The first quarter of 2022 has passed in the blink of an eye, which seems too fast and feels like a dream full of drama. In the past March, there were significant international and domestic events, including the Russian-Ukrainian conflict and the international capital's concerns over China's assets, the Federal Reserve's interest rate hike, and the large-scale outbreak of domestic epidemics.
At this stage, we will do some essay thinking on how to view these events, their subsequent impacts, and our investment methodology and strategies' reflections.
Originally, we planned to discuss these events in chronological order, but the recent impact of the Shanghai epidemic is too profound. We have been stuck at home for about half a month. So, let's talk about this first.
Lock Down Forever?
Despite the fact that economic policies have shifted towards focusing on economic development in 2022, with various monetary, fiscal, and industry policies trending towards the bottom and a rebound, it is expected to gradually alleviate various concerns about the domestic economy since the second half of 2021. Unfortunately, since March, the domestic epidemic has once again surged fiercely, particularly affecting economic powerhouses such as Shanghai and Shenzhen, with outbreaks trending in other regions throughout the country as well.
From SH to future models
The latest strategy for controlling the epidemic in Shanghai is as follows, and it can be seen that after the comprehensive lockdown and numerous nucleic acid tests for the entire population, Shanghai must eventually move towards reopening. This is beyond doubt, but the question always remains: what happens next?
As of now, based on the experience from Shanghai's recent COVID-19 outbreak, it seems that China is still following the COVID zero approach until the government recognizes the effectiveness of vaccination, special drugs, and further reduction in the virus's virulence.
However, the absolute nature of the COVID zero policy and the difficulty in clearing the highly transmissible Omicron variant has led to the continuous upgrade of epidemic prevention measures, resulting in a significant impact on China's economic activities.
It is unlikely that China can entirely isolate itself from the rest of the world in terms of personnel and material exchanges. Moreover, while all countries except China are currently experiencing the Omicron outbreak, it seems inevitable that the virus will eventually spread within China. The country has two options: either continue to maintain strict quarantine measures or, at some point, allow the virus to spread and then take drastic measures to contain it.
One way to understand the situation is by likening the virus and epidemic prevention measures to two runners in a race. If the virus has a low R0 value or has clear symptoms and is easy to screen, then China's governance ability and measures can keep it ahead in the race. However, the current opponent is tough, with a high R0 value of up to 10, 99% asymptomatic cases, and high concealment, making it challenging for China's standard measures to stay ahead of the virus without generating significant losses and secondary harm.
Regardless of the decision taken, there will be some losses. This is the current reality of decision-making. The focus should be on judging the policy's sustainability and its potential impact. For example, the actions of the US government and the Federal Reserve following the outbreak in March 2020 might have been more important to investors than the epidemic itself. Investors need to be cautious about the potential significant economic impact of strict quarantine policies, particularly on offline consumption, and the potential disruptions caused by the epidemic's recurrence.
Thoughts on Chinese's solution...
No matter whether we acknowledge it or not, epidemic prevention and control is never just about the epidemic itself. This is not only true for China, but even in the United States, the attitudes towards the epidemic in different regions controlled by the Democratic and Republican parties are drastically different. Recent information and various data analysis further confirm this point. Despite the tens of thousands of confirmed cases in Shanghai and over 100,000 nationwide, there seem to be very few cases of severe illness.
But regardless, the leadership has already chosen this plan and hopes to use it as a representative of the Chinese model. This means that until an appropriate solution appears, we should choose a relatively tough attitude. As mentioned in an article by Shen Zhongwen in the Shenzhen Special Zone Daily, "dynamic zeroing" is the only way to win the hard battle of epidemic prevention and control. "How to choose seems to be a dispute over the concept, strategy, and method of epidemic prevention, but in essence it is a dispute over system, national strength, governance capacity, and even civilization."
In fact, this phenomenon is not only present in epidemic prevention, but also in the governance of the domestic economy and life. We have our own unique characteristics and emphasize differences with the Western model. However, value investing is ultimately about pursuing the maximum return for shareholders, and the entire market economy system generated by capitalist society is based on a set of business logic and rules. If we do not respect this set of rules, what is the point of value investing? This is a significant risk, not only for secondary investors (although many of them just treat it as a gambling game), but also for real business investors.
