On the occasion of bidding farewell to the old and welcoming the new, although we have already written a summary, we still feel the need to repeatedly thank our investors for their long-term trust and support.
During the second half of the Year of the Rat and before the Year of the Ox, the market has already shown signs of exuberance, with numerous bullish stocks and investment opportunities abound. On the other hand, since mid-2020, our net worth has remained relatively stagnant, experiencing significant volatility in September and October 2020. Therefore, we are even more grateful for the patience and trust of our investors.
In summarizing this phenomenon, we can certainly complain about the market (at least in some areas) being in a bubble, or even a severe bubble. But more importantly, we need to reflect on ourselves and whether there are obvious issues in our cognition, particularly in our investment framework and methodology, to avoid the risk of missing out on significant opportunities in the future.
As we have repeatedly mentioned in our previous articles (see the compilation of essays "Investment Reflections"), our investment methodology can be summarized as "Global Systematic Value investing in Growth." "Global" and "Growth" mainly indicate the areas where we seek opportunities, while "Systematic" and "Value" form the core of our investment methodology.
Let's briefly elaborate on our investment framework: "Value" implies a relative undervaluation compared to the future "intrinsic value." This does not simply mean undervaluation based on current financial indicators. It involves many judgments about future intrinsic value and investment strategies after fully considering the timing and risks of realization, and discounting them.
The "intrinsic value" here is more based on mathematical concepts that have a more solid foundation in terms of cash flow returns. This means that our judgment of "Value" is based on the evaluation of future free cash flows, adjusted for risks and based on mathematical calculations.
"Systematic" means that the methods on which we base any investment decisions are systematic, reusable, and not just a one-time stroke of inspiration. "Systematic" is a process that aims to transform complex and uncertain investment decisions into a simple, well-defined judgment criteria, and a more engineering-oriented approach.
The reason systematization is important to us is that we need to establish a set of evaluation criteria to assist us in making portfolio decisions, such as the profit potential of the target, the risks, the certainty, the correlation with other assets, whether to buy or sell, how much position to take, and the level of risk to bear. Without this evaluation standard, our investments may feel too arbitrary and reliant on luck. Although hitting a stroke of luck can sometimes lead to success, it is difficult to ensure the sustainability of success because we cannot control the timing and extent of luck. The stability and evaluability of win rates are the core goals of our systematization. The compounding effect serves as the benchmark for our evaluation results.
We believe that the true charm of value investing does not lie in its appearance of greatness and righteousness, but in its core foundation built on mathematics, probabilistic thinking, engineering thinking, systematization, compounding, and other more fundamental first principles, which are less prone to errors over a longer time frame.
Our pursuit of capital returns oriented towards compounding makes it difficult for us to seize many opportunities. Our investment evaluation is based on compounding as the benchmark, rather than simply relying on indicators such as space or returns. This means that we need to consider factors such as time cost and corresponding risks, which are important, and our nature and demands as an investment vehicle (see the article "The Dilemma of Step Function and Hedge Funds - Investment Reflections (32)"), implying that our minimum compounding requirement is 15%. This high compounding requirement also means that our investment discount rate may be significantly higher than the market's average discount rate requirement.
This investment approach means that in many categories of pricing evaluations, especially short-term price evaluations that are in a state of overvaluation or even in the phase of low discount rates with excessively high long-term expectations (which can be understood as assets that lack future cash flow returns and rely almost purely on collective beliefs), it is difficult for us to obtain opportunities within our investment framework.
For us, as "Realistic Optimists," it is still possible to lack imagination when it comes to revolutionary products and companies. Therefore, we need continuous introspection and improvement.
In the midst of questioning and negating voices, we find that even in the eyes of very optimistic individuals, the fundamentals of great companies (not referring to stock prices) such as Amazon, Apple, Google, Facebook, Netflix, Tencent, Alibaba, and Maotai are often underestimated, leading us to often deviate from persevering due to short-term valuations, potential risks, and other tempting opportunities.
These reasons are partly due to insufficient cognition and partly due to the anchoring effect of our emotions. This is an area we must strive to avoid and improve in future investments.
However, at the same time, we believe that being a realistic optimist may also have strong vitality in the longer course of human history. Although we may miss some opportunities due to our limited cognition and unconscious psychological reasons, the natural vigilance against overly optimistic and illusory situations brought about by human physiological functions (scientifically explained as a situation where System 2 is triggered due to excessive mismatch with the actual state) is also a reason for ensuring longevity, although it comes at a cost.
Just as we may consider it highly unlikely that we could have recognized the tremendous future potential of Amazon in its early days and may have missed the opportunity, we must have a rational perspective when everyone is enthusiastically participating in the 2000 dot-com bubble, realizing that most (if not all) of the overblown expectations cannot be fulfilled. This failure to meet expectations is not limited to the dot-com bubble of 2000. Even for companies in the 1970s known as the "Nifty Fifty," which seemed to have more solid fundamentals, it was still very difficult to fulfill expectations under excessively high valuations.
From a systemic perspective, we always need to be vigilant about the definition of a bull market by the market, a situation of comprehensive rise or universally high expectations. From a competition perspective, it is unlikely to have a one-sided situation with a competitive advantage. Otherwise, the entire societal return on investment would continue to rise as funds are invested, leading to a bizarre situation where the value of funds severely declines, which is difficult to sustain for those in power.
However, for individual great companies, we believe that an "Adaptive" or "Moving Targets" strategy is still necessary. We cannot rigidly resist innovation and change; we need to embrace change and innovation (in this regard, our ideas differ slightly from those of Warren Buffett). In this era of constant and even accelerating change, sticking to assets that never change may have some benefits, but being overly conservative may cause us to miss out on too many opportunities. We believe that even by following the footsteps of Value Investing guided by Buffett, we can still seize opportunities in growth opportunities as much as possible. However, as mentioned earlier, our cognition is always insufficient. If we don't make an effort to "move our butt" and keep up with the growth of great companies, we may forever remain in a position where we resist accepting them from the beginning.
