation, to control hot money inflows or to raise interest rates, the signal is clear: curbing liquidity.

As that tone settles deeply into investors' psyche, it makes them extremely cautious and stock prices flat.

Q: The central bank governor has signaled that the reserve requirement ratio on banks may be raised further, and analysts agree that at least two more interest rates hikes are likely this year. How severe do you think the policies to curb liquidity will be?

A: The central bank is cautiously trying to rein in inflation, step by step, working on the principle that their actions won't result in a hard landing.

It's a delicate job to find a balance between curbing excessive money and pumping in enough capital to continue China's economic boom. When the authorities see any signs that indicate their 'prudent' policies are too restrictive for the economy, they will change their monetary stance quickly.

Economic growth is still a priority.

For instance, the latest rise in the bank reserve requirement in January froze nearly 350 billion yuan (US$53 billion). But the central bank soon pumped almost 300 billion yuan back into the money markets because data showed them in bad need of capital.

Q: How do you see the prospects for the stock market this year?

A: I'm positive about the market's performance, but the road will be bumpy in a complicated situation.

We all know that market performance is decided by three factors. Firstly, corporate earnings. So far, most analysts forecast at least an average of 15 percent annual profit growth this year, which of course is good news.

A second factor is stock valuations. Price-to-earning ratios of most stocks are now at a relatively low level, which indicate room for a possible price correction this year.

And third is government policies. Since fighting inflation is the current theme, stock markets will be a more preferable option to diverting excess money into areas in the government's cross-hairs, like real estate. These three factors bode well for the stock market this year. However, I don't see a strong bull market this year because that would inflame inflation and alarm the authorities.



Q: What sectors of stocks would you advise in a climate of high inflation and tightening policies?

A: I'd suggest looking for opportunities in two kinds of stocks. First, cyclical stocks such as steel makers and cement producers. These stocks will be on an upward trajectory given their satisfactory earnings reports and low valuations.

Secondly, I see opportunities in the seven new emerging strategic industries listed in China's Five-Year Plan for 2011-2015. Specifically, among the seven industries, I prefer high-end manufacturing companies, information technology and clean-energy vehicles. These are the stocks that could be profitable in the long term.

But investors should be wary of shares on the ChiNext board and the SME board because most stocks there are overvalued and could be quite risky.

Q: Listed firms are expected to release their 2010 earning reports by the end of April. So what should an investor look for in those reports?

A: First of all, whether the company has made profits. That's an obvious and key question.

After that, we usually divide all the firms into three categories to determine what we should buy. The most favorable candidates are usually in industries that have high potential profit growth in the future. In most cases, it would be sensible to buy leading companies if the reports indicate they can maintain large market share for a long time.

In the second category are firms with stable growth, which usually are in traditional industries. But investors should keep an eye on whether these companies have the potential to increase their market shares and cut back on production costs to boost their profits.

And thirdly, companies in industries that are considered outdated or on a declining track. For those, investors should look for opportunities in companies that have good restructuring plans or will fundamentally change their businesses to go into another industry.

Q: Real estate companies and banks are always the most discussed sectors. How do you rate them?

A: For the real estate industry, I think it's quite likely that the newly introduced property tax will bring down housing transaction volumes a bit.

But valuations of developers are now at record lows. I don't think they can drop much more even in the worst-case scenario of a 20 percent plunge in housing prices, which I think is definitely unlikely for now. So basically, I don't think there is much room for developers to lose more ground now.

The situation is much the same for lenders, whose shares are also now quite undervalued even given the banks' encouraging earnings reports.

Many investors worry that China's monetary tightening could erode banking profits. However, when China raised the one-year deposit rate to 3 percent, it also raised the one-year lending rate to 6.06 percent, which means banks still benefit a lot from the large margin gaps.