Prepare for the further shock!
Given the current situation where the Covid-zero policy is difficult to change, regardless of how the statistics bureau reports numbers, the most important thing for investors is the financials and profitability prospects of the companies they invest in. From this perspective, we need to prepare for the impact of negative growth, even significant negative growth in the actual economy. The only variable mainly comes from further relaxation and stimulation of infrastructure and real estate, while consumer spending is almost certain to collapse.
However, it is expected that after the government reshuffle in Q4, we may see a clearer exit roadmap for epidemic prevention and control policies, so 2023 is also likely to gradually usher in a turning point. Ultimately, for company valuations, what is more important is the expectation of long-term cash flow, not just the current situation, even if it is currently poor.
The WAR and Aftermath!
From the current perspective, the Russian-Ukrainian conflict itself is unlikely to have a long-term impact on the global economy (essentially depending on the fiscal capabilities of Russia and Ukraine to sustain a large-scale war for an extended period of time). However, the subsequent effects of the conflict may become long-lasting, such as the closer alliance system between the United States and Europe, further search for security autonomy in Europe, the United States and Europe seeking energy and supply chain self-reliance, and a further increase in the relative attractiveness of the United States to international capital, and so on.
So, What is Money?
During times of crisis, it is easy to question the fundamental nature of modern currency, which is essentially a form of credit rather than an intrinsic value in itself. Therefore, during major conflicts, the issuing country has no obligation or reason to uphold the credit promise behind its currency. This has been demonstrated multiple times in human history, including in the recent conflict between Europe and America. Credit promises, and even currencies, can become incredibly fragile without the protection of a powerful authority.
There is a story about a wealthy German during the country's defeat in war, whose assets became worthless due to the collapse of the government and loss of credit. However, after many years, it was discovered that the most valuable asset he possessed was a forest, which was a truly valuable and irreplaceable resource.
What will the Feds do?
From the March FOMC meeting, the pace of tightening by the Federal Reserve has increased, with Powell suggesting a 50 basis point increase in the next rate hike and a total of 175 basis points for the year, while also starting to taper the balance sheet. The inversion of the US Treasury yield curve suggests concerns about a potential recession in the US economy. Currently, we believe that the Federal Reserve is concerned about being behind the curve in the long term, and it is necessary to lower inflation expectations during a period of decreased concerns over the Russia-Ukraine conflict. As such, the main concern for the US economy currently is stagflation.
The logic of rate hikes and policy roadmap
Recently, Powell gave a detailed explanation of the policy goals and logic of the Federal Reserve in a speech, and recommended reading the "March 2022 FOMC Meeting Press Conference". Simply put, the Federal Reserve's policy goals have always been to (1) promote economic development to achieve full employment, and (2) control inflation within a moderate range. Therefore, at least in terms of policy intent, there is no motivation for unlimited money printing, as this would be highly detrimental to long-term trust in the US dollar and the US economy itself.
Therefore, the role of the Federal Reserve is essentially a passive stabilizing mechanism that responds to market and environmental stability. Its role is to promote employment as much as possible while controlling inflation within a moderate range. As reflected in the "Statement on Longer-Run Goals and Monetary Policy Strategy", the Federal Reserve's monetary policy framework emphasizes anchoring long-term inflation expectations at a 2% long-term target, which helps achieve the aforementioned dual mandate.
Powell is clearly satisfied and convinced with this framework, which once again demonstrates that the Federal Reserve is a very powerful, data-driven, quantitative control institution. Powell apparently hopes to minimize individual over-interference with the system and reduce various emotional fluctuations.
In other words, a deeper understanding of this adaptive mechanism can help us to some extent understand the measures that the Federal Reserve may adopt.
What changed the tone of 'transitory'?
However, as the inflation data continued to show high and persistent levels, the Fed began to revise its outlook on inflation and acknowledge that it may not be as transitory as initially thought. This shift in stance was also influenced by other factors such as the robustness of the economic recovery, supply chain bottlenecks, and rising wages.
The Fed's current stance on inflation is to let it run above 2% for some time to make up for the past undershooting of the target, but it also wants to make sure that inflation expectations remain anchored at 2% in the long term. The Fed's tightening measures are intended to prevent inflation from getting out of control and causing longer-term damage to the economy, such as eroding consumer and business confidence or triggering financial instability.
