Rick Pearson is a Beijing-based private investor focusing on U.S.-listed China small-cap stocks. He is a contributing writer to TheStreet whose views on these stocks are independent of TheStreet's news coverage.


TheStreet ) -- Until quite recently,

China MediaExpress

( CCME) was the

house favorite stock to own. The stock has tripled in a few months and was recently ranked No. 1 in


China 200 small- to mid-cap company survey and has


as its auditor.

Yet yesterday, a negative report by

Muddy Waters

research lopped more than 30% off the value of the stock on more than 10 times daily volume. This follows closely after a similar report by

Citron Research

which dropped the stock by 15-20%. As of now the stock is off by more than 50% from its highs of just a week ago.

China Agritech

( CAGC) was also the subject of a short report,

dragging its stock down by around 10%.

The purpose of this article is not to express an opinion on the validity of CCME, but is rather to point out how investors can (and should) reduce their risk in these types of situations.

I have received a large number of emails on CCME in the past two days. Most of it, I find very concerning. The concerns are not regarding CCME itself, but regarding investors' excessive risk-taking with this stock. One investor told me that even after the first short report by Citron that CCME still comprised 40% of his portfolio. Another investor told me that at a price of $17.50 he was aggressively selling naked puts to "capture the excessive volatility."

The stock traded as low as $10.31 with put option prices increasing by as much as 3-5 times. Everyone had the right to make their own investment decisions, but these decisions clearly reflect excessive confidence in a single stock which is always very dangerous.

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It is my belief that a big contributor to the size and speed of the decline was the fact that many bullish investors held huge positions on margin. Everyone knows that margin magnifies both gains and losses -- that is nothing new. But what some people fail to realize is that their broker can change the maintenance margin on a whim, resulting in an immediate margin call and potentially an immediate involuntary liquidation of stock, permanently locking in a loss even if the stock rebounds.

I am of the opinion that many sellers yesterday were involuntary sellers. The lesson here is that investors should use margin with extreme caution and should be fully prepared for the margin requirement to be changed at any time.

A lesson I am also learning is that it's now more important than ever to go overboard with due diligence. A year ago, if a business were simple, I might pay the company a one-day visit to get more familiar with it before investing. But with the wave of short-seller attacks, I am finding that it makes sense to look at all potential investments from the point of view of a possible short seller, and aggressively try to poke holes in a company's story. If it is too difficult to poke holes in the company's story then the shorts are likely to attack elsewhere, which is what I am looking to accomplish.

On my most recent visit to

SkyPeople Fruit Juice


, I even came close to making a nuisance of myself. The company said it had begun sales to


(WMT) - Get Walmart Inc. Report

, so I visited Wal-Mart to buy their products. They talked about their strong distributors, so I visited the distributors.

They claimed to be FDA- and kosher-certified, so I demanded proof of certification. This is all very time-consuming and expensive from a travel perspective, but it is clearly what is required going forward given the vulnerabilities of Chinese companies to short attacks.

SPU stock was steadily rising while I was doing my due diligence and I missed out on the chance to buy in at a lower level, but ultimately I bought a stock which I knew I wouldn't lose sleep over. Other factors which gave me comfort on SPU (in contrast to CCME) were the fact that there is low short interest, limited stock borrow and virtually no trading in put options.

These technical factors make it an unattractive candidate for a short seller to attack. Avoiding the short sellers is now a key investment criterion for me, and was one of the factors which made me reluctant to invest in CCME.

I visited a number of companies during January and there is a new common theme. At SPU and other China small-caps, even the rank and file employees now regularly ask me why they are getting so many new visits from foreigners. To the employees, their business hasn't fundamentally changed but suddenly investors are taking a much keener interest in having in-person visits.

The types of investors making these visits tend to be sophisticated, have resources and are just as likely to go long as they are to go short. While CCME was a crowd favorite among U.S. investors, the short interest was absolutely huge. A high short interest doesn't guarantee that there is a problem with a stock, but it can indicate that informed people have strong concerns.

More importantly, it can also indicate that short sellers are highly motivated to publish an inflammatory short report. I used to be a fan of the short squeeze play on wrongly shorted stocks. However, the shorts seem to have the upper hand these days, so now I am avoiding heavily shorted stocks out of fear of the seemingly inevitable short report that will be released.

Finally, the notable increase of in-person visits to these companies indicates to me that institutions still have an interest in buying China small caps because the valuations have been pummeled across the board. But differentiating the good stock from the bad will now be more important than ever.

Disclosure: The author holds a long position in SPU.

The author can be reached for comments at comments@pearsoninvestment.com.

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This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

Rick Pearson is a Beijing-based private investor focusing on U.S.-listed China small-cap stocks. Until 2005, Pearson was a director at Deutsche Bank, spending nine years in equity capital markets in New York, Hong Kong and London. Previously, he spent time working in venture capital in Beijing. Mr. Pearson graduated magna cum laude with a degree in finance from the University of Southern California and studied Mandarin for six years. He has frequently lived, worked and traveled in China since 1992.