Real Investment Masters All Possess Probability Thinking

 

I. The Effectiveness of Value Investment

 

In the asset management industry, only the fittest survive. The longer one stays in this field, the better the performance usually is. Especially for those of us engaged in value investment, there are two key points. The first is to avoid losing money, and the second is to maintain a long-term operation. The market is full of great temptations and numerous opportunities. However, if you can't grasp them well, you are likely to fall into traps. Some are lured in by the market itself, while others deviate from the right path on their own.

 

The overall return on capital of listed companies in China is not very high, and there are reasons for this. Generally speaking, the cost of capital in China is not very high. The interest rate in the US market is more market-oriented. Compared with the GDP growth in the US, the interest rate is not that low. While compared with China's GDP growth, our interest rate is quite low. Of course, there are also institutional issues. Both state-owned enterprises and private enterprises aim to expand, preferring large and comprehensive enterprises rather than small and exquisite ones. Even private enterprises do not take maximizing return on capital as the measurement standard.

 

Why does value investment yield relatively high returns in the Chinese market? This is related to the characteristics of the Chinese market. One characteristic is that individual investors account for a high proportion in China's capital market, and the market is particularly emotional with a strong herd effect. A typical feature of the market is that bull markets are short and bear markets are long. Second, the market mainly focuses on trend speculation, using speculative methods as a profit model. Now, the situation has changed a lot. Those who intended to "harvest leeks" have become the "leeks" themselves, while the institutions that accompany listed companies to grow steadily are now in a good situation. Therefore, sometimes people should not be overly clever. In the asset management industry, there is no shortage of smart people, but what is lacking are those who seem "stupid" in appearance but possess great wisdom. Many extremely intelligent people often become victims of the market or find it difficult to last long.

 

Value investment is effective globally, and the reasons for its effectiveness are indeed worth our deep consideration.

 

Firstly, there is mean reversion and the capital's pursuit of profit behind it. Mean reversion is a basic common sense in investment. The risk premium of the entire market fluctuates around an average value in the long run. When the increase is too large and the price rises too high, the future return of this asset will be insufficient, and the potential return on investment will decline, which fails to attract rational investors. Rational investors will then look for more profitable opportunities. Once the power of trend investors starts to fade, the trend will reverse. Conversely, when the decline is significant and the price is lower than the intrinsic value, the potential future return will be very substantial, attracting value investors like us to intervene. As the number of tradable shares decreases, it is relatively easy for the stock price to rise and difficult for it to fall. This is actually a cycle of mean fluctuation.

 

Mean reversion is not only applicable to industry competition but also to the economy, society, industries, and companies. It is a correction of past trends.

 

Secondly, there are more ways to realize value. Why is value investment effective? Because value can be realized through dividends and share repurchases, more opportunities for mergers and acquisitions, shareholdings increases by major shareholders and management, and market trend opportunities. For example, when we bought Vanke, we had no idea at that time that Mr. Yao would make a takeover bid for Vanke, and then Mr. Xu also got involved. If a company is truly undervalued, the management will also want to increase their shareholdings.

 

Of course, there will also be market trend opportunities. Every few years, there will always be some trading opportunities, but they are hard to come by. Some of our returns also come from market trend opportunities. For instance, in 2012 and 2013, we were fully invested, and in 2014, we even had a certain level of leverage.

 

Thirdly, good companies have the ability to continuously create value. We must look at the future of a company. Without considering the future, there is nothing worthy to buy. Generally speaking, good companies can continuously create value in the future. For example, Gree Electric Appliances now has an annual profit of over 20 billion yuan, while in 2005, its profit was only a few hundred million yuan. When the melamine incident in the dairy industry broke out in 2008, Inner Mongolia Yili Industrial Group Co., Ltd. suffered a significant loss that year, with a market value of only 5 billion yuan. Now, its annual profit is much higher than its market value at that time.

 

II. The Essence of Investment and the Logic of Value Investment

 

Investment requires a probabilistic mindset. What does this mean? Investment itself is an expectation of the future, and there is a formula: Ea = E1×P1 + E2×P2 + E3×P3 + …. E represents my expected rate of return on this investment, and P represents the probability of the success of this investment. In this way, we can calculate what the expected return Ea is.

