I have been reflecting on my investment experience over the past five years, especially in the past year, and thinking about how we should improve our investment strategy and methods in the future.
look back at past
Looking back, there is no doubt that our performance in the past year was poor. As for why, we can certainly blame extreme style shifts, various policy interferences that may not have been seen in decades, and exaggerated fluctuations in investor sentiment (mainly in Hong Kong and the Chinese concept stock market), which have indeed exceeded our previous expectations.
What we did not expect was that this series of impacts almost occurred at the same time, causing the decline in the several industries that we were already focused on to be almost simultaneous, and making the diversification of our portfolio almost ineffective.
In the past, our focus on individual stocks has led to a lack of understanding of the macroeconomic background.
We have always emphasized that we focus on fundamental research of individual stocks and their long-term value creation, which is not a problem in itself. However, it is clear that we have not paid enough attention to understanding the impact of policies in China, and we have underestimated the potential impact of a series of policies (or what investors perceive as their impact) under the "unprecedented great changes in a century".
Views on retracements
Value investors and followers of Warren Buffett, including ourselves in the past, tend to have a powerless but indifferent attitude towards drawdowns, for two main reasons: 1) as long as we focus on the long term, value will eventually return, and caring about drawdowns is a behavior that is not related to long-term value judgments, and sometimes even a behavior that confuses priorities (such as reducing positions when stock prices fall, and adding positions when they rise); 2) The valuation system of value investing is relatively objective and does not change with the behavior of other participants. Therefore, the entire evaluation system is powerless in terms of how to evaluate and grasp drawdowns technically.
However, in the past year, we realized that:
The volatility and investor sentiment changes in markets dominated by offshore investors, especially Hong Kong, are very astonishing. The amplitude of these changes may not be simply 20-30%, but may even reach twice or even several times that amount, causing even the most determined investors and listed companies themselves to behave abnormally and lose confidence.
If our portfolio as a whole is affected by such huge fluctuations or drawdowns, we cannot overestimate ourselves, let alone assume that our investors can maintain their composure in the face of emotional fluctuations and loss of confidence.
Even without considering the pain of the process, the key assumption that a lack of flexibility can still "hold up" is that you are ultimately correct. "Stock god" Warren Buffett has undoubtedly proved this (although not always error-free, he is already outstanding enough). But it is highly questionable whether ordinary people like us can do the same, especially since the problem is not that you have been correct many times before, but whether you will place too much emphasis on one big mistake and stick to it excessively.
Revisiting Concentration and Dispersion
The Choice between concentration and diversification is a methodological choice that is often discussed. Almost without exception, "confident" value investors choose to concentrate their holdings. The reasons for this include:
If I have the confidence to choose an outstanding opportunity with an IRR of 30%, why should I hold 10% of ordinary opportunities? Opportunities with an IRR of 30% are rare and difficult to find. Therefore, it is unlikely that I will be able to find many of them to achieve sufficient diversification.
Since entrepreneurs or CEOs can only bet on one company in their careers, why do investors need so many opportunities?
Diversification is often seen as a sign of greed and lack of judgment. Holding numerous positions can lead investors to have a lack of understanding of the companies they own, making them vulnerable to short-term emotional influences.
It is obvious that concentrated holdings can unleash tremendous power when "correct" or popular in the market (of course, the most powerful is certainly concentration + leverage). This is the advantage that many value investors use to highlight the benefits of concentration.
In addition, the focus brought by concentration also makes it easier for investors to "correctly" judge themselves, that is, they believe that effort in research can significantly increase their accuracy. This is an aspect that Buffett, Druckenmiller, and other gurus are highly recommending.
However, the reason why these gurus are gurus is that we may not be able to achieve their level of accuracy and sensitivity. We will still make mistakes from time to time, and the hazards of concentrated holdings will be reflected in this situation.
As for how to diversify, the degree of diversification varies from person to person. Dalio says that 15-20 good ideas are needed, and Greenblatt says that 5 different ones are enough. In our previous research, we did some mathematical calculations and found that 2-3 completely unrelated investments can significantly reduce volatility (probability theory, exhaustive and scientific betting).
However, the world is often interconnected, and achieving this goal is not easy. This year, we may have deployed three industries that we believed were not related to each other, but we still encountered almost homogeneous volatility challenges (we found that many homogeneous volatilities did not come from the correlation of fundamentals, but from the type of investors themselves, such as homogeneity of preferences, similar markets, similar value-growth investors, etc.).
The future is still uncertain, but in order to achieve the goal of "2-3 completely unrelated investments," we have increased our requirements for nationalities. We no longer go all-in on a single market that is undervalued, and we also try to increase our holdings in different industries and categories under the premise of not discounting investment returns and certainty. Of course, we rely more on the breadth of the global market and choose high-quality holdings in the technology, consumer goods, and service industries that are within our capabilities, rather than diversifying for the sake of diversification and lowering our standards. The advantage is that after a systematic research framework, our team can gradually adapt and provide more choices.
