Source: Hochachka, G. 2022. The Distribution of US Stock Returns, 1963-2020. At https://ssrn.com/abstract=4143649. From 1963-1967, the small group contains less than 1000 stocks.

While the median return is the same for both groups, smaller stocks have a higher upside return at all percentiles of the distribution, yielding a higher mean return. However, the smaller stocks have lower returns on the downside. In short, they have higher downside risk compensated with upside potential. But there is a trap: This pattern can flip. Your chapter 12 explains and shows how to avoid the trap.

The turn to style investing as an alternative to full-blooded value investing is a doubtful remedy. Most of the popular styles have also been unsuccessful in recent years. Indeed, the failure of these pseudo-value investing strategies have given value investing a bad name. Of note is the “value” and “growth” investing styles that have appropriated the language of value investing but which chapter 3 shows is cheap value investing. Chapter 12 goes further by showing that these styles lead you into a trap which only sound fundamental analysis exposes.

And so with investing on firm size that is also dealt with in chapter 12. We could continue with other styles, factor investing, smart beta investing, and more, and might do so in the future.

S&P Global has developed a Moat Index:

https://www.spglobal.com/spdji/en/indices/dividends-factors/sp-500-economic-moat-index/?utm_source=pdf_research#overview

This index quantifies the moat abstraction by rating firms on three measures:

• Sustained ROIC (similar to RNOA): The average over the past five years
• Sustained gross margins: Gross margin/Revenue and its standard deviation over the past five years
• High market share: Weighted-average revenue in industry, calculated with Syntax’s Market Share Score

Your authors have not validated the effectiveness of the score but S&P report slightly higher returns to identified moat firms over the S&P 500.

See the S&P Moat Index fact sheet at file:///C:/Users/shp38/Downloads/fs-sp-500-economic-moat-index-usd.pdf

Another attempt to measure the moat is in Mauboussin, M. and D. Callahan, 2013. Measuring the Moat at http://csinvesting.org/2013/07/24/measuring-the-moat/

Data analytics and information aggregators are firms often hailed as castles with moats around them. S&P Global (or its parent company, Moody’s Corporation) is one, as are FactSet Research Systems, MSCI, Equifax, TransUnion, and Fair Isaac. There firms have proprietary data, proprietary methods of analyzing data, and supply benchmark metrics that many employ. They have sustainable revenue with subscriptions and high margins.

These firms trade at high valuations. Fair Isaac, the provider of the FICO score, traded at a forward P/E of 78 at the end of 2024, for example. That might be because of potential growth. But the value investor is cautious: Those multiples could be overpricing. Is the expected growth justified? Is it at risk? Should the P/E be discounted for that risk? Is the advent of AI to elicit and analyze information a breach of the moat?

Here is a report on investing in China using a residual income approach. It is quite interesting as it challenges market prices with a no-growth valuation. That was the approach of Benjamin Graham who refused to pay for growth, rather investing in stocks where the price was less than a no-growth valuation. In mature stock markets, such stocks are rare these days so one has to deal with buying growth⸺the key focus of the book. The Chinese stock market has been subject to big swings, potentially with mispricing. Could it be that a no-growth valuation can identify mispricing there? The report suggests so.

In the study, the no-growth valuation is:

is calculated with forward consensus sell-side analysts’ earnings forecasts provided by Tushare (tushare.pro) which has additional accounting and trading data necessary for the calculation. This value is compared to price in a V/P ratio after each quarterly report date. The strategy then invests in the top 10% of V/P ratios from all Chinese listed stocks for which earnings forecasts are available, equally weighted, with the portfolio rebalanced at each report date.

The cumulative returns from this strategy (before transaction costs) from 2010 to mid-2024 are in the figure below. The benchmark return is that for the HS300 index for the largest stocks on Shanghai Stock Exchange and the Shenzhen Stock Exchange.

Source for all exhibits: Yan, Oliver. Does Value Investing Work in China? Masters thesis, Columbia Business School, 2024. With permission.

Here are the calendar-year returns from the strategy compared to the benchmark:

While the strategy beat the benchmark in most years, it did not in the three years, 2018‒2020. 2020 was a bull market, perhaps a period with price momentum where value strategies are typically challenged. However, with the subsequent drop in the market in 2021, the strategy performed relatively well. And the comparative returns in 2014 indicates resilience of the strategy in up markets with the subsequent drop in 2015 less than the market. There was a significant drawdown in 2011 and 2015 but considerably less than that for the benchmark.

The following plots returns for V/P ratios with a regression line drawn through the observations. For V/P greater than 1.5, there are some very high returns though some with negative returns. This calls for further analysis to sort out these firms.

Value investors invest with are margin of safety, so only invest in stocks with a V/P greater than 1.2 and apply some fundamental features: the firm has positive net income and positive net income growth and exclude small firms with a market cap less than $2 billion RMB. Here are the returns:

There is some improvement in the returns. This shows promise of improving returns by pressing on further with the fundamental analysis in subsequent chapters.

