Risk Control, Challenges and Corrections
2021 can be said to be the most challenging year for my investment career. It's not because of how poorly our performance was or how much we lost (these are common problems in the investment career), but because of the challenge it posed to our investment methodology, which was beyond our expectations. In short, our investment methodology is based on value investing in growth, which expects to achieve returns from fundamental growth in reasonable valuation, without seeking (or giving up) the game of path-dependent investing (referring to purely short-term stock price fluctuations). Therefore, it can be said that value investing is more of a rational analysis based on probability and odds (regardless of whether it is quantifiable enough, but the underlying idea is based on mathematics). Based on the history of human games for hundreds or thousands of years, rational analysis based on probability and odds can always beat zero-sum games in the long term (because it is essentially zero-sum, if someone wins, someone must lose, not to mention trading costs, and no one can always win). However, the idealized method in practice is also difficult because human nature is very complex, and the world made up of people is also very complex, and your understanding may be flawed and incomplete.
Assuming that your fundamental research is generally reasonable after careful study (of course, it is already difficult enough to achieve this point, and it can only be said to be close to the possibility of perfect prediction in probability), one important logic of value investing based on fundamentals is that value will eventually mean-revert, and prices always swing around value. According to Andre Kostolany's saying, the dog running around the owner with a rope tied to it will eventually return to the owner, no matter how far it runs in the short term. Therefore, value investors can use short-term emotions to focus more on studying the owner rather than the dog. But sometimes reality is not that simple, sometimes dogs are very crazy, and sometimes ropes are not that reliable (they may be too long or broken), so it is difficult to completely ignore the dog and only focus on the owner. Ideally, valuation (or emotion, or the dog's position relative to the owner) follows a normal distribution, with nearly 70% probability that emotional fluctuations are within one standard deviation, and two standard deviations already cover over 95% of the probability. Of course, critics can argue that if a black swan event occurs without a contingency plan, the same fate will happen. This is indeed true, but we need to know that no risk control measures are cost-free. Of course, we can take stricter measures to prevent events that exceed two standard deviations, such as maintaining a low position for a long time, strict stop loss, etc. However, it will actually affect the investment effect more to prevent small probabilities of less than 5% and lead to a serious impact on the long-term return rate, not to mention the original intention of investment.
Note: Of course, the world does not operate according to a perfect normal distribution, but we believe that most of the time it is in the middle state of ordinary and mediocre.
Nothing is free
Risk and return are two sides of the same coin. Some media outlets in China like to criticize the US stock market as if it were on the verge of collapse at any moment. One reason often cited is that US stocks have returned too much to shareholders through buybacks and dividends. (Value investors in the US would probably be dizzy from this criticism since the ultimate goal of investing is to generate returns.) When companies have no better investment opportunities, the best way to maintain their core competitiveness without investing blindly is to return excess funds to investors and give them the opportunity to allocate their money to more efficient companies and other places.
Of course, after a large-scale payout through dividends and buybacks, companies become more focused on their main business, their competitiveness increases, their ROE increases, but their ability to withstand risks is reduced because the proportion of cash decreases. For example, after the outbreak of the pandemic in 2020, the aviation industry suffered a devastating blow, Boeing's stock price plummeted, and it needed to be rescued. Many criticized its behavior of returning capital to investors for years prior to the pandemic, saying it weakened its ability to withstand risks. Although we have never invested in Boeing, we do not believe that its capital allocation before the pandemic was a major problem. For Boeing at that time (especially before the 737 Max accidents), its position was extremely stable in the global aviation market, which was dominated by Boeing and Airbus. The order backlog stretched out for 10 years, and the sale of aircraft accounted for only 40% of its business. Nearly 40% of its revenue came from military industries, which was extremely stable, and the remaining 25% came from the sale of parts and maintenance services for existing aircraft, which had little to do with annual sales growth. Under these circumstances, leveraging to a certain extent and repurchasing shares in large quantities, resulting in negative net assets on the financial statements (only on the financial statements, as it generated a large amount of positive cash flow every year), was reasonable and even outstanding in my opinion. At that time, Boeing's management team probably calculated that if a normal economic downturn occurred, which was roughly a situation where one standard deviation did not exceed two standard deviations, its backlog of orders would be sufficient to maintain its negligible impact. However, reality is obviously more magical. The pandemic, which is rare in a century, occurred and was compounded by the black swan event of the 737 Max accident. The risk index suddenly exploded to a situation that may be three standard deviations away, causing a crisis. (From a conspiratorial point of view, perhaps the management and board of directors even had this contingency plan in mind. Given the impact of Boeing on the national economy, employment, upstream and downstream industries, and brand image, if a century-old disaster occurred, they could just seek government assistance and probably still be too big to fail.) In comparison, holding onto a large amount of cash and not returning it to shareholders, but investing recklessly (a common problem among many domestic companies), makes them big but not strong. I would rather see Boeing not make routine preparations for black swan events that are three standard deviations away.
