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Fuqi Fall Highlights Risk in China Small-Caps

In July 2009, Fuqi International (FUQI) raised $105 million from institutional investors via reputable investment banks, all of whom presumably conducted substantial due diligence given the size of the deal.

In addition, Fuqi has research coverage by several well-known investment banks that have presumably done substantial due diligence and maintained an ongoing dialogue with the company and continued to monitor and analyze the company's financial condition.

Finally, Fuqi is listed on Nasdaq, meaning that it has an independent audit committee and has adopted a code of ethics and continues to meet all of Nasdaq's corporate governance standards.

In short, as far as China small-cap stocks go, Fuqi is as "safe" as it gets, and yet Wednesday shares of Fuqi fell by more than 37% (to $11.90 from $19) in one day when the company announced that fourth-quarter results would be delayed, estimates would be missed and past results would be restated. Multiple lawsuits came rolling in within hours.

This time last year, shares of Fuqi were trading at around $3.65. Within six months, the shares hit a high of $32.68 -- a trough-to-peak return of around 800%. Returns like these are the reason why people invest in China stocks. But the Fuqi incident serves to highlight why these returns are possible, namely the greater degree of risk involved.

While the risk level on China stocks as a whole can be considered high, the risk level on OTC stocks should be considered "astronomical." From a corporate governance standpoint, many OTC stocks don't provide even remotely the same level of comfort that Fuqi did. There is often a chairman who happens to be CEO and there are no independent directors and perhaps even a no-name auditor who isn't overly sophisticated and less likely to challenge his client for fear of losing the business. Furthermore, it is often the case that the company hasn't raised capital in years, meaning no outside due diligence has been done.

With these thoughts in mind, I thought it would be appropriate to offer a few suggestions on how to at least minimize your chances of stumbling on the next big loser.

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