1. Investment: Mastery of Techniques Will Reveal the Path

In a letter to shareholders in 1966, Warren Buffett stated:

"We will not sell our holdings at an undervalued price, even if an astrologer claims the market is going down, and even though their predictions are sometimes correctWe also will not buy any stock at a price that already reflects its value, even if experts claim the market will rise."

Who among us makes decisions to buy private companies based on stock market trends? The core value of a company does not significantly change due to market fluctuations; rather, we should profit from the market's irrationality.

Buffett articulates his investment philosophy succinctly: "In the short term, stocks are voting machines, but in the long term, they are weighing machines."Prices fluctuate around values; our task is to take advantage of market irrationality by buying when undervalued and selling when overvalued.

The concepts appear simple, but practical application can be challenging

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The main struggle lies in accurately assessing value.

The most straightforward answer is, "Value equals the discounted future cash flows."

However, the real question is, "How do you estimate future cash flows?" And what discount rate should one use? 5% or 3%? Who could foresee that in the late 1970s, US interest rates would soar above 10%? Under such discount rates, any value gets severely diminished.

Therefore, aside from other complexities, the task of forecasting future cash flows alone is a daunting challenge. Often, we become over-acquainted with esoteric concepts but neglect practical application, such as valuing 500 companies, which is at the heart of understanding investments.

The concepts we intuit often take time to comprehend deeply; true understanding leads to profound insightsHow do we gain this knowledge? Through inductive reasoning based on real-world outcomes. Understand the "techniques," and the underlying principles will gradually reveal themselves.

Focusing on details is critical; once we grasp the tactical aspects, we can more profoundly appreciate the strategic layer's significance

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Without this, we risk becoming superficial commentators—constantly espousing investment theories, but incapable of answering if a company is priced right, and suffering losses time and again.

So how should one proceed?

2. Fish Where the Fish Are

To begin, one must assess the larger environment based on objective realities, for no industry exists in a vacuumAs Charlie Munger states, "The first rule of fishing is to fish where the fish are."

This extends to Benjamin Graham's core philosophy of "buying a dollar for fifty cents."

✓ One should only invest when sufficient information is available to accurately gauge intrinsic value;

✓ Investment should occur only when there is a margin of safety;

✓ Only enter the market when you’re prepared to wait for the market to recognize the security's intrinsic value.

This methodology aims to enable us to capture "certain opportunities," allowing us to invest only when the probability of profit appears high

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Another growth guru, Philip Fisher, may differ in style, but he echoes this sentiment.

✔ Invest only in familiar industries;

✔ Conduct thorough research on the companies of interest, including competitors, suppliers, and customers, ideally through face-to-face interactions;

✔ Seek out companies with outstanding management.

The most critical aspect of investing is preserving the principal; making money starts with not losing anyUnderstanding this principle clarifies the essence of investing.

In simplistic terms, the first step in investing is to locate a fish-rich pond; the second is to match the right bait with the fish, adjust the fishing depth and float size, and patiently wait.

3. Begin Valuation Based on Company Classification

To accurately estimate a company's value, it is essential to project its cash flows

To understand these flows, one must grasp the company's future developments and its type categorization.

The first category of companies I term cyclical companies. These companies experience profit volatility that mirrors economic cycles, leading to sharp, periodic price fluctuations.

Typically distanced from consumers, these companies are closer to the industry's upstreamDue to supply chain dynamics, known as the bullwhip effect, a 10% increase in consumption can lead to a 30% increase in supply chain activity, causing demand fluctuations that hinder capacity adjustments.

Given their distance from end-consumers, raw material manufacturers are the most susceptible to cyclical trends, rendering them the most cyclical companiesExamples include oil, coal, chemicals, steel, and construction materialsThe cash flow trends for such cyclical stocks typically resemble the following:

Indeed, everything has cycles, albeit at varying intensitiesAt different developmental stages, the same company's cyclicality may also differFor instance, bank stocks two decades ago were highly cyclical due to rapid growth and high valuations; now, they have stabilized.

We refer to industries with strong cyclicality mainly as resource stocks. Three avenues allow me to estimate the value of such companies:

✔ Price-to-Book Ratio: These companies usually have a high proportion of fixed assets, which remain stable and follow raw material price fluctuations minimally

When the company’s net worth is substantial, even poor profits retain value, allowing us to assess value via price-to-book ratios, noting that different industries display varied benchmarks.

For instance, a bank’s price-to-book ratio may stand at 0.5 but may not induce feelings of it being undervaluedThus, the price-to-book ratio should be analyzed together with return on equity (ROE)—the higher the ROE, the lower the price-to-book ratio's baseline; conversely, a lower ROE sees a downward pressure on the minimum price-to-book ratio.