Mood swings are always swinging
Although the world is currently quite chaotic, with unprecedented changes happening all the time, it seems like standard deviation could be blown out of proportion at any moment. There may be even more explosive black swan events in the future. However, the power of human society and investor sentiment returning to the mean is still very strong, like the force of gravity. Although events and emotional fluctuations do not conform to a perfect normal distribution, we agree with Taleb's criticisms of modern financial theory, such as over-idealizing models and underestimating the proportion of black swan events. However, when developing investment strategies and methodologies, we still need a basic mathematical model as a pricing support, such as our firm belief that emotional fluctuations are swings rather than infinitely extended in one direction. Of course, we need to optimize the simple normal distribution in the model with reality, for example: 1. Some events are structurally damaged and will not regress, such as companies whose business models have been destroyed by policy factors, companies eliminated from competition and unable to survive, and companies that may go bankrupt during a crisis. These companies do not need to rely on mean regression, and their values may not become more attractive due to falling stock prices. 2. The reflexivity principle may cause reality to be influenced by emotions: for example, the more a stock price falls, the more it can affect the fundamentals. The most typical example is when a company's basic trust foundation depends heavily on people's confidence, and stock prices are an expression of confidence. When stock prices plummet sharply, it will have a ripple effect on its investors, depositors, customers, supply chains, and further exacerbate the decline of its fundamentals. The opposite is also true. This will make the distribution of standard deviation more skewed towards both ends than a normal distribution.
So how much risk prevention is reasonable?
Even if we fully consider the potential scenarios of probability distribution, we still may incur losses beyond one standard deviation and even more at two standard deviations because our strategy can only be formulated based on the probability of the vast majority of possibilities, and we cannot always make the worst-case scenario. In fact, the investment framework based on IRR itself has already considered some degree of risk, such as an investment opportunity originally set at 20% IRR, which is equivalent to investing at one standard deviation if the fundamentals are not affected. If a short-term loss caused purely by emotions or market reasons will lead to a future expected return rate of 30% or even 40% IRR, it objectively increases the attractiveness of further investment or holding. In fact, what we need to achieve is to be able to survive even in a magical world and volatile emotions and to achieve the traversal of our investment goals even in extreme situations.
As for risk management, there are only two things we can do:
Try to prevent the portfolio from being unlucky at the same time. Perhaps we can accept that some stocks in the portfolio are unlucky, even very unlucky to deviate from two standard deviations, and still stick to the expectation that they will eventually mean revert, provided that we still believe that their fundamentals have not been affected by their stock price fluctuations. In this way, even if some individual stocks are unlucky, we may have other stocks that are relatively normal or even in a very lucky situation, which can reduce the overall volatility of the entire portfolio and prevent it from being dragged into a range beyond two standard deviations just because of the unlucky performance of individual companies (which is relatively difficult to accept). Objectively speaking, it is very difficult to achieve Buffett's highly concentrated holdings (often 50% of the portfolio is one stock, and for a long time, there are only two industries: consumption and finance) plus low turnover and a 20% annualized return over a long investment career (not necessarily very long, such as 5-10 years), and the drawdown is within an acceptable range. This is because China's macro impact is very significant and basically belongs to exogenous uncontrollable factors. Moreover, the confidence and tolerance of investors behind the company's operation, especially the fund operation, are often challenged. In fact, even the greats like Buffett and Munger eventually chose to close their funds, as can be seen. In fact, when Buffett operated his fund in the earliest ten years (he started operating Berkshire Hathaway after closing his fund), the composition of his portfolio was also sufficiently diversified, with 1/3 undervalued stocks, 1/3 arbitrage trading, and 1/3 holding unlisted transactions. This means that only 1/3 of the portfolio is really affected by short-term market trends, making the operation of his fund more stable. Because our investment methodology determines that we are biased towards long-term and value, it also determines that we are not market game masters and cannot judge short-term emotional trends. Therefore, if we want to achieve a relatively high annualized return (such as 15% or more IRR) while not taking on too much short-term volatility risk, and we are definitely not as insightful and lucky as Buffett was back then, we can only minimize the possibility of entering an unlucky situation at the same time by investing in companies with differences.
