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Is it time to get over your fear of Chinese stocks?

Investors have shown signs in the latter part of 2013 that they are ready to overcome their fear of Chinese stocks. That's a big change in risk appetite for what had become a "don't touch" list of U.S. listings from the hottest overseas market.

In 2010 alone, thirty-eight Chinese companies listed on U.S. exchanges. But by 2011, allegations of fraud by short-sellers, auditor resignations, stock delistings and investigations by the SEC all but killed the market. By 2012, privatizations outnumbered IPOs, and only two China-based companies went public in the U.S. in 2012—social entertainment platform YY and flash sales site VIPShop.

Both of the 2012 IPOs have performed well, and this year there have been eight Chinese company IPOs listed in the U.S.

David Williams, an investment banker with Palo Alto, Calif.–based Williams Capital Advisors, expects that number to double in 2014. "The wariness about Chinese stocks is gradually being overcome," Williams said. "Investors who were spooked out of the market are going to flow back in."

(Read more: World's top-performing stock markets)

Bigger than Twitter
The focus is likely to remain on Internet companies, the most common type of Chinese company to list in the U.S.—Chinese search engine Baidu and e-retailer Dangdang were modeled after successful U.S.-based Internet businesses and got high market valuations on U.S. exchanges.

This year's top China IPO has been online sports lottery 500.com. Travel search site Qunar has also performed. In fact, the eight Chinese company IPOs had an average increase through early December of 50.3 percent from their trading debut, according to S&P Capital IQ data.

(Read more: The hot IPO action will be in China)

"U.S. investors are growth-focused, and Chinese companies are delivering growth," said Brewer Stone, managing director at Pacific Crest Securities in San Francisco. "We are seeing good performance of quality companies listing out of China, particularly this fall, and that is opening up the new issue market."

If you're willing to pay 300 times EBITDA for Twitter—as investors currently are—why not an Internet company penetrating the largest market of all?

Man looks at share prices at an electronic stock board in Shanghai, China.
Tomohiro Ohsumi | Bloomberg | Getty Images
Man looks at share prices at an electronic stock board in Shanghai, China.

The Hong Kong Exchange, where 29 mainland Chinese companies listed this year, has become an alternative to the U.S., but recent successes like 500.com and Qunar could prompt dozens of high-growth start-ups financed by Sand Hill Road venture capitalists during the 2006–2009 boom—in e-commerce, gaming, mobile apps, cloud computing and digital media companies, as well as a broader cross-section, including education, retail and health-care businesses—to test IPO waters in the U.S.

This from a man who knocks Chinese stocks
"Are they any safer today? The answer is yes," said Andrew Left of Citron Research, which was involved in uncovering the Chinese reverse-merger stock frauds of recent years. "The reason is that what makes any of them unsafe is resignation of an auditor. All the frauds had one thing in common—resignation of an auditor—so any U.S.-listed Chinese company that made it through 10, 11, 12, and 13 in compliance with an auditor is less of a risk to fail audit now." As for new listings specifically, Left said, "The ones that have gone public lately look pretty in step with U.S. internet IPOs. And there is more opportunity in Chinese Internet stocks than U.S. ones."

(Read more: ETF investors pouring billions into country funds)

Some big risks remain for investors. For one, it's uncertain if the complex corporate structure of many U.S.-listed Chinese Internet companies known as variable interest entities (VIE) will continue to be allowed by Chinese courts. VIEs allow foreigners to bypass Chinese laws and invest in Chinese Internet companies through an offshore holding, typically in the Cayman Islands. Investors could end up having few rights in a VIE if Chinese courts strike them down.

The SEC and regulators in Hong Kong recently added a requirement that companies disclose this risk in their filings, and Baidu was among the companies to comply. Left dismissed the requirement as a "new warning label on a cigarette," but he downplayed the VIE issue. He doesn't believe push will ever come to shove with the VIE structure. He said if companies like Baidu ended up disenfranchising overseas shareholders, "that would put China back financially and economically reputation-wise 100 years. No one would ever invest in China again anywhere."

