Here is a statement by Hong Liang, a successful value investor in China. His fund, Shiva Shanghai Asset Management, founded in 2015 has returned over 24% per year up to 2024. Read this testimonial in conjunction with the P/B-ROE discussion in chapter 2 that is continued in the P/B-ROE discussion on this web page: There are other subtleties involved.
“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)