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I think we can all agree that Chinese small caps are an identifiably risky asset class. As such, I think the conclusion here would be that the probability assessments were too optimistic?

This is where I think this discussion veers into the realm of the academic. The answer to your question is, yes, provided we assign an equal probability of zero value (fraud) to every name in the sector. The real-world counter would be that we can identify variable probabilities based on certain qualitative factors uncovered via further study. Some of those might include the presence of a Big 4 auditor, verified operations and channel checks, etc. For example, while CGA and CMFO offered the same return potential in the example above, I thought we had a better handle on CGA, its business, and management team.

One reason why I think there's still opportunity in this sector for "choosy" investors like us is because the sector is all being treated the same. For example, Roth's price target on YONG is derived by multiplying their EPS guess by 5 -- the average P/E for the sector. Of course, as I've said before, 5 is a stupid multiple to apply. The right one (if you believe in applying multiples at all) would either be 0 (fraud) or something higher (a verifiable growth business). The stocks -- as theory would tell you -- are all being treated the same, but they probably shouldn't be. Some are disasters, and some are not. We've seen some disasters first-hand in China and talked with the CEOs of those disasters. I can say that those have been different experiences from what we experience with, say, Yongye.

if you have non-performance or negative performance it turns out pretty ineffectual (at 0% for the 70% you end up with 3% total return, at a catatstropic -90% you end up with a 60% loss for the portfolio).

This is why we spread our exposure to the small Chinese stocks. I generally thought that no matter what our diligence we would end up with one disaster (a 66% percent batting average would be great, but the risk of getting one wrong was likely catastrophic). This is one reason CMFO was replaced by Chaoda -- a much larger company -- rather than another tiny one. Ultimately, I though we had been too aggressive originally. On the bright side, we initially benefited from that risk and rebalanced before it really bit us.

you either end up with much less protection than you might think (unless you strongly discount negative scenarios)

Again, the key here is that these are not randomly chosen companies, but companies that we believe, based on our work and multiyear study, have a better than average probability of not delivering a negative scenario. If you think our analysis is flawed, though, and have no better than average chance at avoiding a RINO, then the basket will not protect you. Its goal, rather, is to help investors hang in there with something like Yongye, that in terms of its role in the portfolio, while volatile, is a worthwhile long-term holding.

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