市场保持非理智的时间可能比你能活着的时间长
In the past, our selection of the market and assets was idealized and based purely on the compound returns and certainty that the assets could provide. Due to our high standards for valuation and growth, as well as limited research breadth, the majority of our positions were chosen in Hong Kong's service industry. However, the degree of irrationality in the market far exceeded our expectations. Despite being the cheapest market in the world and in a global environment of monetary easing, it has had the worst performance this year.
As value investors, it is even more distressing to see that the market's over-optimism for future growth stories and lack of recognition for current value does not seem to be narrowing, but widening instead. This year, except for the high-flyers in new energy and defense, traditional value stocks have all experienced major declines. Even powerhouse companies like Moutai, Tencent, and Alibaba have fallen as much as 40%, 45%, and 55%, respectively, due to factors such as internet anti-monopoly regulations.
Choices about the market
As we mentioned earlier, our idealized approach of using purely fundamental growth and valuation as the sole criteria for measuring compounding returns and certainty made it easy for us to conclude that the Hong Kong market (which enjoys the growth of Mainland Chinese companies and the low valuation characteristics of Hong Kong) is the optimal choice.
Hong Kong serves as a bridge for foreign and Mainland Chinese investors, providing convenience for various types of investors. However, it is also an offshore market for investors from both regions, and its vulnerability in terms of confidence creates a significant difference from other onshore markets, which we overlooked in our previous research.
After reviewing past results, it is clear that market conditions have a significant impact on investment returns. The same stock selection and investment strategy can generate a compound annual growth rate for A-shares that is no lower than that of Hong Kong or US stocks. This may be due to the fact that A-share investors are relatively more optimistic (possibly due to the absence of short-selling mechanisms and a higher proportion of retail investors), which motivates them to pursue higher returns and reduces the penalty for investing in low-quality companies. Therefore, under the same stock selection logic, it is easier to get lucky in A-shares, and the punishment for being unlucky is less severe than in other markets.
The problem with Hong Kong lies in its excessively negative valuations, which means that offshore investors lack fundamental confidence in the market (due to factors such as system, nationality, and market composition). This results in a relatively low amount of Lucky rewards even during optimistic bull markets, but very severe Unlucky punishment during bear markets or when companies have negative news. Even in the same growth companies with the same valuations, Hong Kong's returns may not be as good as A-shares, which must be compensated by a valuation discount, leading to its long-term undervaluation.
However, this is only a regression based on past valuation distributions, and is heavily influenced by extreme valuations. It does not mean that such valuation and reward/punishment distributions will continue in the future, and it is necessary to observe the investor structure and overall market governance situation to adjust for these factors.
looking to the future
It can be said that if we have any confidence in the future, it is that we have made improvements and optimizations in our investment methods based on the lessons learned this year, in order to better assess the future and adapt to the market.
A better evaluation system for super growth stocks
Our investment standard is to invest in growth companies that can provide satisfactory compound returns, which means we need to grasp their growth potential and make reasonable judgments on pricing. However, for some super growth stocks, it is a difficult problem to evaluate whether their future growth potential is still insufficient or already too high when their valuation is already relatively high due to market recognition (because their valuation may look very expensive on the surface). This is because our research on this issue is lacking, which has led us to miss or sell some super growth stocks too early, and is also an important reason why we abandoned US stocks and heavily invested in Hong Kong from the second half of last year to the first half of this year. In the final analysis, it is because our underlying pricing system is not sophisticated enough.
Of course, some investors choose to ignore this difficult problem and choose to believe that the market's valuation is always reasonable (market efficiency), and focus their energy and judgment on researching future trends. This way of linear extrapolation based on current situation is certainly scientific, but it makes all judgments too dependent on linear deduction at present, which may cause the entire investment judgment to be very volatile and exhausting.
In 2021, based on our original judgments, we gradually established a model system for mid- to long-term judgment and pricing through learning from the valuation systems of some funds that have long focused on investing in growth enterprises. Therefore, we have more confidence in pricing future growth companies. We patched up our pricing method, making it more universally applicable, and more effective, especially for super growth stocks.
Past situation: For super growth stocks, it is easy to experience left-side discovery, holding through the bottom is very painful, and selling too early after the stock price takes off (holding experience is very energy-consuming). Or, the pricing system for some companies that are already very expensive has failed, making it impossible to rationally understand the long-term value and make confident buying and selling decisions.
The core idea of the adjustment: In the entire investment return cycle, we adjusted our judgment to make it more in line with reality, that is, we believe that before a company is self-verified, it faces higher risks and therefore provides higher investment returns. As the risk decreases after the company is self-verified, the investment return requirement decreases, so the distribution of returns over the entire lifecycle should be high at the beginning and low at the end.
Adjustment method: Determine the target valuation through a three-stage model.
Do not overly oppose the market.