In summary, the Fed's shift in stance on inflation is driven by a combination of factors, including the persistence of high inflation levels, the robustness of the economic recovery, and concerns over longer-term damage to the economy. Its tightening measures are intended to keep inflation under control while also ensuring long-term price stability and economic growth.
The real concern for the Federal Reserve, or what drives its tightening, is the fear of an inflation-wage spiral, where once entered, would substantially distort long-term inflation expectations, leading to significant and prolonged effects on investment decisions, employment, asset values, and currency values.
The reason for the change in attitude is that the Federal Reserve sees full employment in the labor market currently, with labor market tightness significantly higher than the strong labor market before the pandemic. Compared to before the pandemic, there are many more job openings despite the higher unemployment rate. In fact, there is a record-high 1.7 job openings per job seeker. The number of people quitting their jobs each month is also at a record high, usually to take on another job with higher pay. Nominal wages are growing at the fastest pace in decades, with wage increases being the largest for low-wage and non-managerial workers.
The tightness of the labor market is the key factor that has changed the decision-making of the Federal Reserve.
Of course, both the path and the peak of this interest rate hiking cycle have been significantly revised. Currently, the peak of this cycle has reached the level of 2.8, exceeding the peak of the previous interest rate hiking cycle.
However, fortunately, long-term inflation expectations are still within a manageable range. The current long-term inflation expectations are still in the range of 3.0%, higher than the policy target of 2.0%, but still within a reasonable range.
However, perhaps equally important as interest rate hikes is the speed and intensity of the Federal Reserve's balance sheet reduction. At the March FOMC meeting, the Fed hinted that it may start reducing its balance sheet in May, with a possible reduction rate of up to $90-100 billion per month, according to CICC's estimate. If this rate is maintained, the Fed's balance sheet reduction over a 2-year cycle could be between $2-3 trillion, bringing the size of securities holdings back to around $6 trillion. However, this is an ideal scenario and unexpected inflation expectations or excessive economic contraction risks could change the pace of the Fed's balance sheet reduction. It is also important to note that balance sheet reduction does not necessarily mean an overall contraction of market funds and liquidity, as an important factor is the money multiplier, which is closely related to economic growth and confidence. When economic fundamentals are healthy and improving, the Fed's balance sheet reduction may not necessarily lead to a contraction of overall market credit, and this requires a comprehensive analysis.
Is the US going to get into a recession?
The US bond yield curve has flattened to a considerable extent, with yields on government bonds of two years and longer being quite flat, although the 3-month bond yield is still low due to policy rates. This indicates that the market has already priced in a significant amount of rate hikes. On the other hand, historically, every recession has been preceded by a yield curve flattening, and the market is concerned that the US economy is about to enter a recession.
The Federal Reserve's policy goal is precisely to achieve a soft and as short as possible economic downturn to combat overheating and inflation issues and also to prepare for the next crisis.
Currently, we do not believe that the US economy will experience a severe financial and economic crisis. The main reason for this is that during the pandemic, the household savings rate was relatively high. Although it has since returned to normal, there is still an excess savings of $2.45 trillion.
The balance sheets of households are much better than in the previous crisis. The leverage level of the corporate sector is relatively high, but it has already fallen, and the leverage level of the government sector is the highest. However, if the US hegemony is not challenged in the short term, its reliance on the US dollar as the pillar of the global financial system is not yet a significant problem. Of course, in the long run, if the US hegemony faces serious challenges and the credit of the US dollar collapses, the high leverage of the US government sector will face severe problems. This is also why the US has an unshakable determination to defend its hegemonic position.
More important is our internal policy!
There are many events that may seem urgent but may not be as important in the longer term, such as pandemics or even wars. The policy logic and governance models that follow these events may have a more profound impact on our investments. For long-term pricing, pandemics or wars, no matter how severe they may seem in the short term, will not have a significant impact on the discounted cash flow (FCF) pricing as long as they are not long-lasting and do not cause irreversible effects (such as for highly-leveraged or operationally fragile companies).
However, if these short-term impacts could lead to long-term issues, such as the aforementioned "confidence" and persistence in governance models or long-term effects on the international governance system, then they will have a significant impact on the pricing of assets. This is why the Russia-Ukraine conflict has a certain degree of rationality in affecting the pricing of Chinese assets.
