Mid-term stock trading guide--company quality--valuation--marginal changes in cryptocurrency exchange platforms

The main discussion is about the importance of a company’s quality, what aspects it includes, and how to quantify a company’s quality.

The importance of a company’s quality is generally undisputed. Aside from short-term speculation that doesn’t require considering company quality, strategies that rely on business performance are inseparable from good company quality. Whether it’s shareholder returns from investments or the price differences sought in speculation, both come from the company generating more net profit during its operations.

However, what aspects mainly constitute a company’s quality may be more controversial. Different strategies focus on different points.

For value investing strategies, if the valuation of a company is primarily based on discounted free cash flow, then the most important factor is the free cash flow throughout the company’s lifecycle. This corresponds to requiring the company to have a sufficiently long lifespan, a good business model, and a strong moat—what is often called a long slope and thick snow. Among these, Duan Yongping emphasizes corporate culture on top of the business model. Naturally, companies that meet these conditions can be considered rare. Additionally, it’s crucial to truly understand the company—knowing what the company might look like ten years from now. The difficulty of value investing lies in understanding a company, which is not an easy task.

Another school within value investing is the high-dividend strategy. If a company’s value is based on discounted free cash flow, then for those who own the entire company or can control it, the stock’s value equals the company’s value. But for most secondary market investors, they are just small shareholders who cannot control the company or influence decisions. For these small shareholders, the company’s free cash flow does not equal the investor’s free cash flow. Only when management uses the company’s free cash flow to reward shareholders (including dividends and buybacks) does this free cash flow become the investor’s free cash flow. This leads to the dividend discount valuation method. The high-dividend strategy often performs well in bear markets because shareholders receive tangible cash flows, which is crucial for surviving downturns. However, in bull markets, this strategy may not perform as well. Since a company’s profits are fixed, paying out more in dividends leaves less for reinvestment and growth, limiting the company’s growth potential. Another important point is that, under normal circumstances, a dividend yield of 7-8% is already high. Without profit growth, relying solely on dividends makes it difficult to recover the investment in ten years.

Corresponding to the high-dividend strategy is the growth stock investment strategy. Growth stock investors often value companies with a terminal perspective, so they are not concerned with current dividends and actively support financing to expand production, essentially mirroring the high-dividend approach. Growth investors typically set a target terminal market value for the company, then discount it back to the present using an appropriate discount rate, and compare it with the current market value to assess valuation reasonableness. Growth stock investing is somewhat similar to venture capital, focusing more on the people—like Buffett investing in BYD, which was essentially investing in Wang Chuanfu. This strategy demands high management capability. The biggest risk is misjudging the terminal value.

In summary, regardless of the school, the foundation of successful value investing is understanding the company—knowing what it will look like ten, twenty, or thirty years from now. Many associate value investing with long-term holding. Indeed, the core principle of value investing is discounted free cash flow, which is generated through the company’s year-after-year operational efforts. Therefore, holding for the long term is a natural way to capture these cash flows. Conversely, long-term holding is not necessarily value investing. Holding a junk stock for ten years not only fails to create value but can destroy it.

Mid-term speculation naturally corresponds to long-term investing. Why choose mid-term speculation over long-term investing? The answer is simple: insufficient skill to see through the company’s operational state ten years from now. Besides these two, there is also short-term speculation, which is popular among many traders and speculators. Honestly, I have tried it too, but unfortunately, my skill level is insufficient, and I can’t make money. Fortunately, I haven’t lost much because I never dared to fully commit from the start.

Back to the main topic, what are the requirements for company quality in mid-term speculation?

First, the business model must not be too poor; operations should be sustainable. Even if you can’t guarantee the company will still be around in ten years, it should at least still exist with decent performance. This requires the demand in the industry to be sustainable. For example, industries like fuel vehicles, where demand is rapidly declining, should be avoided.

Second, the company should have a good industry position. For relatively homogeneous industries, typically choose the top one or two in the niche. In some special cases, the top three may be acceptable. For non-homogeneous industries, the limit is looser; it can be considered the regional or segment leader. For example, leading brands in various aroma types in the liquor industry, regional leaders. Some large industries contain companies with unique advantages; even if they are not in the top three, they can be considered. For example, CNOOC in the oil industry, COSCO Shipping in logistics, etc. A high industry position itself indicates good company quality, accumulated over years of operation. Additionally, a high industry position ensures the company can benefit fully during industry recovery.

