Three timeless principles of value investing

Red and Green Guide:

Cycles primarily describe the changes in macroeconomic, industry, and corporate prosperity from the perspective of the real economy; valuation projects the real economy into the secondary market, determining how much we are willing to pay to express our assessment of the real economy; while human nature is infinitely amplified in the secondary market, exacerbating the volatility of valuation and even prosperity.

Source: "Cycles, Valuation, and Human Nature"

The author of "Cycles, Valuation, and Human Nature," Ling Peng, is currently the founder of an investment company. He has long been engaged in investment research activities at mainstream institutions. As a member of a professional investment institution, he has always been at the forefront of investment research, personally experiencing the ups and downs of the A-share market over 20 years. After years of reflection, continuous abstraction, and refinement, he has summarized three unchanging principles of investment: cycles, valuation, and human nature.

I. The First Unchanging Principle: Everything is Cyclical

Some people divide stocks into growth stocks and cyclical stocks, as if the two are opposites. In reality, all growth is cyclical; it's just that the length of the cycle varies across industries due to different business models. For example, the pig cycle averages 3–5 years; the liquor industry has experienced two cycles since 2000—2000–2012 was an upward cycle, 2013–2015 was a downward cycle, 2016–2021 saw a renewed rise, and since 2021, it has declined again. The banking cycle is even longer, with only about 1.5 cycles since the 1990s. The entire 1990s saw a decline as China's economy "soft-landed," 2000–2010 was a golden decade, 2011–2020 was a decade of dealing with non-performing assets, and since 2021, the sector has rebounded from the bottom.

Thus,no flower blooms forever. When an industry is at its peak, who could have predicted it would one day be deserted? There are no eternal tracks in this world, only eternal cyclical thinking.

What factors dominate cycles? There are two main ones: the slope of demand release and capacity supply. Generally, when an industry's penetration rate rises rapidly, demand is released quickly, making it easy to create bubbles where everything rises. Once penetration reaches a certain level, demand continues to be released, but the pace slows significantly, leading to valuation compression, intensified industry competition, and increased concentration.

Generally, supply lags behind demand. When demand surges, supply often can't keep up, but companies inevitably ramp up capacity, setting the stage for future supply surges. The time gap between demand release and capacity construction leads to significant fluctuations in industry prosperity.

Initially, demand rises rapidly while supply lags, leading to unprecedented industry prosperity—prices rise but volumes are insufficient. Next, demand continues to be released, but microeconomic entities invest heavily in capital expenditures, increasing supply but still not keeping up with demand growth, leading to rising prices and volumes. Later, as penetration reaches a certain level, the pace of demand release slows, while the capital expenditures invested earlier begin to translate into large-scale capacity supply, causing prosperity to decline. This is followed by brutal price wars, capacity reductions, and corporate bankruptcies, leading to increased industry concentration.

Ling Peng divides the development of the A-share market after 2005 into three stages, and the protagonists of each stage have gone through this process. From 2005 to 2009, cyclical stocks, driven by both real estate and exports, saw massive demand release. At the time, it seemed no amount of supply was a problem, commodity prices soared, and the valuations of all cyclical stocks reached staggering levels. Over the next decade, urbanization continued to rise, but the slope slowed, and the excess capacity accumulated during the boom became a burden. It wasn't until after self-driven capacity reductions and the government's strong supply-side structural reforms that cyclical stocks enjoyed a second spring, a process that took roughly 10 years.

Similarly, from 2010 to 2015, the penetration rate of mobile internet rose rapidly on the back of 3G/4G networks and smartphones. Novel business models, high-frequency data, and frequent expansions jointly fueled a bull market. The three rounds of "stock market crashes" in the second half of 2015 ended the A-share internet bull market, but Chinese concept stocks in international markets continued to enjoy the dividends until the Spring Festival of 2021.

After 2016, liquor stocks and some cyclical financial blue chips were the first to end the cyclical adjustment that began in 2011, ushering in a second spring, with nearly 10-fold gains from the "Davis Double Play." New energy stocks, after experiencing early policy-driven and theme-driven phases, entered a period of rapid penetration growth in 2017. But similarly, they accumulated massive capacity during their most prosperous years, which would emerge in subsequent years, inevitably leading to fierce competition. Thus,times change, but the principles remain—everything is cyclical.

II. The Second Unchanging Principle: Valuation Always Matters

Many believe the A-share market is an emerging market with only trends and no valuation. This is wrong. Based on Ling Peng's years of observation, the valuation factor is highly effective in the A-share market. The trends in A-shares are indeed extreme, but these extreme trends only push the pendulum further from the midpoint, not preventing its eventual return.

Many believe the stock market can foresee the future—for example, U.S. stocks rose during the 1918–1919 flu pandemic, and the U.K. stock market bottomed before the Blitz. Ling Peng has conducted in-depth reviews of these two cases, reaching conclusions that differ from mainstream views.