Of course, the more important factor affecting pricing is actually the logic of our domestic policy, as it will have a more profound and long-term impact on long-term value. Unlike capitalism, China, as a socialist country, considers socialist public property sacred and inviolable, while the legitimate private property of citizens is only inviolable. In order to meet the needs of the public interest, the state may, in accordance with the law, expropriate or requisition the private property of citizens and provide compensation. This means that private property and interests can be affected and lost in the face of public interests or "high morals". This is why understanding the governance model and logic of public interest is essential when investing in China.
The above passage explains why there is a complex coexistence and game between private property rights and public property rights in China, and why the ROE of Chinese listed companies has been consistently lower than that of the United States in the long run. It also explains why corporate governance in China is difficult to focus solely on shareholder interests, and why some extreme policy measures may be introduced in areas such as education and real estate. However, it is necessary to reassess the future capital return trend under the strong and opaque management model and the "common prosperity" goal. It is still believed that China and the United States are the most promising investment destinations in the future world development, but a clear understanding of the risks that Chinese investments may face and corresponding reasonable growth expectations and risk premiums need to be incorporated into our investment framework and system. For example, we may not expect China's universal services (the more universal, the closer to public services) to reach the level of other countries, as typified by payments and e-commerce commissions, which may be difficult to achieve at the high level of the United States. The premium for selective consumption in China may also have some justification and may be easier to maintain in the long run (if not considered as widening the wealth gap or affecting social ethics) if the direction of social development is not entirely equal.
And Real Estate!
In March, due to the impact of the pandemic, real estate sales continued to plummet, with sales of the top 100 property developers falling by 53%. This is not surprising at all because if people can't even leave their homes, how can they talk about buying a house?
However, even so, we can still draw some conclusions and even see some hope:
Although the drop in sales is very severe, there is still a significant difference between each company, ranging from -15% to -96%. In fact, companies that have suffered the most significant decline in sales in this round of adjustment have mostly started with a drop of 50%-70%. As these companies will continue to be forced to rapidly reduce their balance sheets in the future, it will be difficult for them to quickly repair their fundamentals.
Sales of companies that have not suffered significant declines are generally within -50%, most of which are concentrated around -30%. On the one hand, this shows that even state-owned enterprises cannot be self-sufficient. On the other hand, it indicates that these companies generally have good market credibility and cash flow turnover, and once the market recovers, they are likely to quickly occupy the market share of companies that have suffered losses.
Based on the data of 1.6 billion square meters of residential sales in 2021, the reduction in sales caused by companies that have suffered significant losses is close to 200 million square meters. If the sales decline for the entire year of 2022 is within -20%, especially if the market stabilizes and rebounds in the second half of the year, the sales decline of companies that have not suffered significant losses may not be significant, and even some companies may see growth.
Home Bias!
Although I have been investing in overseas markets for more than 6 years and have always known that Hong Kong's market is often undervalued, the extreme performance shown in the 2021-2022 market still shocked me. The excessive pessimism and irrationality displayed by the Hong Kong market in the pessimistic period can even shake the soul of a rational value investor. I also felt this bitterness and sourness when reading "The Model 37 Years Investing in Asian Equities- Richard H. Lawrence" recently. The huge difference between the Hong Kong market and the A-share and US stock markets is indeed shocking.
One important reason for this is Home Bias. Previously, our understanding of Home Bias was more about the risk premium requirements added due to the lack of understanding of overseas markets. Many textbooks also explained it this way, but we found that we had underestimated the impact even though we had made a lot of preparations.
Especially in critical moments, determination determines the bottom of the market, which means that the more loyal fans a market has, the more solid its bottom will be! In this regard, the impact of Home Bias may be more apparent than in normal market conditions. In other words, foreign investors who do not understand or do not necessarily have to invest in a certain market may have a "take it or leave it" mentality, which can cause the standard deviation of the market's downward fluctuations to deviate significantly from the average. For example, foreign funds that only invest 5% or even less in the Chinese market may easily choose to give up after hearing some alarming words (such as Russification, nationalization, non-profit, Chinese version of Lehman moment, etc.), and due to short selling mechanisms, lack of understanding of the offshore market, and various media's deliberate amplification, this effect becomes even more obvious at the bottom.