From 0-1 to 1-10 With more and more new listings, especially many SPACs going public through shell mergers, many companies are still in the very early stages of their business models, and many currently only have some technological development without generating revenue.
Currently, it is still very challenging for us to evaluate the value of these companies that are still in the 0-1 stage using our existing pricing models. On the one hand, we currently have no way to conduct rational and systematic (meaning stable win rate judgment) value assessments of these companies. On the other hand, it poses significant challenges to integrate the investment and position judgments for these types of assets with our systematic pricing and risk analysis for other categories of companies.
Until we understand these issues and have a way to rationalize our methodology, we prefer the "hammer swinging" approach that may have the potential for greater stability and superior long-term performance, rather than learning "all the skills" at once.
Valuation Drift and Transfer of Analogous Objects Facts constantly prove that humans always lack reasonable understanding of the future world, either being overly pessimistic or overly optimistic, fluctuating back and forth, as no one has the ability to foresee the future (otherwise, they would be the world's richest person or ruler).
People's imagination of the future mainly relies on linear extrapolation from the current situation and analogies. Either they believe that a favorable situation can be maintained for a long time, or they judge the future prospects of things and companies based on successful existing companies. Although this judgment criterion is often correct, it frequently goes wrong, and the key issue is that no one knows when it will go wrong.
The change in analogous objects often leads to drastic changes in pricing systems, creating significant investment opportunities. We have summarized some of these phenomena during the 2014-2015 period ("Analysis of A-share Pricing Mechanism and Discussion on the Current Market (2) - Valuation Stratification and Anchoring Effect").
Although we are often amazed by the tremendous impact of these recurring phenomena, we do not have a clear answer on how to better grasp them and develop a systematic method to study, track, judge, and make decisions about future investments.
An important reason is that we believe various types of analog valuation methods or attempts to use simple indicators (including PE, PB, EV/EBITDA, market cap/users, market cap/influence) are shortcuts to help us make judgments about future value assessments. These methods are undoubtedly useful and can help us approach answers quickly, but the downside is that they are only approximate methods and are often subjectively adjusted based on market sentiment.
What we need to do is to fully understand these valuation analog methods, listen to various perspectives, and continuously return to the first principles of value assessment. Although it may be difficult to do this for many assets, the advantage is that we do not need to seize every opportunity, we only need to make reasonable evaluations of assets that we can price reasonably.
Or is it about eternal belief?
Of course, there is also an argument that with the proliferation of capital and the prevalence of trends such as WSB (WallStreetBets) and YOLO (You Only Live Once), many stocks can rely on belief and remain in a situation that cannot be explained by fundamentals, the so-called "f**k fundamentals" argument. Fundamentals are not important at all; as long as there are believers and continuous expansion.
We believe that the existence of faith and its impact on pricing is indeed objective and reasonable. Pricing does not necessarily need to be supported by future cash flows. The existence of faith can endure in the long term. The example of gold, which has been regarded as a form of faith and pricing logic for thousands of years, is a typical case. Another prominent example is religion, which has a foundation of faith spanning thousands of years. Religion does not rely on cash flows as its basis; it is enough for people to believe and continue to believe. The ability of religion to generate cash flows in human society far surpasses that of modern belief assets. For instance, the historical tithe in medieval Europe demonstrates how faith alone can establish pricing power equivalent to that of a nation. This is also why PayPal has advocated for companies to establish organizations similar to religious faith.
We fully acknowledge the existence of asset miracles generated by such beliefs. For example, the pricing and value of Bitcoin ultimately depend on the "evangelizing ability" of the emerging currency community. Therefore, any high or low valuation may be reasonable.
However, investing based on the judgment of a group's level of belief presents significant challenges for our system. Currently, we do not have a framework to systematically study, track, judge, and make future bets based on changes in group belief. The decision-making mechanism of a group, although influenced by the public, is also discrete, which can result in significant volatility and arbitrariness. Thus, forming a consensus and ensuring conviction is not diluted during the continuous expansion process is rare and difficult. Throughout human history, sustained and widespread consensus has mainly been achieved in three major religions, gold, and other rare assets. Other examples of consensus may include collectivism and liberalism, which have the potential for long-term existence and continuity.
Therefore, for us, faith-based investments are extremely challenging. We do not know how to establish rational pricing or systematize the process. Moreover, looking at the course of history, it is not easy to rely on numerous individuals forming long-term, united, and pure consensus of belief. Therefore, it is overly optimistic to think that the current market, with its numerous so-called beliefs and reliance on forums, WallStreetBets, and YOLO, can dominate the pricing power of Wall Street. The scarcity and purity of belief are essential for the birth of faith (which is why polytheistic religions find it difficult to surpass monotheistic religions, as the power of belief is easily diluted).
In summary, "Global Systematic Value investing in Growth" is the core of our value evaluation methodology.
It certainly does not guarantee that we capture all opportunities or that all our judgments are correct.
Our work revolves around refining our methodology and continuously upgrading our understanding, rather than conducting extensive customized evaluations for individual opportunities in an attempt to adapt to the market.
Such an approach would result in fragmented, non-systematic, and arbitrary evaluation work. While we need to continuously enhance our understanding in fundamental research, we should primarily return to the essence and first principles in our aesthetic standards, making them more systematic.
The Year of the Ox has arrived, and regardless of our past successes or failures, we should let go and embrace a Day One mindset to start anew.
BEDROCK
2021/02/12
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