China small-cap stocks have seen a number of frauds, near-frauds and alleged frauds this year, all of which have sent share prices tumbling. I have heard from more than one investor who has said that they will no longer invest in any China stocks due to these problems.

The recent case of fraud at Rino International ( RINO) will only serve to make this worse. The Rino case has sent shares of many other companies tumbling, including many clients of their auditor Frazer Frost. Over the past five days, the following Frazer Frost clients performed as follows:

The only one of these stocks to rise was Puda Coal ( PUDA) which announced stellar third-quarter results and has been on a meteoric rise over the past few months.

China stocks should be viewed as high risk, with the potential for high reward. During 2009, there were dozens of stocks that offered returns which were five, 10 and even 15 baggers. Anyone riding that train could do no wrong and made a fortune. However, stocks with that type of upside will naturally have a much greater degree of downside. But in 2009 and early 2010, investors became complacent and felt that these stocks were a one-way ride up. The past six months have shown us that this is clearly not the case.

Now that China small caps are no longer a one-way street, I think that they are not appropriate for many investors but still very appropriate for those investors who have a high risk tolerance and a demand for high returns. But to repeat, these stocks are no longer appropriate for conservative investors.

I currently follow 302 China companies and track all of their technical and fundamental data. This is actually much easier than it sounds if you use the right software. I use a program call XLQ which can be obtained at www.qmatix.com. I highly recommend it.

In the following chart I analyze the 302 China small caps that I follow (over $30 million market cap and with adequate liquidity). The data shows that over the past two months, 206 of the stocks have risen while only 96 have fallen. That is a fairly bullish ratio. In addition, there is a built in skew to these returns. It may sound like an odd way to reason, but the fact is that in this type of volatile stock, your downside is limited to 100% while your upside can be several hundred percent. As a result, the average return on these stocks has been a positive 12.6% over the past three months. With three stocks more than doubling in just two months ( China Shen Zhou Mining ( SHZ), Far East Energy ( FEEC), and Air Media Group ( AMCN)(AMCN)).

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