An investor who receives dividends and who doesn’t need the cash for living expenses can simply reinvest the dividends to recover the value lost from the drop in price. Indeed, many firms have dividend reinvestment schemes where the dividend is reinvested back into the same firm. Of course, as with any investment, check that the stock is not overpriced (with the fundamental analysis in this book) before you buy it with your dividend. If it is, you might take the dividend and create a further dividend for yourself by selling the stock.

By the same logic, an investor who needs cash for living expenses need not buy a dividend stock, particularly if she sees not much value generation in that stock. She can buy a non-dividend paying stock and create her own dividend by selling part of her stock holding when she needs cash. This has the same effect as the firm paying a dividend: The price of her holding drops but she has the dividend equal to the same amount.

Both these cases are homemade dividends. They amount to the investor creating her own dividend policy, making the dividend policy of the firm irrelevant.

“Most people in research still like to study PE ratios and dividend yields. However, I am different from them. I like to study PB (Price-to-Book) ratios and ROE (Return on Equity). This makes it easier for me to grasp the essence of things.

For some companies that rely on their business models and have light assets, using the PB and ROE models doesn’t hold much meaning.  Take a high-quality company with a 20% ROE. After four years, this company’s net assets will have doubled.

If it is a leading internet or liquor company, for example, which is a light-asset company with a high PB ratio, the success of its business is not dependent on its net assets. For instance, a company with a market value of 1 trillion RMB and net assets increasing from 100 billion to 200 billion RMB — what would its market value be four years later? It’s hard to predict. Its stock price may remain 1 trillion RMB, maybe less than 1 trillion RMB, or it may exceed 1 trillion RMB.

But for another type of company, one with heavy assets that continuously takes on projects, its business expansion depends on the growth of net assets and quality projects. With a 20% ROE and an initial PB ratio of 1.25, a market value of 1 trillion RMB, and 800 billion RMB in net assets — after four years, the net assets could grow to 1.6 trillion RMB. Of course, 50% of the increase in net assets, or 800 billion RMB, could be distributed as dividends, and 50% could be used for capital expenditures, with part of it replacing capacity and part of it going toward expansion.

In fact, this example of the business model for real estate companies can also apply to upstream resource stocks. After four years, if the PB ratio remains stable, the market value will grow in proportion to the net assets. If no dividends are paid, the net assets will become 1.6 trillion RMB, and the market value will be 2 trillion RMB. If, during this period, 400 billion RMB is distributed as dividends, the net assets will be 1.2 trillion RMB, and the market value will be 1.5 trillion RMB. Over four years, the company would have distributed 400 billion RMB in pre-tax dividends.

After explaining this, everyone can understand why I use the PB and ROE models as my theoretical foundation for analyzing such companies. As long as the business has a monopoly, and the product is universal, the company’s price range can allow for sensitivity analysis on profitability or ROE. When the PB ratio is at a reasonably low level, anywhere below 1 and up to 1.5, I consider it a low PB range, and you can hold the stock, capturing the 20% ROE annually and essentially recreating the company in four years. This way, you won’t be scared by fluctuations. The company’s ability to make money, combined with its valuation, can lead to the company doubling in value every four years. So why not hold onto it and let it double every four years, and in eight years, double again? This business model is suited for this kind of analysis.

In contrast, the previous examples of internet and liquor giants do not apply to this method. Therefore, I don’t care how much the stock price has risen in the past or where it is on the chart. I only focus on the PB level and the ROE’s ability to represent profitability, allowing me to hold the stock perpetually. This investment model allows me to make money in a secure and steady way, without worrying during market adjustments, because I know exactly how I am making money.

I’ve seen those who analyze economic cycles, recent market trends, how to rotate sectors, and how to analyze growth stocks using PE and PEG ratios. They engage in all sorts of stock price speculation, but I find it overwhelming. It’s nowhere near as stable and reliable as my system.

In 2017, I achieved my greatest success with the real estate sector. Now, once again, I’m relying on resource stocks with high ROE and low PB. These companies acquire new projects, replacing their old, depleted ones (like exhausted mines). The difference is that in real estate, projects typically have lower profit margins and rely on leverage to increase ROE. However, in the resource sector, where profit margins are high, even with low leverage, ROE can still be high. Therefore, the risks in the latter are much lower, though the income growth rate is slower.    But if the essence of these companies’ profitability is ROE, and their valuation method is PB, does it really matter if their income growth is slow? Does the world only have one type of performance growth that can increase valuations? Does performance decline always lead to a lower valuation? This only applies to certain companies that follow the PE and PEG model. But the essence of investing is to make money. If my net assets are 800 billion RMB this year and 1 trillion RMB next year, even if my growth rate slows down, the company’s value will increase. Why should the market value fall? It should rise.

