Veteran Global Gains members know what we love about China. There's tremendous potential upside there, with many cheap stocks ready to explode in value -- especially among smaller companies.

We can never emphasize enough, however, the dangers that lurk in the world's most populous country -- the nasty traits of some Chinese businesses that make us fear and loathe them.

An emerging giant
There are nearly 2,000 public companies in China. About 450 are listed in the U.S., with that number growing all the time. And many of them are future multibaggers that will make their shareholders rich. Look around, and you'll find businesses such as Sinovac Biotech (AMEX: SVA) and AgFeed Industries (Nasdaq: FEED), up 215% and 299%, respectively, in just the past six months alone.

But we can't pretend these types of winners are easy to find. If you don't know the lay of the land -- the ins and outs of Chinese political structure -- you could quite literally lose a fortune.

Here are just three of the problems to look out for:

1. Hard-to-decipher financials
The Economist magazine sums it up better than I can: "The financial results of companies that global investors wish to buy into can be as unintelligible as the dialect spoken in the company town. It is said (with apparent sincerity) that some Chinese firms keep several sets of books — one for the government, one for company records, one for foreigners and one to report what is actually going on."

In fairness, this was written a couple of years ago, and Chinese financials are a bit easier to understand now. And there's no doubt that American companies also do not make available the books we'd really like to see. Even the ones we can see aren't necessarily easy to decipher -- Bank of America (NYSE: BAC) and Fannie Mae (NYSE: FNM) are perfect examples.

But there's little question that we simply can't get the same lucidity and transparency from Chinese companies that we do from domestic firms.

2. Questionable quality of earnings
Quality of earnings refers to the extent to which financial reporting can be trusted. The more conservative management is with its assumptions, the better we feel about the numbers it reports. A 2008 Barron's article relayed a pretty sobering study from RateFinancials, an independent firm that rates financial reports. Looking at the five largest recent Chinese IPOs -- including LDK Solar and Yingli Green Energy -- RateFinancials found problems with "big increases in receivables, negative operating and free-cash flows, significant amounts of deferred revenues, major prepayments, and sizable long-term commitments to suppliers."

3. Poor corporate governance
China is "perceived to routinely engage in bribery when doing business abroad," according to Transparency International. And in TI's 2008 corruption report, the country falls well below any comfortable level, ranking 72nd. That doesn't mean every Chinese company is dicey, of course, but investors must be on guard. So while investors can check Yahoo! Finance and see that U.S.-based Halliburton (NYSE: HAL), for example, has a much higher-than-average corporate governance rating in the energy sector, such easy tools don't exist for Chinese companies.

To sum it up, our Global Gains team warns that "Shareholders of Chinese companies should know that there is no real apparatus by which their interests are protected and that they are essentially betting on being on the same side as management and the majority shareholders -- who as often as not are branches of the government, the military, and/or the Communist Party." Continued...