What does it say about investors when a sloppily researched, negative article by one Ian Bezek, amateur investor, recent Colorado State University graduate, and lover of cats, chess, and Mexican food, was able to shave 10% -- or $40 million -- off the value of Nasdaq-listed Yongye International (Nasdaq: YONG) on Monday morning? It says that when it comes to small Chinese companies, investors are scared as heck. It also says that many have not done the level of due diligence necessary nor diversified their portfolios sufficiently to be able to take the risks associated with investing in this volatile and murky sector.

As a result, whenever some small research shop, hedge fund, blogger (anonymous or not), or short-seller raises questions, the stock drops dramatically before the claims can be examined in any depth by any rational person. That's why small Chinese fertilizer maker Yongye dropped 10% after Bezek called its story "too good to be true" and presented flimsy evidence to insinuate that the company was stealing cash from investors and lying about its recent rapid growth. This is stupid, but blind selling in situations like this is passing for investment advice in some circles. Columnist Rick Pearson advised readers recently that, "When a serious and detailed allegation of fraud surfaces, sell. Sell immediately."

Pearson's advice should not have applied in this case since it's a stretch to call Bezek's effort either serious or detailed (see Yongye's related press release for an easy rebuttal), but the net effect was the same. Investors are struggling to separate fact from fiction in the world of small Chinese stocks, and they're making bad decisions as a result.

Opportunity knockingĀ 
This has not gone unnoticed across the investing universe, and a cottage industry has sprouted up around shorting a small Chinese stock, releasing a negative report, pushing it out through various unregulated channels, and then profiting as the stock drops and covering. Yet just as there is truth in every jest, small-cap Chinese companies are not meritless targets for short-sellers. Many struggle with corporate governance, transparency, and internal controls, are poor capital allocators, and often pursue rapid revenue growth at the expense of efficiency and profitability.

Even some others are frauds. RINO International was delisted after it admitted, as firm Muddy Waters alleged, that it had not entered into contracts it told investors it had signed. And be forewarned: There are other fraudulent Chinese companies out there (and I remain convinced that I've toured a few of their factories while visiting China in search of investment ideas).

All of this is in the headlines thanks to a Barron's story this past summer, Bloomberg's story on Texas short-seller John Bird and his discovery of discrepancies between the numbers Chinese companies are filing with China's State Administration for Industry & Commerce (SAIC) and with our own Securities and Exchange Commission, the recent RINO blow-up, high-profile mentions in The Wall Street Journal and New Yorker, and the announcement of an SEC investigation into the sector. But it is not new news. In fact, the origins go back to March 2008 when Mark Cuban's Sharesleuth website wrote about a company called China Fire & Security (Nasdaq: CFSG).

Begin at the beginning
When Sharesleuth published its negative report on China Fire, Cuban was already short the stock. The stock dropped from $7 to less than $4 in a matter of hours as China Fire struggled to respond. Sometime after, Cuban covered his short, profiting handsomely even though China Fire went on to rise to more than $18 per share by the fall of 2009.The stock has since declined again for myriad reasons, including real problems in the business such as rising accounts receivable, but China Fire's long-term performance doesn't matter as much as the fact Sharesleuth revealed a powerful profit model that has since been franchised.

There are two perspectives why this activity continues today with such frequency. The first is that fraudulent Chinese companies continue to list in the U.S. and make themselves targets by doing so. The second more cynical take is that sophisticated investors have discovered they can make some money forcing Chinese stock prices down, regardless of whether their allegations turn out to be true (and the jury remains out in a number of cases). Either way, "reports" on small Chinese companies are not going to stop being published around the Internet anytime soon.

What to do with this information
Knowing this, one can either decide that the sector is too hairy and too volatile for capital (a fair decision) or endeavor to learn more about China, its business practices, and its companies and market opportunities and prepare yourself to intelligently buy when others are blindly selling. Bezek's errors, for example, were easy to spot for anyone who follows Yongye. He wrote that it was implausible that Yongye could have opened some 20,000 stores since 2007 with only 399 employees. Heck, how could the company even staff those stores? But what Bezek failed to note about Yongye's business model is that it doesn't open, own, or operate those stores. Rather, it sponsors existing stores in small villages across China and works with them to promote its product. So the people opening and staffing Yongye's stores aren't Yongye employees at all.

Similarly, another tried and true data point for short-sellers is to point out the aforementioned discrepancies between SEC and SAIC filings. Although this is a more substantive debate, there's reason to be skeptical of these repeated claims. Consider, for example, the case of Sahm Adrangi of Kerrisdale Capital, who recently posted a negative report about China Education Alliance (NYSE: CEU) on his firm's website. Among his pieces of evidence was the observation that "the company's local filings to the Chinese government show that the online business generated less than $1 million in revenue in 2008."

But Sahm Adrangi is also the previously anonymous Chinese company analyst who, upon discovering that the local filings for short target China Marine Food (AMEX: CMFO) suddenly matched the SEC filings, wrote, "This by no means leads me to believe that CMFO has been accurately representing itself in its SEC filings. ... I believe that I have overestimated the veracity of SAIC filings in my previous article. Now I think they can be falsified just as SEC filings can." What this demonstrates is that Adrangi is consciously not interested in presenting reliable data to support his investment cases, but rather happy to make use of whatever tactics have been effective to persuade -- or scare -- others.

Good luck to the SEC
Ultimately, resolution, to the extent that investors will get any, looks like it lies in the hands of the SEC. That's another scary thought, but at least that agency is investigating China-based companies listed in the U.S. as well as the auditors, law firms, and investment banks that helped them come public. This part of the market is the Wild West right now and would benefit from additional oversight.

Yet the biggest winners who emerge from this investigation may actually end up being the Chinese companies themselves. Legitimate operations that improve corporate governance, upgrade their auditors, and continue to trade after lesser operations have been purged from the market will benefit from higher valuations. The key, of course, is identifying those legitimate operations and having the emotional wherewithal to hold on during this period of volatility.

The global view
We continue to invest in China at Motley Fool Global Gains, but we do so carefully, only after meeting companies on the ground in China, and via a diversified approach that combines small Chinese companies such as Yongye with larger Chinese companies such as Guangshen Railway (NYSE: GSH) and multinationals such as Coca-Cola (NYSE: KO) within a broader basket of China exposure. As a result, although we hope that our diligence will prevent us from suffering a blow-up, we're confident that one disaster won't torpedo our overall returns.

Furthermore, we look to build long-term relationships with our investments in China, endeavoring to get to know management over time and judge their decision-making over a multiyear period. That enables us to rationally examine any negative reports on our investments and add to our positions, as I did personally on Monday with Yongye, when it merits.