Third, the management team should be reliable, with no history of fraud or deception. If such issues exist, all your analysis might be built on a house of cards.

Finally, quantitative metrics—ROIC (Return on Invested Capital). Companies with a normal ROIC below 8% should be excluded. A simple rule is: the higher the normal ROIC, the better the quality, even across industries. Here, “normal” is key. Due to various one-time or cyclical factors, some companies may have low or negative current ROIC, but these should not be excluded; instead, focus on whether and when they can return to normal.

The ROIC method cannot cover financial companies like banks, insurance firms, or brokerages, as they lack ROIC data. This model is invalid for financial firms. My personal expertise also doesn’t support coverage of banks and insurance companies. Brokerages are somewhat special, as their valuation is closely tied to stock market cycles. For these, ROE (Return on Equity) is used as a substitute for ROIC. Regardless of the metric, the focus is on predicting the company’s normal performance over the next 1-3 years.

The importance of company quality and quantification standards. Once the quality threshold is passed, the next step is to assess whether the valuation is high or low. After all, a good company needs a good price.

The most basic valuation method is discounted free cash flow. However, this requires knowing the future free cash flows for each year, which is impossible if you can’t determine the company’s operational state ten years from now. As mentioned earlier, even a true value investor cannot precisely calculate each year’s free cash flow over the company’s lifecycle. Many consider the discounted free cash flow method meaningless.

So, what is the significance of the discounted free cash flow method? It is a way of thinking—an approach that highlights what matters and what doesn’t. The core concern of a true value investor is always the company’s culture, business model, and competitive landscape, rather than one-time gains or losses. Valuation isn’t about calculating free cash flow precisely; it’s about a rough estimate—assuming that profits ten years from now will be significantly higher than today. Those who can truly accept this principle are exceedingly rare.

If you lack the ability to use the discounted free cash flow method, you need some way to estimate valuation. You can’t just buy at any arbitrary price. I tend to use PB (Price-to-Book ratio) because it is more stable and less prone to rapid changes. Is it then simply assumed that a high PB means overvaluation and a low PB means undervaluation? For the same company, yes. But when selecting stocks, comparisons across different companies are necessary—sometimes within the same industry, sometimes across industries. Therefore, looking solely at the absolute PB value isn’t very meaningful, as different companies have different qualities and growth expectations.

To facilitate comparison, a formula is created: IRR = ROIC / PB + G. Here, G is the average annual growth rate of net profit over the next ten years, which can be negative. By comparing the IRR values of different companies, you can assess their relative value. Note that ROIC is based on the normal state, and the profit growth rate is calculated using the normal state at the end of the period relative to the beginning. When IRR exceeds 12%, it is considered undervalued; below 6%, overvalued; and in between, reasonable. Of course, these are personal settings, and everyone can adjust the undervaluation and overvaluation thresholds based on their risk preferences and opportunity costs.

Clearly, this formula is only applicable to cyclical or highly stable companies. When G (the compound growth rate) exceeds 6%, even with infinite PB, valuation remains reasonable, which defies common sense. For growth companies with G greater than 5%, this formula becomes invalid. However, Graham’s classic valuation formula for growth companies is PE = 8.5 + 2*G, so there’s no need to reinvent the wheel.

The question then arises: whether using IRR or PE, the key variable is G. This brings us back to the starting point—you must understand the company’s normal profit level ten years from now. After all, it seems there’s no clear answer.

However, sometimes the market helps solve this problem. For example, when a company’s stock price drops to where ROIC / PB exceeds 10, as long as its future ten-year compound growth rate exceeds 2%, it enters the undervalued zone. When ROIC / PB exceeds 12, you only need to confirm that the company’s profits won’t decline over the next ten years. When it exceeds 15, just ensure that the profit decline rate over ten years is less than 3% annually. Since the selected companies are mostly industry leaders and avoid sectors with significant future demand decline, their profits should remain relatively stable, making this feasible. Further research is needed to verify this.

