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No pain, no gain? How investors are playing China

Chinese stocks have been on a bumpy ride of late, but after a strong week of gains and better-than-expected growth data, investors are now considering whether some much needed stability has crept back into the market.

China's benchmark stock market, the Shanghai Composite, surged more than 100 percent between October last year and June. It has since shed 20 percent of its value in a violent selloff that forced Beijing to step in with a number of supportive measures.

And they appear to have worked – at least for now; over the last seven days the index has posted gains of more than 6.5 percent.

Read MoreThe (sad) truth about China's rally and crash: Stocks are too frothy

An investor sits in front of screens showing stock information, at a brokerage house in Hefei, China, July 8, 2015.
Reuters
An investor sits in front of screens showing stock information, at a brokerage house in Hefei, China, July 8, 2015.

'Not a cheap market'

But fund managers assessing Chinese stocks on a purely price-to-earnings basis argued that, even with the sharp correction in the domestic equity market and a stronger-than-forecast underlying economy, valuations are stretched to put it mildly.

"When you think about this market, you should look really look at valuations metric. The Shanghai Composite is still trading at around 20 times earnings -- that isn't a cheap market, that isn't a distressed valuation," Will Ballard, head of emerging market and Asia Pacific equities at Aviva Investors, told CNBC.

"If you look at Shenzen Composite, these are mid-cap companies that trade on 40-50 times earnings. ChiNext -- these are the tech and biotech firms on 80-90 times earnings – these are already stretched valuations."

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In light of this, Ballard said Aviva was maintaining its substantial and long-standing underweight allocation to China, but he said there was real potential on a longer-term basis.

"We are mindful of the disconnect between what remain bubble-like valuations of some of the domestic equities, and the more attractive valuations found in Chinese companies listed in Hong Kong or offshore," he added.

Chinese equities rallied on Friday after reports that state banks lent around 1.3 trillion yuan ($209 billion) to the country's margin finance agency, in the latest step to prevent a market freefall.

China's benchmark Shanghai Composite closed up 3.5 percent, while the CSI300 index rocketed nearly 4 percent and the Shenzhen Composite ended 5 percent higher.

Shanghai Composite returns year to date

GDP boost

Investors have also been encouraged by recent data releases, including a levelling off in the manufacturing slowdown and a pick-up in both retail sales and industrial production. While earlier this week, figures revealed that China's economic growth for the second quarter had beat expectations, rising 7 percent from a year earlier.

As such, Jade Fu, investment manager at Heartwood Invesment Management, said that within the group's emerging market allocation they are overweight China. This is predominantly through the offshore market in Hong Kong, but also with some A-share domestic market exposure.

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"We are invested in active managers who have a demonstrated ability to navigate uncertain and challenging market environment as the structural slowdown story plays out," Fu said.

"Market volatility has dampened over the last few trading sessions. Equity valuations are starting to look interesting in the offshore market, which trades at a discount to the A-share market and is underpinned by a largely institutional investor base."

'Policymakers lost control'

On a fundamental basis, others argue that nothing much has changed in spite of the recent selloff.

Moves in the mainland A-share Chinese market have been exacerbated by the high proportional of retail investors, rather than institutions. According to Michael Lai, investment director at GAM, this has leaked into the Hong Kong H-share market, creating buying opportunities.

"For us, the moment that the Chinese central bank cut interest rates at the end of last month was the moment we realized that the policymakers had lost control," he said. "We then liquidated the bulk of our A-share exposure. The recent dramatic falls in Hong Kong have prompted us to cautiously start adding to select names where the relative strength indicators are pointing towards oversold levels."

Lai said he continued to value in these holdings because "nothing has changed in their fundamentals."

"Clearly, we do not know where the bottom in this selloff will be, but our experience tells us that picking up selected shares on 1 times book value or 6 times price-to-earnings ratio usually benefits in the long run," he added.