Some thoughts on investment methodology and pricing issues

Continuing from the four previous articles on "Some Thoughts on Inflation," "Some Thoughts on Interest Rates," "Some Thoughts on Exchange Rates," and "Some Thoughts on Regional Investment Selection," we will attempt to reflect on investment methodology and analyze current pricing issues for reference.

Some underlying logic of value investing

Value investing is based on a fundamental logic that believes in the continuity of certain things in the world and invests around these unchanging things, such as a company's competitive strength. This is why Charlie Munger's Lattice theory is heavily focused on theoretical sciences like mathematics, physics, natural sciences, psychology, sociology, anthropology, and economics, which are even more important than investment science (which is not even a science). Lattice theory is not a specific understanding or view of the current world (which is too short-term and prone to change).

This approach is quite fundamental, not based on short-term speculation, and they believe that short-term behaviors and fluctuations will eventually revert. They just need to be patient and wait. However, this lack of flexibility and unresponsive behavior itself requires courage or even arrogance. Especially if someone tries to follow their behavior without their insight, they may make significant mistakes. Moreover, in this era of unprecedented changes (it may not necessarily be a century, but the occurrence of many events is unimaginable in the previous years), how can one have such powerful insight?

In addition to their outstanding understanding of business itself, their success is also due to being in an external environment with relatively stable institutions, such as the United States (although it has experienced several economic crises, booms, and downturns, the United States has been in a world-leading position since World War II, and its internal economic system has not undergone major changes). It is unclear whether they could still be successful if they were in other parts of the world.

In terms of fundamental investment philosophy, trend investing and value investing are fundamentally different. Trend investing is an adaptive strategy that believes the future is unknowable and that any current price is a reasonable judgment under full information. They do not need to challenge it, but rather adapt to the present. As for narratives, logic, and reasons, there are always many people trying to find various reasons to explain and justify it. In fact, the survival ability of people with fox-like personalities is very strong, but if they follow various fluctuations and noises too much, they will find it difficult to have excess returns in the long run.

Value investing is more like a hedgehog, with excellent noise resistance. If the path is correct, the final return will be very outstanding. However, the problem is that it may be stuck in a wrong swamp and unable to extricate itself.

Do investors overestimate their own insight capabilities?

Even if we try our best and use first principles as much as possible, the power of humans may still be small, especially in making long-term predictions in such a complex and interconnected system. Such predictions can be very fragile and may even have a large margin of error.

However, once we have the ability and luck to make accurate judgments, we can achieve remarkable results, just like the great first-tier investors and second-tier investors such as BG.

Beta vs Alpha

In the past two years, investing based on macro beta judgments (often based on the short term) rather than long-term alpha judgments has been particularly successful, because the alpha generated by company-level research is unable to withstand the impact of beta. This is why trend-following investors and macro traders have been the most successful in the past two years.

But is this the norm? It is worth pondering. In the long run, beta is going nowhere, because beta is beta precisely because it only serves the purpose of fluctuation (otherwise it would be alpha). The problem is that people often find it difficult to distinguish between the two. When markets or companies rise, there must be some narrative or justification to explain the structural rise rather than the cyclical one (such as the global zero interest rate in 2020, which has many articles explaining its rationality and long-term prospects, or the global inflation and interest rate hikes in 2022, which have many other arguments to explain their rationality and long-term prospects). The mistake is easy to make when you follow the market and convince yourself of a long-term trend, and then give a high valuation or high certainty premium based on long-term logic, only to find that this is not the real long-term trend. The current pricing is already too high (or too low).

Another difficulty is that even if you have a keen eye for finding long-term alpha, under the short-term fluctuation of beta, can you withstand the ups and downs that cause your confidence to waver or become arrogant, and in fact, there is no way to pursue the original alpha (or whether your investors can persist)?

Especially, has the low volatility period in the past made it too easy to make money, to the point where algorithms based on low volatility can easily succeed? And is the era of high volatility in the future lasting, to the point where we are forced to add a lot of beta considerations to our investment framework and models?

Investors may be too accustomed to investing within the 1σ range.

Although we have also read many articles similar to Taleb's "The Black Swan" and "Antifragile" that suggest that the long tail effect may be underestimated, there are still many difficulties in integrating it into systematic investing. The main reason is that even if the market may underestimate the fat-tail effect, it is still a low-probability event. Most of the time, the world operates within the 1σ (68% or 2/3 probability) or 2σ (96% or vast majority of cases) range. As mentioned earlier, the underlying logic of long-term value investing is based on the assumption of continuity. We are not saying that investing in risky, uncertain opportunities in the early stages is not value investing, as long as the calculated return is greater than the cost, there is no problem. We are only saying that the model assumptions cannot be based on one-time events or purely gambling low-probability events.