For growth companies, when the market assigns a PE around 10, the difficulty is reduced. For example, Wuliangye’s current PE (TTM) = 14.15. Using Graham’s growth stock formula, the market expects a ten-year net profit growth rate G = 2.825, meaning the market believes Wuliangye’s net profit in ten years will be 132% of the current. If you are confident that Wuliangye’s ten-year net profit growth exceeds 2.825%, then Wuliangye is undervalued (for illustration purposes, not a stock recommendation).

If a company passes both the quality and valuation thresholds, it enters the key watch list.

Once a stock passes the initial screening, it has value for focused observation. But between the initial screening and actual purchase, there’s a crucial issue to resolve. Based on the first step’s quality requirements, among over 5,000 A-share companies, no more than 10% meet the criteria. If you score on a 100-point scale, above 90 points is generally considered excellent. Why would an excellent company be cheap enough to have an IRR over 12%?

If you can’t figure this out, never buy. Never deceive yourself with vague reasons like “the market is wrong.” Every undervalued stock has a reason. If you can’t identify that reason and arbitrarily dismiss it as wrong, you’re just gambling. Don’t even think about investing or speculating without understanding.

Therefore, at this stage, each case must be analyzed individually. Because the reasons for a company’s decline vary, so do the responses.

However, some experts have summarized common decline patterns: Feng Liu mentions killing valuation, killing performance, and killing logic. Wu Zong adds emotional killing. Below, I share my understanding of these four scenarios and how to respond.

First, emotional killing. This occurs when the company’s fundamentals haven’t changed negatively; valuation is reasonable, but the stock crashes purely due to market or sector sentiment. Once sentiment recovers, the stock price tends to rebound quickly, like in January-February this year. Such market movements are hard to predict; the only response is to keep some cash ready for bottom-fishing.

Second, valuation killing. The company’s fundamentals haven’t worsened, but due to liquidity issues, rising risk-free rates, or market style shifts, the valuation drops from reasonable to undervalued. It’s crucial to distinguish between valuation and performance declines. Don’t judge based on last quarter’s earnings; detailed research is needed to avoid overestimating the decline. If after research, the valuation drop remains uncertain, then avoid the stock. If confirmed as valuation-driven, further analyze the cause of valuation decline. For example, if risk-free rates rise, the overall market valuation drops, and companies with shorter durations are less affected. Next, assess whether risk-free rates will continue to rise, stabilize, or fall. Only buy when rates stabilize. Many growth stocks are already at a turning point.

Third, performance killing. This is similar to valuation killing but with a key difference: the company’s fundamentals are deteriorating, but not yet reflected in financial reports. Be careful to distinguish between performance and logic. Performance decline without changes in competitive advantage, business model, or profitability is often cyclical or incidental. If these factors change significantly, it’s no longer performance decline but a change in logic.

If the decline is due to cyclical factors, the buy signal is the start of a new cycle—tracking product prices, industry capacity, and demand. Understanding the cycle’s logic is crucial. If caused by incidental factors, evaluate whether these are temporary. Usually, events affecting only one quarter won’t cause major price drops. If the market continues to fall, reassess whether important factors are missing.

Fourth, logic killing. This is the most troublesome. It involves major changes in industry outlook, competitive landscape, or business model, leading to a significant drop in long-term profitability. If the market reflects reality, the company can be disregarded. Once a company reaches a steady state, it’s unlikely to meet the initial quality criteria anymore. For example, Nantong E-commerce was such a case; it will never return to previous profitability levels.

All these are from a fundamental perspective, focusing on marginal changes. While marginal changes drive medium-term stock price increases, the actual price is heavily influenced by capital flows. Therefore, monitoring fund movements and shareholding changes is also very important. Whether it’s company quality, valuation, or marginal changes, subjective factors are involved. No one is infallible. Observing market reactions to marginal changes can add a safety margin—markets are often smarter than us. Diversification is another safety measure.

In summary, investing is about understanding the company—truly knowing a company so that market fluctuations can be ignored. Mid-term speculation, because it cannot rely solely on understanding a company, uses the market as a tool to validate views. Therefore, mid-term speculation requires both understanding the company and the market. Since misjudging the company is possible, respecting the market is necessary. And since misjudging the market can happen, diversification is essential.