Philippine stocks, the best performers in Asia this year, have gained more than 22% in 2012, but the market is now looking expensive compared to Southeast Asian peers, and analysts say it may be particularly vulnerable to capital outflows should the global economy deteriorate further.

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Buying by foreign investors has helped drive the Philippine Stock Exchange (PSE) index to a valuation of 15.9 times forward earnings, compared to 12.1 times for Indonesia and just 10.5 times for Thailand.

"Our general view on Manila is that the market is overvalued and has limited investment options," David O'Neil, Chief Investment Officer of Asean Investment Management told CNBC. "Yes, the market has performed well but we put it in the camp of 'fairly valued and at risk of capital outflows if global issues turn more negative'."

Last year, the Philippine stock market drew the most foreign buying in Asia as a percentage of its market capitalization . New foreign money accounted for USD 1.3 billion, or 5.6%, of the Philippine Composite Index last year, according to data from Nomura.

There has been no let-up in foreign buying in 2012, with net inflows into the market every month of this year.

According to Nomura, the inflows are likely to continue, especially if Moody's Investors Service and Standard and Poor's follow Fitch's move and raise their credit ratings for the Philippines to one notch below investment grade.

"The Philippines is seeing the strongest buying in the region so far this year and we expect this to go on," Equity Strategist Mixo Das said. "Every month this year, we have seen net inflows into the market while Taiwan, Korea and Thailand have had at least two months of outflows."

While this means that the stock market will continue to chalk up gains, it makes the market more vulnerable to outflows. James Thom, Investment Manager at Aberdeen Asset Management, which owns Philippine consumer, financial and conglomerate shares, likes the market because of its positive macroeconomic story but is concerned about its exposure to foreign flows.

"It's a relatively small market with a certain risk profile," Thom said. "Its economy is a little bit more exposed to exports than Indonesia's but on par with Thailand's, for example. If we see a sudden deterioration in the global economy, led by events in Europe, this could trigger a reversal of flows."

Despite the growing short-term risks, analysts say the long-term fundamentals remain strong. They say the market should still be able to perform well, provided that that economy stays its course and the corporate sector continues to report steady earnings growth.

In fact, O'Neil of Asean Investment Management expects Phillipine stocks to gain as much as 40 percent over the next two years.

- By CNBC's Jean Chua.

Copyright 2011 cnbc.com

First Published:Jul 4, 2012 9:00 AM IST