✔ Price: For cyclical stocks, the prices of key commodities that shape corporate profitability are critical; higher prices equate to lower profits, and lower prices result in greater lossesHowever, there exists a profitability threshold for businesses; loss exceeding this threshold leads to bankruptcy, prompting a supply reduction which can rectify the supply-demand imbalance.

Thus, when commodity prices drop below sustainable costs, caution is warrantedHowever, falling below cost does not guarantee a rebound, as this often coincides with collapsing costs and reduced profits, further exacerbating price declines downstreamCash flow thresholds are nearly inviolable for most businesses.

Once commodities approach cash flow costs or historical lows (adjusted for inflation), we consider the enterprise undervalued. The larger the drop below costs, the more pronounced the undervaluation.

✔ Shiller P/E Ratio: This metric is calculated by dividing the price by the average earnings over the previous ten years (a moving average), adjusted for inflation, smoothing out market price fluctuations on corporate profit impacts.

Next, applying the Shiller P/E, alongside sentiments regarding future market interest rates, can yield a valuation expectation

The further below this valuation, the greater the undervaluation; conversely, exceeding this projection indicates a lack of safety margin and investment potential.

It's crucial to note that even cyclical stocks experience upward and downward cycles. For example, every major market correction between 2000 and 2020 coincided with a rising cycle in real estate, where profits consistently peakedHowever, post-2020, each upturn has merely been a rebound, with diminishing profits.

The second category I call blue-chip stocks. These companies usually exhibit stable competitive dynamics and are in mature industries.

Compared to cyclical stocks, these firms, closer to the end-consumer, possess greater cost elasticity and can control expenses to sustain profitabilityFor instance, Nike, which can reduce marketing expenditures amid economic downturns or Moutai, which raises prices to maintain profits even during economic slowdowns.

Essentially, such companies can mitigate earnings volatility during downturns through cost transfer and spending reductions, leading to relatively stable stock price fluctuations

These companies' cash flow trends typically unfolds as:

Valuing these companies typically involves P/E ratios, but the critical variable is the expected growth rateWhat expectations correspond to what multiples to consider as not overpriced?

In this context, we find it reasonable to estimate based on profit growth projections over the next decade since, generally speaking, a firm's intrinsic value equals the present value of its profit generation over ten years.

What dictates profit levels are critical growth rate expectations. As illustrated below, the variance in profit totals from growth rates ranging from 0% to 30% can exceed fivefoldMaintaining a 30% growth rate could yield a 13.79-fold increase in net profits after a decade.

For these relatively stable, mature blue-chip firms, we can formulate valuations based on growth rate expectations; should they fall below these estimates, the expectation would classify them as undervalued.

Now, regarding profit growth rate projections?

First, assess the industry's prospects: is it still in an expansion phase? Second, evaluate if there's room for concentration to increase

Third, consider the company's gross margin—see if there are opportunities for enhancementFinally, check if the firm can diversify its product categories, assessing potential third or second growth curves.

The third category encompasses growth stocks, including some tech stocks and promising smaller firms characterized by high growth.

Technology stocks are widely recognized; once a breakthrough occurs in a field, market opportunities rapidly expandFurthermore, due to high entry barriers and pronounced information asymmetry, market perception can vary drastically, resulting in substantial valuation fluctuations.

However, growth may not solely rely on technology; take the pet industry, like ZOETIS, which has thrived amidst consumer downturns, showcasing robust growth patternsThe cash flow trajectories for such companies often resemble:

The cash flow and profit dynamics of these firms usually do not follow a linear trend; rather, they exhibit exponential growthBefore achieving a certain critical point, they may resemble blue-chip or cyclical stocks; yet, once they breach pivotal moments, exponential growth ensues.

An illustrative example is BYD, whose net profit soared from 1.6 billion yuan in 2019 to over 30 billion yuan in 2023, representing nearly a twenty-fold increase.

For such companies, there is often little intrinsic value apparent; they tend to carry a degree of speculative risk.

When contemplating an investment, three key considerations arise:

First, can the company's trajectory be sustained? We can leverage first principles to analyze, for instance, my optimism regarding the renewable energy landscape stemmed from the knowledge that electric vehicles offer a tenth of the operating costs of traditional combustion vehicles, and humanity’s pursuit of lower energy costs will remain unwavering.

Second, a careful assessment of market size is vital; larger markets merit broader valuation opportunities.

Lastly, accurately estimating turning points in technological advancements or structural shifts within industries is crucial

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