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.

Always Do Due Diligence Before Buying a Stock

With most stocks, I typically follow their trading patterns and research their fundamentals for weeks or even months before I buy. I risk the fact that the stock might go up (and I would potentially miss the trade) and spend the extra time doing research, and in the end I know more about the company. Even if I pay a higher price, the extra comfort level is worth it, and there is always the option of simply not buying the stock if the price is too high. You can always move on to the next stock.

On one recent investment, the stock was trading so cheaply that it looked like something must be wrong with it. After reading all of the financial statements and company filings, the story looked compelling. I only bought the stock after I verified that the company used an auditor I trust and that it had an independent board, with and audit committee chaired by an experienced financial chief of another U.S.-listed company, which is listed on the New York Stock Exchange.

I also verified that a number of well-regarded institutional investors recently bought into the stock in a private placement, which gave me comfort that the numbers were real. The numbers seemed great on the surface, but I didn't buy until I became comfortable that I could actually trust the numbers.

It should be noted that Fuqi met all of these criteria and yet these accounting errors slipped by its auditors, its audit committee, institutional investors, research analysts and investment bankers -- all of them! Clearly, these events are often almost impossible to foresee. In short, proper due diligence can help to minimize these risks but cannot eliminate them.

At a bare minimum, investors should never buy a stock without having first read all of the recent 10-Q, 10-K and 8-K filings. Before buying a stock, investors should also have a very good understanding of insider ownership by management as well as any recent buys and sells by management. Particularly with U.S.-listed China small-caps, it is important to understand if the company has an independent board of directors and who the auditor is.

For gathering this type of data, the site I use daily is www.secinfo.com and I highly recommend it.

Never Buy or Hold What You Don't Understand

In August 2009, I became aware of a great value play in New Energy Systems ( NEWN.OB). I spent several weeks researching the stock, comparing scenarios with other investors and even visiting the company's factory in Shenzhen. The company didn't have an independent board or audit committee, but I decided to take that risk anyway. I ultimately ended up "loading the boat" with shares on New Energy at prices around $2, confident that I had a winner.

The stock price was a rollercoaster, but it never made me nervous because I felt I had a bargain. In fact, I bought more on the way up. A few months later I sold the stock at prices in the $8 to $9 range. Why did I sell? Because the story had changed. The company completed two major acquisitions that were paid for by issuing large amounts of stock. I didn't have a firm grasp on whether or not the additional income from the acquisitions would offset the additional dilution from the issuance of shares.

I liked the company, I liked the industry and I liked the management, but still I sold. The reason why is that I refuse to own what I don't feel that I understand. I strongly suggest to investors that you never hold what you don't fully understand, and if the story changes, sell first knowing you can always buy back in later. (Note on New Energy: Now that management has provided full transparency on the details of the acquisitions, I am currently re-evaluating whether or not to buy back into it. When I get an answer, I'll do a follow-up story here.)

Another stock in which I'm on the sidelines is China Sun Group ( CSGH.OB). At some point in time the company will hopefully announce new contracts for its lithium iron phosphate batteries and the stock will likely jump 20% to 30% that day. I have resigned myself to missing that ump and buying in on day two after the contracts are announced and provided that enough detail is disclosed.

Before buying a stock, and while holding it, investors should be comfortable with what they feel is the stocks "fair value." At any price below fair value you should feel that you own a bargain. If you have done your research and come up with an ironclad idea of a stock's true value, then you will not be nervous if a stock falls a bit when the day traders sell. In fact, you may buy more. But if you don't understand it, then sell it.

Check back tomorrow for Part 2.

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.

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