Increase the ability to withstand potential impacts: Due to the linkage of the global economy and funds, it is often inevitable to have the same direction of volatility, although it has greatly reduced the probability of volatility beyond one or even two standard deviations (our goal is not to avoid drawdown completely, which is impossible, but to reduce the possibility of catastrophic situations). In addition, more detailed research work (to ensure
Keep patient
One of the biggest challenges in investing is understanding which trends are sustainable and which are temporary deviations from existing trends, and this is often not obvious (otherwise, it would be easy to identify and would not form a trend), especially in a rapidly developing society. Due to human nature, people tend to summarize and extend the current state of affairs. This is fundamentally an energy-saving mechanism, as people's brains tend to simplify the current situation and believe it is sustainable, and will also self-justify its sustainability. Therefore, no matter when in history, we always seem to see the argument that "times have changed and will never return" to prove the rationality of current trends. Especially when many trends and long-term trends are mixed together, it becomes more difficult for people to distinguish them, such as whether we are really at a turning point in a once-in-a-century great upheaval, and many situations are different now? Perhaps the development brought about by technological progress will not stop because of policies, or there are bottlenecks in China? Or is inflation a long-term problem or a short-term problem? If it is short-term, long-term interest rates will still return to low levels? For example, in the current technology and knowledge-intensive society, the widening wealth gap is inevitable, or will it cause a revolution? ...
Most of the time, history is continuous, but there are also many turning points. The core of value investing is to distinguish between long-term trends and short-term ones, and to avoid short-term ones or take advantage of undervalued opportunities to obtain long-term returns. However, the difficulty lies in people's tendency to self-justify, which is inevitable even for relatively rigorous and objective investors. Therefore, it is important to remain conscious of where to persist and to maintain lifelong learning and patience. Almost every period, we see the market completely abandoning some trends and those who were once thought to be trendsetters, just like "violent delight will have violent ends". Similarly, many industries that were once pronounced dead or even dead to the bone have gradually come back to life and rejuvenated (such as the widely regarded junk industry of new energy, especially photovoltaics, as low-tech and highly homogeneous, and heavily dependent on subsidies; or even Maotai and Apple, which fell below 10 times PE and were considered to have no future not long ago). This extreme swing in attitude is often more important than profit growth as the main source of short-term investment returns. This is why many trend investors focus on researching valuation fluctuations rather than fundamental research (again, there are countless investment methods, and there is no right or wrong, as long as you serve investors' assets with dedication and effort without going against your conscience). Of course, from a longer-term perspective, whether the market favors or dislikes, whether it is lucky or unlucky, we still believe that this volatility tends to be conserved, but because of the length of life, career time (the golden period is only 30-40 years), let alone the continuation time of funds and the trust cost time of investors (often only 1-2 years), many correct judgments cannot withstand the pressure and deformation under huge pressure, so it is easy to find a "comfortable" place, which is to self-justify and conform to the market side. Therefore, it is not surprising that there is a famous saying "the market is always right" ... Of course, this is not always the case, otherwise, why would there be such frequent and drastic fluctuations in the market? Since there are fluctuations, it means that the trend before the fluctuations is wrong and needs to be corrected. Similarly, the trend that the current market believes is not necessarily correct ...
The challenge in investing is to understand which trends are sustainable and which are temporary deviations from existing trends. However, this is not always obvious, especially in a rapidly developing society. Due to human nature, people tend to simplify the current situation and believe that it is sustainable, which is a self-justification mechanism. Therefore, we often see the belief that "times have changed and will never return" to justify current trends. The difficulty in distinguishing between long-term and short-term trends increases when many trends and long-term trends are mixed together. In value investing, the key is to identify which trends are long-term and to avoid short-term trends or to use undervalued opportunities to obtain long-term returns. However, this is challenging for investors because of the human tendency for self-justification.
Investors need to be aware of where they need to be persistent and where they need to be clear-headed, and to maintain lifelong learning and patience. Almost every period, we see the market abandon trends and those who followed them, and we also see industries that were once considered dead or hopeless come back to life. This extreme swing in attitude is often more important than profit growth as the main source of short-term investment returns. Therefore, many trend investors focus on studying valuation fluctuations rather than the fundamentals themselves. However, from a longer-term perspective, whether the market favors or dislikes something, whether it is lucky or unlucky, these trends tend to be conserved. However, many correct judgments cannot withstand the pressure and time required for them to return, and they are easily distorted by the huge pressures. The self-justification mechanism makes it easy to find a "comfortable" place that follows the market.