At least one noted short-seller of Chinese stocks remains skeptical.

"The coming wave of China IPOs isn't necessarily safer than before," said Carson Block of Muddy Waters in an email.

A report from Muddy Waters in October alleged inflated sales at NQ Mobile—which went public in 2011—leading to half of the company's share value being erased. The company has publicly deniedthe allegations made by Muddy Waters. Left said even though he is confident saying Chinese stocks are "safer" today, that's a relative judgment, comparing today to the recent past, and specifically based on a premise that when it comes to shorting Chinese stocks, "the low-hanging fruit is gone." And he said that since the NQ report from Muddy Waters, three Chinese firms have successfully gone public in the U.S., including 58.com.

(Read more: Why Credit Suisse isn't keen on US stocks)

The untouchables
Since 2010, increased scrutiny by the SEC resulted in 65 fraud cases, while the securities of more than 50 Chinese companies have been deregistered, but the Chinese stock watchers don't take much comfort in the actions of regulators.

"Committing fraud in the U.S. is still a no-lose proposition for Chinese fraudsters," Block said. "The Chinese government has failed to punish one single fraudster ever, and U.S. authorities' remedies have been limited at best. Even worse, the Chinese government continues to obstruct all efforts to ensure audit quality by the PCAOB; generally refuses to cooperate with the SEC in investigating frauds; defies its own archive law by attempting to frustrate attempts to access public records in China."

Left agreed that investors shouldn't bet on regulators. "The SEC hasn't done much ... not a person in jail, and prosecuting people who are un-prosecutable, but one thing we learned in 2011 is that the markets did an amazing job of self-regulation."

The SEC declined to comment on its Chinese stock investigations.

The number of fraud cases decreased from 35 in 2011 to 3 in 2013, according to Harry Edelson, founder and general partner of Edelson Technology Partners, but he said the negative impact of fraud cases against Chinese companies will take years to dissipate.

Top ten performing China IPOs in 2013

Company
Exchange
Return from offer price to date (12/16/2013)
New Ray Medicine International Holding Limited SEHK +496.7%
CT Environmental Group Limited SEHK +153.7%
Wisdom Holdings Group SEHK +119.6%
500.com Limited NYSE +113.8%
China Binary Sale Technology Limited SEHK +91.3%
Qunar Cayman Islands Limited NASDAQ +84.7%
ZMFY Automobile Glass Services Limited SEHK +83.3%
Montage Technology Group Limited NASDAQ +79.5%
58.com Inc. NYSE +72.3%
Autohome Inc. NYSE +64.7%
Source: S&P Capital IQ

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The big bang for China IPOs could come as Alibaba considers a 2014 listing, though the date and exchange (reported to be Hong Kong), remain moving targets. "Everyone is awaiting Alibaba's slipstream. It's on everyone's front burner," said Porter Bibb, managing partner at Mediatech Capital Partners in New York.

Left, who helped to trigger one of the more prominent delistings during the Chinese stock scandals, Longtop Financial Technologies, said he is currently net long in China. But he thinks the Alibaba IPO and the wave of Chinese IPOs coming to market are good reasons for investors to be wary of Chinese stocks right now. "Though there is a tremendous opportunity in Chinese Internet, more than in the U.S., no one wants to miss it, so they just buy them all," Left said.

He also expects many China stocks to drift lower after the Alibaba IPO. "That's the way it always works with catalysts: You buy on the rumor and sell on the news," Left said. And with $50 billion in hedge fund and retail money dedicated to Chinese stocks, assets will be redistributed from current gainers to new IPOs because an IPO "makes other value stocks seems more overvalued."

So for investors ready to get over their fear of Chinese stocks, it may be wise to take a deep breath, literally, before moving to action.

"These stocks could use a breather," Left said. "They've been up a tremendous amount."

Up a tremendous amount, not long after just about everyone in the world was down on them.

By Rebecca Fannin, Special to CNBC.com

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