However, the events that have occurred since 2020 have repeatedly challenged the definition of "once in a century"

Investors can frequently reach high or low values, breaking through the 2σ threshold, regardless of whether the market is rising or falling because the narrative around investment always involves significant changes in the world. Everything seems to be changing and the market is either skyrocketing or plummeting. Trend investors, on the other hand, are relatively unconcerned with pricing and are happy as long as they can identify the trend. The market will naturally provide justifications, even if they are not entirely reasonable, so they are not as important.

Do value investors believe they can calculate reasonable valuations with relative accuracy?

Value investors believe that they can calculate a relatively accurate valuation of an asset, i.e., they buy businesses that they believe will be worth more in the future, which means that the current price is undervalued. In other words, they believe that they can at least relatively accurately evaluate the current value of an asset. Once they find this reasonable price, they will relatively persist in their decision (of course, they will make adjustments based on the fundamental situation), rather than being influenced by the market and adjusting their positions randomly. They will, of course, seek some bargains, but based on probability logic, most of the time, when the price is at 1σ (the low point of the 2/3 probability), it is time to take action, and when the situation appears at 2σ, the value investor may already think it is a rare opportunity and go all-in.

This relatively rational approach to value analysis certainly has its great advantages and is not influenced by market trends. However, the downside is that: 1) if you judge the so-called fair price wrongly, i.e., if you misjudge the position of the zero point, the buy/sell point may be wrong (e.g., being influenced by the previous bull market thinking and believing that high valuations are reasonable and sustainable, etc.), and you may treat an asset that is actually fairly priced as a rare opportunity at -2σ; 2) the market may sometimes be very irrational and deviate significantly from what you believe to be -2σ, and because value investors find it challenging to have a stop-loss mechanism, they may even try to buy at the low point (because on the one hand they think it's undervalued, on the other hand, the logic of selling is very confusing). However, this also means that when some situations deviate significantly from -2σ, investors who adopt the value investing approach may incur significant losses.

Because of these two points, long-term value investing, which is widely touted, is actually very challenging to implement in practice.

What possible paradigm shifts should be studied?

Researching potential paradigm shifts is crucial for investment and refining investment frameworks. For example, one possible significant paradigm shift is the reemergence of a bipolar world trend. In the past 30 years after the dissolution of the Soviet Union, the world was clearly unipolar, with the United States being the sole dominant power and other participants following its lead without daring to challenge its power. The overall operation of the world, including commerce, was efficiency-driven under the supervision of US hegemony.

However, today, especially with the rise of China, there is a challenge to the US's dominant position, and this will continue to produce ongoing challenges and conflicts.

Image: The world may be looking for a new balance between efficiency and resilience.

Other paradigm shifts will be discussed to a greater or lesser extent in our future articles, and we are also constantly learning and understanding this time.

The risks and opportunities brought about by paradigm shifts in investing.

One cannot help but marvel at how periods of paradigm shift in investment markets and modes (especially when previous investment paradigms have become widespread and persistent, causing investors to become accustomed and take them for granted, leading them to adopt increasingly aggressive investment strategies and even leverage) often lead to many disruptions! For example, when the overwhelming majority of investors are borrowing short and investing long, and are highly leveraged, the reversal of this trend can lead to many risky events. Similarly, assuming that house prices will never fall can also lead to hidden overdrafts and leverage (even if it is not reflected in the surface level of debt); and investors engaged in interest rate arbitrage may be accustomed to the long-term reality of higher RMB interest rates compared to USD interest rates, but may be caught off guard if the interest rate trends in the two countries reverse completely, and so on.

How do we view current investment opportunities?

There are many analysts who come out and make predictions about the appropriate valuation for the index, with methods that typically involve analyzing historical trends and valuations. However, there are still many irrational and unreasonable aspects to these approaches. Here, we will share our perspective.

While it is impossible to predict with certainty how high the index will go due to the unpredictability of human behavior and group dynamics, we can attempt to estimate a relatively reasonable pricing framework.

The chart below shows the historical trends of risk-free rates and risk premiums from 1960 to the present, which have been extremely volatile. If we were to reach the levels of 1981, the index would basically have to fall to single-digit valuations, indicating that there is still a significant potential for further declines. However, more importantly, the main determining factor at that time was a risk-free rate of 13%, which we do not expect to see in the current market.

Therefore, we cannot simply compare historical valuations to current ones on an apples-to-apples basis because many factors have changed significantly.

The key reason for the historical single-digit valuations was the risk-free rate approaching 15%, and we estimate that this situation is unlikely to reoccur.

From the perspective of risk premium, the fluctuation range of investors' risk preference is relatively smaller.

Based on observations of index changes and investor behavior over the past 60 years, we can summarize as follows (although the actual situation may deviate from this experience of 50 years):

• The volatility of the equity risk premium (ERP) over the past 60 years has been generally between 4-5.5%, with extreme cases sometimes exceeding 6%, depending on market sentiment. The actual value of the ERP may not necessarily increase proportionally with the rise in risk-free interest rates, but may reflect the pricing of the scarcity of growth opportunities for investors at high interest rate levels.