For the first case, U.S. stocks did rise during the height of the flu pandemic, with the Dow Jones Industrial Average gaining 10.51% in 1918 and 30.45% in 1919. Many hastily concluded that "the pandemic didn't hinder the stock market!" But when we place this period in a broader context, this conclusion becomes debatable.

From 1916 to 1921, U.S. stocks fell, rose, and fell again—down 4.19% in 1916 and 21.71% in 1917, up in 1918 and 1919, down 32.9% in 1920, up 12.3% in 1921, and then came the "Roaring Twenties."

Looking at daily data, the Dow peaked at 110.15 on November 21, 1916, then fell to 65.95 on December 19, 1917—nearly halving. It then rose to 119.62 on November 3, 1919, before falling to 63.9 on August 24, 1921.

In other words, before the 1918 rally, U.S. stocks were at a low of 65.95, a level only briefly breached in 1907 (when J.P. Morgan asked Jesse Livermore to stop shorting) and 1914–1915 (World War I). Thus, before the flu outbreak, U.S. stocks were at historic lows.

Combined with the U.S. economic situation at the time, the conclusion becomes clearer. From 1916 to 1922, U.S. real GDP growth rates were 13.9%, -2.5%, 9%, 0.8%, -0.9%, -2.3%, and 5.6%, almost perfectly matching stock market trends. The 21.71% crash in 1917 was due to a -2.5% economic contraction, while the 1918–1919 rally was driven by 9% and 0.8% growth, followed by another downturn until the post-1922 boom.

Thus, a rough review shows the 1918–1919 rally wasn't due to the market ignoring the virus but two other factors: U.S. stocks were at historic lows, and the economy was booming. Valuation played the decisive role.

For the second case, we can't find specific U.K. or German stock indices from that time—today's FTSE 100 and DAX 30 were created after World War II. Fortunately, Barton Biggs' "Wealth, War & Wisdom" provides detailed records.

While Biggs also believes the market has a magical foresight, he overlooks key facts. First, the Blitz occurred from July 10 to October 31, 1940; the U.K. market bottomed in early June, trading at just 0.2–0.4x P/B, nearly breaching the 1932 bear market low.

Second, global markets rose during the Blitz, with the U.K. underperforming Germany (which peaked in fall 1941). If the market foresaw victory, was it for the U.K. or Germany? Third, the U.K. market didn't rise steadily after June 1940—it retested lows several times over the next two years without breaking them. The real rally began after July 1942, when the U.S. had entered the war, improving Britain's prospects. Thus, the uptrend coincided with improving war conditions—no foresight was involved.

In fact, "Wealth, War & Wisdom" notes many June 1940 buyers believed Hitler would invade and permanently rule Europe—they bet valuations justified the risk. Thus, it wasn't foresight but low prices that made investors to gamble.No one can predict the future. Warren Buffett has repeatedly said he doesn't profit by forecasting indices or stock prices. We invest not because something will happen but because the current risk-reward is favorable!

Returning to A-shares, the past 20 years have seen repeated "high-to-low rotations." At the 2009 peak, cyclical stocks were far more expensive than consumer or growth stocks, so growth replaced cyclicals. By early 2016, even after three "crashes,"创业板 and internet stocks were still pricier than blue chips, driving capital to "core assets." If our post-2021 outlook is correct, it again proves valuation's power—low multiples will dominate the next phase.

III. The Third Unchanging Principle: Human Nature Never Changes

A key driver of bull and bear markets is human nature. Despite centuries of wisdom and countless books by masters, greed and fear persist.

In the past three phases, October 2007's "Golden Decade," May 2015's "Internet+" frenzy, and February 2021's belief in the "Maotai Index" and "Ningde Portfolio" as eternal tracks all reflected extreme greed. Conversely, panic reigned at 1664, post-2016 "circuit breakers," and late 2018, as if the world were ending. All are manifestations of human nature.

After nearly 20 years of research, reviewing lessons, we find many failures stem not from knowledge gaps but poor control of human nature. As Wang Yangming wrote in "Instructions for Practical Living": "To merely know quiet cultivation without self-discipline is to collapse when tested. One must temper oneself through action to stand firm, calm in stillness and motion."

Book learning is shallow; true understanding requires practice. Experience and discipline are vital, but if we must learn everything firsthand, how much can one fleeting life hold?Thus, read, review, study history and masters' insights—learning from predecessors is the lowest-cost path to progress. As Du Mu wrote in "Epang Palace": "The Qin mourned not themselves, but we mourn them; if we mourn but don't learn, others will mourn us."

Over 20 years, despite changes, three constants emerge through the noise: cycles, valuation, and human nature.Cycles describe real-economy prosperity; valuation bridges the economy and markets; human nature amplifies volatility in both.

Indeed,mastering cycles, respecting valuation, and controlling human nature are the essence of value investing. Many call A-shares a casino where rationality fails. The opposite is true—the more irrational the market, the greater the rewards for discipline. If all were rational, where would profits come from? Corporate earnings alone rarely deliver huge returns. It's like poker: if playing for money, not skill, would you rather face experts or novices? Novices may fluster you with wild moves, but sticking to sound strategy ensures long-term gains.