In the past, our investment system had little consideration for the market, mainly or only considering whether the current fundamentals and pricing were attractive enough. However, as mentioned earlier, in certain market environments and situations where our own knowledge is insufficient, it may result in an over-concentration of positions in areas that the market does not favor, as these areas are often more undervalued, making it easier to increase positions according to our system.
This behavior of actually opposing the market is a strategy that puts "me" first, not responding to changes, and if the judgment can eventually be proven correct, it cannot be said to be right or wrong.
However, problems may arise:
Overly opposing the market may lead to "The market can stay irrational longer than you can stay solvent", meaning that you cannot hold on until the victory day due to various reasons;
Sometimes, even if you hold on until the end, you may find that your judgment was wrong. Therefore, we cannot overestimate our current judgment power and underestimate the judgment power of the market group, even though sometimes they seem completely irrational.
In this regard, we have made some adjustments to our methodology, mainly adjusting the way we place bets:
Past: Mainly based on IRR and probability to determine position size.
Adjustment approach: Seek profit while avoiding risks. Under the premise of not adjusting the investment principles, find the intersection between our investment method and market consensus, and do more betting when there is an intersection (that is, when we are very optimistic, and the market also begins to be optimistic); in the stage where we are optimistic but the market does not recognize it, avoid being too opposite to the market and reduce the proportion of bets, patiently wait.
Adjustment method: Adding the catalyst and sentiment factors to adjust the position size recommendation based on IRR and probability, and making a general adjustment of up to 30% to the previously judged position size (but this situation is relatively rare, and overall, the adjustment is still moderate).
Of course, we are unlikely to make a 180-degree turn to become trend investors or market-oriented investors. This deviates from our original intention and the fundamental basis of our value judgment. Our methodology's strength is not to try to time the market, and the changes we have made are mainly based on:
Reduce the overly negative situations produced by opposing the market and the losses incurred when making mistakes;
Objectively, if the income target can be achieved faster, it can increase the IRR to a certain extent in the long run.
View on future portfolio construction: Adhere to technology + consumer and moderate diversification
For the medium to long-term portfolio structure, we will continue to hold technology + consumer (consumer goods and services) as the core holdings in China and the US. However, we have put forward some relatively strict risk control indicators for the portfolio diversification. For example, single-country holdings should not exceed 2/3, and single-industry holdings should not exceed 40%, and we try to layout five or more industries and investment logics with relatively weak correlation.
Of course, according to our investment framework, the concentration level will definitely be much higher than that of the general public funds, but this is inevitable as we pursue a compounded return of 15% or more, and the available investment targets are relatively limited.
Currently, we have selected the following research and investment directions for 2022:
China-US technology: internet, cloud computing, payment, semiconductor, blockchain, new energy, etc.;
China's service industry: including property services, higher and vocational education, etc.;
China-US branded consumer goods;
China's manufacturing and supply chain companies.
Market Outlook 2022
Reopening
As special drugs (such as Pfizer's drug) are becoming available, the US is starting to open its borders, and more and more countries are entering a state of reopening. Assumptions and judgments for next year will likely need to be based on this consideration, and there may be new opportunities.
The impact of interest rates on liquidity may be relatively mild, and the US stock market still focuses on individual stocks rather than macro issues.
According to the current Taper plan, the reduction of bond purchases is a gradual process, and rate hikes are also cautious. The current level of liquidity may not be so sensitive to this change. This round of monetary easing is likely to have a higher tolerance for inflation. In the past, controlling inflation was a major concern because it often caused one group of people to exploit another, leading to social division and conflict, which is not conducive to maintaining national stability and order. However, in this round of monetary easing, the US is using helicopter money to distribute funds to low- and middle-income earners (whose income may even be higher than before the pandemic), who have also benefited from investing in YOLO and digital currencies from an asset perspective. China is adjusting through a shared prosperity approach, which has eased the social conflicts caused by the monetary easing. On the other hand, the competition between China and the US is intensifying, and the government needs to be more proactive both domestically and internationally. The impulse for fiscal expansion is strong, and the central bank will be forced to finance the government, but may be hesitant to rashly raise the price of funds.
Investment in China next year, especially in Hong Kong:
At the beginning of this year, expectations for China were high, and the economy had a period of high growth followed by a period of decline. This year, many unprecedented reform measures have been taken in China, which have had a significant impact. Therefore, Hong Kong is priced very low globally, and expectations are also low. After this year's extreme reform measures, many areas are now showing situations where the harm is greater than the benefits, and policy may be reversed. Therefore, the market may start from a low expectation and a low base next year, and investment may be easier than this year, especially in Hong Kong.
In conclusion, in the current extreme valuation environment, we believe that most of the risks have already been priced in. Looking at 2022, many opportunities are quite attractive. We cannot say when this repair will come, but if we maintain enough confidence, we believe that most of them will pay out.
Note: The table above is for illustrative purposes only and does not represent our fund holdings, nor does it serve as a buying recommendation.
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