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I've said before that investing in China today is like investing in the US in the early 1900s - it's the wild west (or more appropriately, the wild east), and the rules are not well defined. But the opportunities are still there, and many China stocks offer huge gains for investors.

We've been aware of these risks, and accept them when pursuing outsized gains in these types of volatile stocks. But that doesn't mean that we should ALWAYS stay in them or keep buying shares for our retirement portfolios - we're investing in these companies to make money, not as activists.

So what, if anything, does it mean for investors in China and for investors in small-cap China stocks? It means two simple things:

  1. Don't invest in China unless you can handle the risk.
  2. Remember the China Discount.

By now the above should be obvious - but what might not be so obvious are the specific risks inherent to investing in these types of companies. Outlining all of the risks would take a 1000 page manual, so I'm not going to do it. But I'll outline the basics:

First, China is a communist country. This means it is a totally different investment climate than the US. The 2010 Index of Economic Freedom ranks the country 140th in the world in terms of economic freedom, with a total score of 51 out of 100. The following graphic gives a little more color. Click here to see a lot more of the details on China's Economic Freedom rankings relative to other countries. Bottom line, expect that public-private partnerships in China are the norm, but they are vastly different than those found stateside.

(Click to enlarge)

Second, accounting rules and tax law in China is totally different than here in the US China has a value added tax (VAT) that applies to certain types of businesses, as well as a business tax that applies to others - most notably service industries. Reports vary regarding the efficacy of China's oversight of tax reporting and collection.

Despite best efforts to come to some agreement on International GAAP (Generally Accepted Accounting Practices), investors in China based companies do not get two versions of financials. Differences exist between Securities and Exchange Commission (SEC) financials and Chinese State Administration for Industry Commerce (SAIC) financials - most likely because of different tax regulations but also because it's almost certain that loopholes exist between the different systems, governing bodies, regulating authorities, etc. etc. Accounting is more art than science, and there are people - not impassioned machines - doing these jobs.

In summary, the potential to avoid oversight and regulation, engage in fraud, etc., etc., is greater in China than here in the U.S. So risk is greater - but reward can be great too. The following chart shows the relative performance of China's Shanghai Index, the S&P 500, L&L Energy (NASDAQ:LLEN), a company I've been bullish on, and two companies discussed in the Barron's article: China Green Agriculture, and China Natural Gas over the last 355 days.

(Click to enlarge)

Notice the vast outperformance of the individual stocks over this period. And the following chart shows the Shanghai Index, the S&P 500, and the Russell 2000 small cap index over the last ten years.

(Click to enlarge)

Notice how, even after a massive pullback, the performance of the Shanghai Index still trumps that of the S&P 500 and the Russell 2000.

The prior discussion and above charts bear out what should be clear (even though my stock selection doesn't represent a statistically significant sample): there is great risk and great reward potential for investors in China.

I can't tell you exactly where the Shanghai Index will be one year, or ten years from now. But I bet that it will be higher than it is now. That doesn't mean that there's not still going to be huge bumps along the road for investors and highly volatile China small caps, but having some exposure to the Chinese market seems well worth the risks to me.

Of course, it's important to choose the right companies. And as a starting point I'd look for those trading at a deep discount and those where management is transparent with shareholders.

The recent Barron's article, the protagonists with pitchforks, and the plummeting share prices of many China small caps, are all signals that investors have had about enough of the opaque investing climate for now. Look for the strongest companies to counter with shareholder communication initiatives. Yesterday, China Natural Gas announced that it had retained big four accounting firm Ernst and Young to help the company sort out its current mess.

I'll continue to look for great opportunities to invest in China small cap stocks, and to try to limit the risks. Hopefully the above helps you decide if these types of investments are right for you, and to explain why there is so much interest at present on these stocks.

Disclosure: No positions

Source: The Mystery of the China Discount, Part 2