Investment, especially fund management and wealth management, requires calm and rationality in the face of various market behaviors and seemingly plausible but ultimately false logic. It is difficult to achieve and maintain this attitude, which is why it is rare in the world. Recently, many great stories that were touted in 2020/2021 have been proven false or severely weakened. Many companies that we did not buy for various reasons, such as not understanding the "great" story or fearing competition or valuation concerns, have also experienced huge declines in such a short period of time. This is shocking to us, especially since many of these companies were considered highly competitive, such as FB, PYPL, SQ, PTON, ZM, SHOP, SEA, RBLX, U, etc.
However, the steep decline in these companies should be a happy opportunity for value investors because they can now purchase excellent companies at a discount, sometimes as much as 50%, or even 20%, 30%, or 40% lower than before. This is the opportunity that the recent growth stock crash has given us.
Note: Sometimes the market can be even crazier than we imagine, whether it's going up or down.
Of course, shorting is still very difficult.
Even considering the recent sharp decline, purely from a strategic perspective, we still believe that shorting is difficult for value investors. For example, if we look at valuation alone, many companies may have already seemed very expensive after July 2020 (coincidentally the recent drop-back point), but if one started shorting at that time, it would have likely suffered losses within the first half of 2021. According to the speed of loss for short positions, losses can double. If one had a 100% short position, the entire principal would have been lost by January 2021, and one would have missed the opportunity to benefit from the recent return to the original position. In practice, one is often forced to make many trades, selling at high prices and buying at low prices. The transaction costs are enormous. Unless one can accurately predict that January 2021 was the peak and the market would drop thereafter, shorting is not a practical strategy. There are also many hidden costs, the most important being the depletion of energy and the different skill requirements for timing the investments that can take a toll on the team. After all, human productivity is always improving, and there is a certain degree of inflation in economic needs, which leads to the depreciation of currency. In the longer term, the market tends to rise (unless there are exogenous anti-capitalist policies).
I rambled on for half a day, but I found that Charlie Munger's article on how to face massive drawdowns in investing is really well written. I recommend that interested students read it: "Charlie Munger: How to Deal with Huge Drawdowns in Investing? You Need Patience, Discipline and the Ability to Take Losses and Be in Adversity without Going Crazy," 2005.
Looking to the future
First of all, it should be clear that after significant declines in both the Chinese (A/H shares) and US markets, we have become increasingly confident in finding more attractive opportunities in the future. We will briefly discuss some of our views on core market issues: 1. US interest rates and US stocks: Due to current inflationary pressures, the US entering an interest rate cycle this year is a significant paradigm shift, contrasting sharply with the trend of long-term asset inflation caused by the desperate liquidity injection of 0% interest rates since the beginning of the pandemic. This is also one of the reasons why many long-term investment target companies have experienced huge declines since the end of last year. Although the US stock index seems calm on the surface, the decline of many companies, even star companies, has been as much as 50-70%, which is also very surprising. The relatively small volatility of the index is only because: 1) the leading companies' valuations were already reasonable, and not too far-fetched (they are not the targets favored by the 2020-2021 YOLOs); 2) leading companies continue to exceed expectations in their performance, and their performance growth is significant. Of course, we see that the market mechanism of the US stock market is very efficient. Once a company's medium to long-term growth logic is challenged, the market will punish it in a very short period of time. Even giant companies like META, which used to be worth trillions of dollars, can experience a significant decline in the short term when faced with substantial competitive challenges that may cause long-term growth concerns for investors. We do not believe that this round of inflation will result in a long-term loss of control. The main reason is that as the impact of the epidemic gradually fades, supply capacity will eventually recover with the gradual resumption of work, productivity recovery, and logistics system recovery (although it will take time); in addition, under the situation of US Federal Reserve tightening, there is no particularly strong foundation for global total demand. Of course, the current Russia-Ukraine crisis may cause temporary disturbances to our judgment, especially the distortion of energy prices it may cause, which may intensify current inflation risks. It must be said that we are not macro experts. Although we will make some major background judgments, our approach is to establish a relatively safe risk-free interest rate standard at a 70-80% confidence level to calculate the valuation bottom line. For example, the 10-year US Treasury bond rate, which we currently set as the high point of this round of interest rate cycles in 2022, is 3.0% (currently 2.0%), and China is 4.0% (currently 2.8%). According to CICC's calculation results, the current CME interest rate futures imply a 94% probability of a 50bp rate hike in March and 6.3 times throughout the year. From the perspective of asset prices, the number of rate hikes included in current US stocks, US bonds, and gold for the entire year is 4.8, 4.8, and 6.8 times, respectively. According to calculations and market feedback from other institutions, the current expected number of rate hikes for US stocks is 5-6 times. Therefore, we believe that this year's interest rate hikes are not beyond expectations at the moment, and the focus of market games has shifted to whether there will be five rate hikes and whether the rate hikes will continue in 2023, and how negatively the interest rate hikes will affect the fundamentals of the economy and whether they will significantly affect corporate profits.