Local funds tend to be more optimistic, or they have no choice because even if these scenarios occur, their holdings of RMB will most likely suffer significant depreciation, and they have nowhere else to go. But for those dollar investors, they have many investment options. If China loses its investment attractiveness (such as high growth and Chinese stories) and contains a lot of frightening risks, they can easily leave. This mentality determines that the offshore market is not only constantly discounted in the long term, but also more prone to extreme valuation discounts during crises, especially for companies with liquidity shortages.
We still do not have a deep enough understanding of this in our investment in offshore markets. We can recognize the discount, but we have confidence in the medium and long-term narrowing of the discount itself (as China's share of the global economy continues to expand, and as it further opens up to the international financial system, it gradually becomes a necessary investment product, as well as the further development of the AH arbitrage and connectivity mechanism). However, we lack sufficient preparation for the volatility of short-term discount fluctuations.
Of course, from an optimistic point of view, this also provides a rare opportunity for truly long-term value investors.
Yes! The markets do matter!
According to the traditional value investing philosophy, including Buffett's view, the listing status or location of an asset is not important at all. In other words, in the short term, the market is a beauty contest, but in the long term, it is a weighing machine. Therefore, as long-term investors, it does not matter how the market perceives the asset.
However, after paying a lot of tuition fees, I believe that at least for value investors like us, there may be some different views. Apart from fulfilling our fiduciary responsibilities to help our clients reduce losses, both monetarily and psychologically, how different market investors structurally view assets and how they price them may change the curve of returns over a long time.
Focusing on long-term value is a logic that emphasizes the result while ignoring the process (or giving up on research), but in reality, the process can still have a significant impact on the result. Soros, for example, pays more attention to the process. We discussed this in detail in our previous article "Probability Theory, Randomness, and Scientific Betting." In short, a more optimistic market tends to reward innovation and positivity in the process. On the one hand, this may indeed promote its development and improve the final result. On the other hand, it may also provide investors with opportunities to get lucky and exit early, which acts as a booster for IRR returns. In contrast, a more cautious and pessimistic market encourages a conservative and cautious approach. On the one hand, it may suppress its rapid development, and on the other hand, it may frequently make investors unlucky in the process and lack the opportunity to get lucky and exit early. Of course, such a market often provides investors with opportunities to buy at extremely low prices due to excessive pessimism.
Another factor that may affect pricing in the long term but is often overlooked or selectively deemed unimportant by value investors is liquidity. Yes, it does matter! Value investors tend to believe that as long as they hold and do not sell, liquidity is not important at all. At least some of the die-hard value investors think so, so they believe that whether an asset is listed or not does not affect pricing, let alone liquidity.
However, even long-term investors must recognize that their judgment may be completely wrong, especially if it is based on long-term judgment. Therefore, liquidity is essentially a correction cost for judgment errors. If this correction cost is too high, we must demand a higher return at the beginning of the investment to compensate for the actual higher risk. In other words, risk premiums and liquidity are indeed related and may exist for a long time. Since it is a long-term factor, we must fully consider it in our pricing system, rather than selectively ignoring it.
Risk Control!
What is an appropriate level of risk control? We have made some explanations and discussions on the theoretical aspects in our previous articles, such as "Probability, Concentration, and Traverseability", "Probability Theory, Traverseability, and Scientific Betting", and "2022 Investment Thinking and Essays", so we will not elaborate on them here. In short, our goal is to find companies with a 1-standard deviation fluctuation amplitude of less than -40% and a 2-standard deviation fluctuation amplitude of less than -70%, and to create a portfolio with as much diversification as possible, striving to keep the overall fluctuation amplitude of the portfolio within 2 standard deviations.
In addition to the requirements for industry and stock diversification, we have also added requirements for national diversity, such as balancing the assets of China and the United States in a ratio between 6:4 and 4:6, which we see as a long-term opportunity.
Rise From Ashes!
Don't waste every crises！This statement is actually very reasonable. If everything always goes smoothly, it can only encourage those who are reckless and willing to take on more leverage, while those who are cautious and focused on internal development will not benefit much. Every crisis is a brutal purge for these gamblers, and after supply-side reforms, when the market and opportunities reappear, those who remain will have better opportunities.