 

Ordinary investors do not have a probabilistic mindset. Many ordinary people only see a high expected rate of return, so they are always deceived. Why? The probability P in this case is definitely equal to 0. Over time, this P will definitely be 0. No matter how high your expected rate of return is, it will ultimately be 0. Some hot money operators of speculative stocks do the same thing. They tell big stories, such as what will happen if they succeed, to attract ordinary investors who want to make huge profits in the short term. In the long run, the probability of these stories coming true is basically zero. When the hot money operators think the stock has risen enough, they sell it to the ordinary people who are eager for short-term huge profits. I think this style is not advisable from beginning to end.

 

For example, George Soros' success lies in that he doesn't care much about the probability of making a profit but rather focuses on the magnitude of the profit. That is, he doesn't care how high the P is, but he knows that with leverage, as long as he succeeds in one bet, his expected rate of return E will increase tenfold or even more. His P is not extremely high either, but when the probability is relatively high, he will place a large bet. Therefore, he loses small amounts of money but makes big profits. However, we never engage in low-probability events. Low-probability events are like gambling, and many people turn investment into gambling.

 

The investments we make are high-probability events. Just like Warren Buffett, Buffett focuses on P (probability) and takes E (expected rate of return) as a supplement. For some stocks held by Buffett, other fund managers either understand them but disdain to invest, or they simply don't understand. Why does Buffett pursue a high P? Firstly, the scale of assets he manages is already very large, so he can't find small companies with very high rates of return. Secondly, he has a leverage ratio of 1.5 to 1.6 times, but his leverage is the kind that won't cause problems. Therefore, Buffett requires that the expected rate of return of the things he buys doesn't need to be very high, around 10% to 15% is enough, but the probability P of making a profit is as high as 80% to 90%. Of course, Buffett has been investing for more than 50 years, and it's not easy to compare with him. The most important thing is to be able to invest for a long time and avoid falling into traps. It doesn't matter if the rate of return is a little lower in some years.

 

In addition, value investment attaches great importance to the principle of compound interest. Its long-term return is very astonishing, with a high probability of winning and tries to avoid losing money as much as possible. When there are particularly good opportunities, one should dare to invest heavily.

 

In the simplest terms, value investment means buying good products at a low price. This is very important, but many people want to do it but can't do it well. The main reason is that investors can't evaluate the intrinsic value. Evaluating the value of corporate equity is extremely difficult. Why does the market value of a company sometimes drop so much and sometimes rise so much? Besides human nature, it's because the stock market is a capital market. The more difficult it is to value a market, the more likely it is to have huge fluctuations.

 

The intrinsic value of an enterprise can theoretically be calculated by discounting future free cash flows, but the DCF model has poor operability and is more of a way of thinking. Value investment judges the intrinsic value not by calculating through formulas but by your own understanding of the industry, the company, people, and the business, etc.

 

Those who focus on pure value stocks often face a greater test of human nature. Sometimes, these stocks are scorned and don't show any response for a long time. Their reaction cycle and sluggishness are more obvious. Therefore, a more appropriate growth rate of performance (g) is needed.

 

III. Value Investment Practice

 

For value investment, the most certain and important thing is to buy at a low price. The second most certain thing is to select excellent companies. The third is to have a sense of the market cycle, and the most uncertain thing is to predict the market.

 

Firstly, the most important thing in value investment is to keep in mind the valuation.

It's not that those who buy value stocks are practicing value investment, and those who buy seemingly ordinary companies are not. The key is at what price you buy. Of course, on the premise of valuation, it's best to buy excellent enterprises because excellent enterprises have a greater chance of success. Meeting your valuation requirements means that the potential rate of return is higher than your required rate of return. For example, if our calculation shows that the intrinsic value and price will provide an increase of more than 15% over three to five years, that is, an annual compound growth rate of more than 15%, then it can enter our field of vision. But if it doesn't meet this target, it is not a target for value investment.

 

Personally, I think that value investment is very popular now, not because everyone recognizes the value investment concept, but because they recognize the value investment style. Styles will change, but the concept remains the same. The concept has been around for nearly 80 years without change. Its methods, strategies, applicable targets, and applicable markets are all different. However, its basic principle is to buy cheap goods, which is the most fundamental. Buying a large number of so-called value stocks now may still be because the value investment style has been recognized, rather than the value investment concept itself. More popularly speaking, investors buy these stocks because they have gone up, not because they are truly valuable with a high expected return. I think the concept of value investment will not change, but the style of value investment will definitely change. Of course, I don't know when that will be.