• Overall, the low point in late 2020 was historically due to the near-zero risk-free interest rates and low risk premiums. Over the past 20 years, the ERP + risk-free rate has generally remained at the level of 8% (which may be a more sustainable expectation for stock market returns in the future), and the central return over the past 60 years, including periods of high inflation and high risk-free rates, has been around 10%. This is quite consistent with the overall return of the US stock market of 8% (i.e., an expected return of 8% is relatively sustainable).

Our Model Calculation for the Current Environment

Our model assumes a risk-free rate of 4.15% and an equity risk premium of 5.25% (assuming long-term sustainability), and we have made some assumptions about the sustainable growth rates and long-term inflation levels in both the US and China. Based on these assumptions, we have calculated that the reasonable valuation levels for US and China should be around 16.9 and 15.4 times earnings, respectively. After applying a discount rate of 40% and 50% for Hong Kong and Chinese concept stocks, respectively, the valuations would be around 9.3 and 9.9 times earnings.

We can also analyze reasonable valuations based on bottom-up analysis.

The problem with directly comparing based on historical PE is that the world is actually changing, and the structure of the index may have undergone significant changes. For example, today's leading companies may have stronger competitiveness, higher profitability (the bottom line of high-margin businesses has less volatility), more recurring revenue rather than cyclical revenue, and so on, so these current leading companies may be worth a higher, sustainable valuation compared to past companies. For example, you can't really expect software companies with monopolistic competitiveness to have the same valuation as high-leverage, high-volatility bank and steel stocks. Therefore, the structural changes in the index may trend-wise affect the long-term direction of the index's reasonable valuation. We can also do some more detailed work, such as trying to judge the valuation of the main components in the index. Especially for the analysis of the Nasdaq index, since the top 10 account for 50% of the index, analyzing the valuation status of the top 10 stocks can basically give an idea of the overall index's valuation.

The composition of the top 15 Nasdaq companies:

How far is the expectation?

Since 2022, the market correction has been very significant, not to mention Hong Kong. Since 2021, the correction has been remarkable enough. So, how far have these pessimistic expectations gone? How much further do we have to go? Is the turning point approaching? No one can tell for sure.

The hardest part of investing is that it is often difficult to have a clear-cut point to tell you how far the market has gone, how much expectation is not enough, and how much is sufficient. Especially when most participants quietly do their own calculations, the only fair display of the results is the price itself.

The predictions made by the sell-side are publicly available, but they may be different from those of the buy-side (many buyers also refer to the sell-side's views). The sell-side's forecast itself may only be a slow variable, and many expectations have already been adjusted in the minds of the buyers and the general market participants. In the past 50 years, the sell-side's forecasts and the actual market performance have often been inconsistent.

We cannot only focus on the downside risks and overlook the upside risks.

Due to various macro risks that have emerged since 2022, people have been highly concerned about downside risks and are very sensitive to various pessimistic expectations. It is difficult to say whether this trend has come to an end (perhaps we are naturally optimistic), but we believe that the current downside is limited, while the upside may have been overlooked.

Graph: If inflation expectations peak at the end of 2022, could there be a rapid return to normal in 2023?

If our and MS's inflation expectations meet the Fed's own requirements, then based on our previous expectations for the US economy, the long-term interest rate level could reach the target of 2.5% (although this process may be slower or faster than the speed predicted by the Fed).

The current market has priced in an expected endpoint for rate hikes at around 5%.

The endpoint of a 5% rate hike implies a level of 250 basis points above the long-term center rate of 2.5%, which would have a restrictive effect on the economy similar to the peak level during Volcker's time. It can be said that this expectation may already be quite sufficient.

Estimation of Upside and Downside Risks

According to our team's model calculations, if the risk-free rate and equity risk premium (ERP) can return to a relatively normal level of 8% (or comparable to the past 20 years), our portfolio has the potential to achieve an astonishing 140% upside and close to a 60% IRR over the next three years without adjusting the current earnings forecast model.

However, if inflation levels remain stubbornly high and the Fed needs to continue to use more aggressive interest rates to restrict and prolong inflation, pushing the risk-free rate + ERP from the assumed 9.4% to a high of 10%, our portfolio can still provide a 22% IRR, although we recommend reducing our current position from about 75% to 50%.

Note: The model calculation is based on many assumptions and should not be taken as investment advice, but rather as a reference.

Maybe there should be some confidence!

Therefore, to be bold, although we still face many challenges in the short term and the market sentiment is pessimistic, the current situation we face may have already priced in to a considerable extent various pessimistic and negative possibilities. The upward risk in the current pricing is far greater than the downward risk. Of course, never say never, no one knows how the market will go in the future? Even the best companies may be misjudged... We are just saying that we should be more optimistic at least for now...

Attached are the current valuation situations of some companies according to our model calculations.

Note: The modeling calculations are based on many assumptions and are not intended as investment advice, but only for reference.