So, I understand the theory behind valuing growth stocks, but I don’t believe it can be applied universally. Similarly, the idea that cyclical stocks’ prices should fall when commodities peak is nonsensical to me. When my PB ratio is below 1, and my profits over 2-3 years exceed the market value, why should the stock price drop? Some people say cyclical stocks should be sold when they become cheap, but they don’t realize that theory is based on buying at a high PE and selling at a low PE. They don’t understand the significance of an extremely undervalued PB ratio. Various strange theories about cyclical stocks and growth stock valuations have trapped most people. They fail to understand the most fundamental value theory: year after year, the company’s net assets are increasing, its cash flow is growing, and so its value should rise.

Yet, they insist on applying ridiculous cyclical stock or growth stock valuation theories. These theories aren’t true investment theories, they are stock speculation theories, mere stock price gambling theories, not real value investment theories. Today, I’ve shared all my most valuable knowledge. I believe very few people discuss these things, because everyone’s understanding and experience with investing are different. I feel like I’ve already grasped the essence of things. Many people may not even “get” what I’ve shared today.”

(Translated by Zhi (Oliver) Yan)

E/P = E/B x B/P = ROE x B/P

So a given E/P (P/E) can be any mixture of ROE and B/P, a high ROE with low B/P or low ROE with high B/P, for example.

For the historical average P/E since 1960 of about 16 (E/P = 6.7%) with a P/B of 2.99 (a B/P of 0.334) and an ROE of 20%,

E/P = 6.7% = 20% x 0.334

But an E/P of 6.7% can also be accounted for by

E/P = 6.7% = 5% x 1.34

That is, an ROE of 5% and a P/B of 0.75 (a B/P of 1.34).

Now, as chapter 2 instructs, a high P/B is justified by a high ROE (as in the first calculation here) and a low P/B is justified by a low P/B (the second calculation). The interesting case for a value investor is that with a high ROE and a low P/B. It suggests the market is underpricing the ROE: Why is the P/B so low while the book value is generating a high return on book value? See also the testimonial on a P/B-ROE strategy on this webpage.

There is a Vignette in chapter 2 pointing to some interesting cases. Here are the subsequent returns over one year and two years for the firms exhibited there. Note that for Newell Brands and China Eastern, the second year ahead was the Covid pandemic year.

This is not a completely informed strategy for three reasons.

First, it’s not current ROE that the P/B prices but expected future ROE. So look at the forward ROE but, even then, ROE in later years also matter.

Second P/B is not only based on expected ROE but also the amount of investment that the firm puts in place to earn the ROE; more investment to earn at a high ROE adds value. The two generate growth.

Third, expected ROE needs to be discounted for risk to ROE. That affects the price in P/B. If expected ROE is high but at risk of falling a lot, price should be lower.

These are the additional features to the P/B-ROE strategy that the book brings in as it proceeds.

However, screening can help by filtering out stocks for that further analysis. There are many firms to which we can bring value investing analysis, and sorting out those where there might be payoff to the work involved would be helpful. You can be stimulated to investigate a firm by a number of catalysts: Recognizing the prospects of a business, recognizing good management, recognizing a promising business model, an insightful newspaper report, an analyst’s informed report, an unexplained drop in the stock price, and much more. But the chapter suggests other filters which can be combined with these filters to identify potential investing targets.

One is a low PEG with low indicated risk. The PEG ratio compares the forward P/E to a forecast of earnings growth in the near term. In effect, it challenges P/E with an (informed) growth estimate: If the P/E is low but the growth estimate is high (that is, PEG is low), that could be mispricing. That is a cue to investigate further. As the chapter informs, P/E could be low for a given growth because the expected growth is risky, discounting the price in the P/E ratio. So, a low PEG must be evaluated against the risk involved. Investigate further with a complete value investing analysis.

So, here’s the filter to help identify a promising stock to buy: A low PEG with indications that risk is low. And avoid stocks with high PEG and high perceived risk. That, of course, requires a risk indicator, a topic for later in the book. Chapter 2 refers to beta, not to be ignored but not a fundamental measure. Keep in mind that the integrity of the PEG ratio requires the earnings in the P/E to be sustainable earnings, not affected by one-time items that cannot grow. And a good estimate of future earnings growth is also important. The five-year estimate from analysts’ forecasts are not very accurate.

A similar cue can be given by the P/B ratio: A low P/B with a high forward ROE indicates possible mispricing. But, again, recognizing risk is crucial: P/B should be low if the risk to future ROE is high.

In January 2025, China Sunshine Paper Holdings Company Limited (2002.HK) traded at a P/E of 4.73, a P/B of 0.4, and an ROE of 9.2%. Worth looking into?

The answer is not clear except to say value investing is gaining traction in China. Two value investors that we know of have been very successful, Yongping Duan and Hong Liang. There is a value investing website called Xueqiu where Yongping Duan and Hong Liang write blogs and testimonials. You can go there and, if you cannot handle the Mandarin, use Google Chrome’s translate function to translate to English. Yongping Duan’s home page is https://xueqiu.com/u/1247347556 and that for Hong Liang is https://xueqiu.com/u/9887656769. More on their investing style on the web page for chapter 2.