For companies, this is absolutely true. Each crisis clears out some companies in the industry, leaving them half-dead and struggling to recover while others happily gain market share that was previously difficult to obtain. For example, in the real estate industry mentioned earlier, I believe this is how it will play out after the industry recovers.
For BEDROCK, the first priority is to ensure survival and continuously strengthen internal capabilities. It is particularly important to establish internal research frameworks and models, as well as to analyze and track the fundamental drivers of future investment targets.
Currently, we have made great progress, especially in the establishment of frameworks and systems. In the past six months alone, we have achieved results that are no less impressive than the previous few years.
Where to look and what do we do?
How should we deal with huge uncertainties? This is just our opinion and cannot be considered advice.
Firstly, in terms of structure: continue to balance between Chinese and American assets. For our investments in American growth stocks, what is more important is the potential impact on their growth paths and discount rates. To deal with any potential shocks, we have adjusted our expectations for the peak point of interest rate hikes (3.0% 10-year Treasury yield) and risk premium (5.5%).
On the domestic macro level, our view remains the same - the main contradiction this year is stabilizing growth, especially given the severe impact of the pandemic.
Regarding Hong Kong stocks, we still hold a positive outlook as they are undervalued and our investments are in Chinese companies. Although Hong Kong is an offshore market that can be easily influenced by various factors, the valuations of our investments are historically low and globally undervalued, making them attractive investments.
As for US stocks, despite recent macro disruptions, their corporate governance is superior and they offer opportunities for structural growth driven by innovation.
Sector views?
Our focus is mainly on the technology and consumer sectors in China and the US, while we believe that opportunities in other sectors may be more cyclical rather than compounder opportunities from a long-term perspective, so we have strategically chosen to abandon them. So, how do we view the internal opportunities in these two large sectors? Due to limited space, we can only briefly discuss our views on a few sub-sectors, which may not be accurate. We do not rely on market consensus, but only on our own models and frameworks:
Chinese internet companies listed in the US: Overall, after such a brutal decline (starting at -50%, with many exceeding -95%), the current valuation must not be expensive! But whether they can achieve our pursuit of compound returns (we require a minimum IRR of 15%) is uncertain. This is mainly due to adjustments to growth expectations and risk premium adjustments after adjustments to industry environments and growth spaces. At the same time, we once again express our surprise at the previously crazy valuations. Many companies were really in a bubble not long ago... In addition, regardless of the outcome of the US-China negotiations on Chinese accounting audits, we will make certain discounts on companies listed in the US and without the possibility of return. These companies have major flaws in corporate governance and are difficult to return to investors. They will eventually become growth fantasy targets.
Chinese consumer goods: Except for a few (such as Maotai), most of China's consumer goods face extremely fierce competition. Due to China's high urban density, competition is very white-hot, which leads to our lack of full visibility. In addition, we have not found many suitable targets due to concerns about the disturbance that Covid Zero policies may bring. We obviously need to double our efforts in the future...
US consumer goods: We currently feel that the pricing of US consumer goods is relatively reasonable, and it is difficult to find high IRR targets. This is mainly because the valuations of mature and awesome enterprises are relatively reasonable, and their growth potential is weak, while emerging brands are either expensive or we cannot calculate their long-term runway. We obviously need to double our efforts in the future...
China's hard technology and new energy: Although there is some imagination, we believe that they have generally been excessively pursued by domestic capital, and we cannot calculate the accounts. At the same time, we also believe that there will be very strong competition in the future, and many of them are quite homogenized.
At present, our main focuses are:
Investment opportunities in cloud computing;
Structural growth opportunities in semiconductors;
Investment opportunities in the service industry (service platforms) under overseas reopen;
Investment opportunities in the domestic service industry, such as property management and higher vocational education, which have long-term growth potential and are severely undervalued;
Investment opportunities that may arise from blockchain as a new infrastructure; We are continuously researching other directions, and we will be happy to include any that meet our standards.
The current valuation status of some companies is attached for reference:
Note: The above mentioned stocks are not recommended stocks, nor does it represent BEDROCK's holdings. The calculation results above are only BEDROCK's estimation based on various assumptions, and may be subject to errors. It is for reference only.
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