 

Secondly, select excellent companies and accompany them to grow.

Value investment is a process of arbitrage. Some people engage in static arbitrage, and some engage in dynamic arbitrage. Whether it's static or dynamic arbitrage, the most important thing is to choose good companies. The reason is simple. If you deal with a group of mediocre people, the possibility of making mistakes is relatively high. If you deal with a group of outstanding people, although it may cost more, they will surpass your imagination over time. Therefore, for ordinary enterprises, we need a higher discount, and that's the principle. However, the ability to select enterprises is the core fundamental ability of value investment. Theoretically speaking, valuation tests your character, personality, values, as well as the values, culture, and incentive mechanism of the institution.

 

In fact, very few people can truly practice value investment. Many people claim to be value investors when they are trapped, and some people say they are value investors but have a high turnover rate. According to my understanding of value investment, a high turnover rate does not conform to the laws of value investment. The law of value investment is that value will eventually be reflected, and it generally takes a long time for this reflection to occur.

 

At least, the assessment mechanism for value investment must be long-term, and the funds should also be long-term. There should be no daily rankings. Many times, the stock price does not reflect its value. So what should we do? Wait or endure. It's very painful to endure. Can you hold on? If you look at the rankings every day, it's very difficult to hold on, because some stocks really don't show any reflection for a long time. That's why we launched funds with a three-year lock-up period, because they match value investment. It's normal for the assets bought through value investment not to reflect their value within a year. The probability of not reflecting their value within three years is relatively low, of course, on the premise of evaluating the intrinsic value of the enterprise.

 

Thirdly, feel the market cycle.

The alternation of the four seasons in the market is cyclical, and behind it is the unchanging human nature. The market cycle is like this, sometimes it may be three years, sometimes it may be seven years. Generally, the decline period is long, and the rise period is short. However, it may change in the future, but the cycle itself remains unchanged. If you have been in the market for a long time, you will have a feeling about the alternation of the four seasons. For example, in winter, you need to dress warmly; in summer, you can't wear too much; in spring, you need to bring an umbrella. You should have your own coping strategies in different seasons instead of trying to predict the market. Predicting the so-called market points is completely a matter of luck. But when can you feel that the market is overheated, or when are there many investment values? Professional people can definitely experience this.

 

Finally, don't try to predict the market.

In fact, many people can't help it. If you can predict the market accurately, it is the easiest goal to achieve. However, the more you want to achieve this goal, the more likely you are to make mistakes. The market is very difficult to predict. Even someone as shrewd as George Soros can't predict most of the market. He only feels that he can participate, and even influence the market to form a trend in that small period when panic and greed gather due to human nature. Most of the time, predicting the market is basically a failure.

 

The reason is simple. The capital market is a complex, non-steady-state, chaotic market, and it is a second-order chaos. In second-order chaos, you can only predict the third day after you know the performance of the second day. If you can't even predict what will happen tomorrow, how can you predict the third day? Therefore, most of the time, the market is unpredictable, and only in a few cases can there be some clues.

 

There is also an artistic element. Very few people can master this art, and this may be the biggest difference. It is almost something that can only be understood intuitively but cannot be explained in words. Grasping the selling point is very important. There is not much difference when buying, but when selling, it is basically mastered according to the market trend and various factors. Those who are good at selling are the real masters, and this is basically the case in the asset management industry. However, buying in line with value investment can be completely replicated.

 

It is quite difficult to beat the market, unless you correctly predict extreme events. Howard Marks once said that excellent performance comes from correct non-consensus predictions. However, it is difficult to make non-consensus predictions, even more difficult to be correct, and even more difficult to execute. We don't make many correct non-consensus predictions. There are probably only two cases. The first time was in 2009 when we fully shifted to investing in domestic social construction and cleared out many investment-related varieties. The second time was in the second quarter of 2015 when we reduced our positions and switched to blue-chip stocks. If you always want to go against the market, your chances of winning will be very low.

 

Investment is more about managing your own desires. In fact, this is not only applicable to investment but also to career and life.