In history, the phase of the US interest rate hike often indicates a relatively strong economic fundamentals. Therefore, the final trend of the stock index depends on the tug-of-war between the possible downward valuation and the possible upward earnings growth. If there is no serious policy mistakes causing the valuation to decline and the earnings not to grow, the trend of the stock index may not necessarily be bad.
In our strategy selection, we have fully considered not only the potential impact on valuation, but also the fundamental factors of industries with relatively low sensitivity to global macroeconomics. Regarding growth stock investment, since a significant portion of its value is discounted based on future, relatively long-term potential, the limited cognitive ability of humans can severely affect their ability to predict the future. For example, two companies with the same performance, one with a more stable upward trend and one with greater fluctuation, can result in significant changes in investor expectations during a short-term downward cycle. This is also the reason why we are relatively cautious about companies with a long-term outlook but currently facing obvious economic downturns or fundamental challenges. This does not mean that we are not optimistic about their long-term prospects, but rather that we need stronger confidence to support and prove their long-term potential. For example, when we believe a company has 10x growth potential in the future, we need even stronger confidence when it encounters a significant slowdown in growth, even zero or negative growth, in the short term. Currently, companies that have been significantly affected by this slowdown include WFH-related companies that benefited during the previous pandemic period, such as remote work, home life, and even e-commerce and takeout. Especially in this downward cycle, if they also face problems such as competition and market share loss, their impact on long-term pricing will be extremely serious. In the face of the temporary pressure of onlineization caused by reopen, the decline in physical demand and the rise in service demand, as well as the uncertainty brought by interest rate hikes on the overall economy, without a clear view of the medium- to long-term, we still try to choose industries with more structural growth potential. As the first financial report season of 2022 gradually unfolds, our view on US tech stocks has become clearer. Due to the long-term structural upgrade of cloud computing, we believe that its penetration is still in the middle stage this year, and the stability brought by enterprise investment and subscription models will make the process of cloud migration relatively stable and upward, especially since the demand side is mainly from medium and large enterprises, which are more resilient than SMBs. In addition, semiconductor demand is still strong, whether it is from computing demand or automotive demand, mainly because these fields have structural upgrade needs, and as the industry gradually becomes more concentrated and monopolized, the pricing power and concentration of leading companies make their value more prominent. As mentioned earlier, although the apparent valuation of the stock index is still in a historically high position, it has fallen significantly from its peak. Considering the industry status, competitive landscape, and profit stability of current leading companies, we believe that their valuation is relatively reasonable. Of course, market sentiment can change rapidly and there is no guarantee against further decline, but we believe that the current valuation is not in the same overvalued situation as before and there are many good investment opportunities to choose from.
There is a high degree of differentiation in the performance of Chinese assets in 2021, with policy playing a significant role. Many industries that have previously shown strong competitiveness, such as internet, real estate, and education services, have been affected to varying degrees by policy changes. As the economy has significantly declined, consumer-related industries have also started to weaken rapidly, so in 2021, apart from a few industries such as new energy and military industry, most industries have performed poorly. In offshore markets, Hong Kong and Chinese concept stocks have experienced significant volatility due to investor sentiment, even for some stocks that we believe have healthy fundamentals and have not been significantly affected by policy changes. Looking ahead to 2022, the economic inertia is still downward, but the central government's tone is one of stable growth, indicating a certain degree of policy correction and counter-cyclical adjustment. This means that the economic and policy directions of China and the United States this year are somewhat opposite. However, investors are still relatively pessimistic and do not believe that the Chinese economy can stabilize and rebound. We still have confidence in the central government's determination and motivation to maintain economic resilience this year, and we believe that policies will be stepped up. Of course, we do not time the market based on economic cycles. We still focus on longer-term growth opportunities that are less affected by economic fluctuations. However, due to emotional factors and other reasons, these companies are currently severely undervalued, and we expect them to return to a relatively reasonable valuation as the Chinese economy stabilizes and confidence is restored. We remain optimistic about industries with sound fundamentals but severely undervalued, such as property services, education, as well as many technology and consumer-related industries that have already experienced significant declines, and we are currently tracking and researching them.
Some of the tracking companies' current valuations are for reference:
Note: The mentioned stocks are not recommended by BEDROCK nor do they represent holdings of BEDROCK. The calculated results are only estimates made by BEDROCK based on various assumptions and are subject to errors. They are for reference purposes only.
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