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3 Risks to Avoid When Investing in China Stocks

Plus 2 China stocks to sell

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As the number of Chinese companies listed on major U.S. stock exchanges grows, it is more important than ever to identify pitfalls associated with investing in China stocks.

Here are three potential risks that can hurt Chinese companies in 2011 and how to avoid them:

#1 Short-Seller Attacks: One of the most significant pitfalls in investing in China stocks today is attacks by short-sellers. Numerous successful short-seller attacks this year showed how easy it is for shorts to profit by making accusations — no matter whether true or not — against Chinese companies and drive share prices lower. And in 2011, I expect to see more short-seller attacks against Chinese companies.

Because most of the companies targeted by short-sellers are companies that were listed in the U.S. through reverse merger, we can sidestep most short attacks in the future by largely avoiding reverse merger companies next year. It is also increasingly important to invest in companies backed by top-tiered global investment banks that can fight off attacks from short-sellers.

I think reverse-merger stocks that improve their credibility by hiring top-notch auditors, taking corporate governance seriously and improving operational transparency will recover from the sell off. It would also help if senior management buys more stock in the company.

#2 Corporate Frauds: Although most Chinese companies listed in the U.S. capital markets are legitimate, like anywhere else China does have its share of fraudulent companies. One way to reduce the risk of investing in frauds is to invest in companies backed by well-regarded institutional investors that can lend support to the company. Goldman Sachs, Morgan Stanley and Sequoia Capital are some of the firms with substantial investment in Chinese companies.

Another strategy to reduce risk of fraud is to visit target companies in China and check out their operations — exactly what my associates and I do for our China Strategy subscribers. Next year, we plan on visiting even more companies and bringing back updates.

#3 Monetary Tightening: Inflation is accelerating in China, with November CPI numbers coming in at 5.1% over the same period last year. As a result of the higher inflation numbers, Beijing has recently announced that it would be switching to a “prudent” monetary policy from the “moderately loose” policies we’ve seen over the past two years.

Not surprisingly, many China stocks have come under some slight pressure as a result of the news — and the uncertainty regarding speculation of more PBOC tightening and increased efforts by the government to make sure inflation doesn’t get out of hand has introduced extra volatility in the major Chinese market indices, as well as U.S.-listed Chinese companies.

Policies designed to combat inflation, such as monetary tightening, can hurt stock market valuation, which is a potential pitfall for 2011.

But with that said, monetary tightening is not necessarily bearish for China stocks, especially considering that tightening is often a sign of strong economic growth. For example, Beijing raised interest rate six times between 2006 and 2007, yet the Chinese stock market rose with every rate hike during the period. I will be watching the situation closely.

These are the three biggest pitfalls associated with investing in China stocks that I currently see for 2011. Although these problems may arise, I think that with a solid strategy in place investors can avoid most of the damage from these issues.

Start by closely examining your China stocks holdings to determine which stocks make sense to carry with you into the New Year.

Next: 2 China Stocks to Sell Now

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