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"China is on a treadway to hell" - Jim Chanos

"Dangers lurk in Chinese reverse mergers" - Herb Greenberg

"SEC probes China stock fraud network" - TheStreet.com

Every few weeks it seems another Chinese smallcap faces fraud allegations: Orient Paper (Amex:ONP), Fuqi International (Nasdaq:FUQI), RINO International (Nasdaq:RINO), China Education Alliance (Amex:CEU). The list goes on. In many cases the allegations seem to be correct.

Fears of fraud have many investors fleeing Chinese smallcaps and microcaps altogether, just as many of these companies are improving performance and in some cases, corporate governance. There are huge bargains to be had…if the companies and the numbers they report are real.

Betting on the legitimacy of a company half way around the globe is a gamble that most investors now want to avoid like the plague. That's why the odds are so good. I believe that a diversified basket of Chinese smallcaps and microcaps is likely to outperform most asset classes over the next six months, and I have put a lot of my own capital on the line to test that proposition.

There will be frauds, so owning only one or two of these companies is — in my view — a mistake. I spread my risk capital across a dozen of them, and plan to increase that number over the next month. Some will turn out to be frauds. I accept that. In fact, I always believe that to be the case when investing in a basket of microcaps. It's certainly an enhanced risk in the Chinese reverse merger space, and should not be disregarded. Part of that risk can be managed by watching for red flags and technical signals, but not all. The basket will succeed or fail not because of fraud, but despite it. The remaining companies will have to offset the performance hit from the bad apples.

Here are some of the China stocks in my basket, along with my approximate entry price. I'm not wedded to any of the particular positions and plan to trade the basket actively. However, gun to head, I would say my favorites are China MediaExpress Holdings (Nasdaq:CCME) followed by China Redstone Group (OTCPK:CGPI).

Stock symbol ~ avg. entry
American Jianye Greentech Holdings AJGH.OB 0.81
Artificial Life OTCPK:ALIF 1.07
Bona Film Group BONA 6.01
China Botanic Phamaceutical CBP 1.99
China MediaExpress Holdings OTCPK:CCME 15.05
China Redstone Group OTCPK:CGPI 4.35
China Industrial Lighting CIL 2.80
China Mass Media CMM 3.45
China Sunergy CSUN 4.45
DeHaier Medical DHRM
5.30
Sky Mobi MOBI 5.50
Weikang Bio-Technology Group OTC:WKBT 2.68

Do you have a view on any of these stocks? Is there a China stock you think I should look at? If so, leave a comment.

DISCLOSURE: Long AJGH.OB, ALIF.OB, BONA, CBP, CCME, CGPI.OB, CIL, CMM, CSUN, DHRM, MOBI, WKBT.OB.

Source: Macro Call of the Year: Buy Chinese Micro Caps