This article is sourced from: Sixiang Gangyin
01 Compound Interest: Repeatedly Applying a Simple, Sustainable Method Countless Times
Value investing has two core components: one is identifying companies that are continuously growing, and the other is compound interest. The former is the source of profit, while the latter is the process of capital appreciation; the former represents the concept of research, and the latter embodies the method of investment.
In institutional settings, these two cores belong to the research and investment departments respectively. However, individual investors must combine both roles, often leading many value investors to focus solely on company research, treating 'compound interest' as a natural outcome of long-term investing.
Is this truly the case? Previous discussions have focused more on industry research and company analysis, but today’s article will start with 'compound interest.'
Consider this thought experiment: A small patch of duckweed appears in a pond, doubling in size every day. Experts predict it will cover the entire pond in 10 days. How many days will it take to cover half the pond?
The answer is 9 days, the day before the 10th. This is because, on the 10th day, all the duckweed that grew during the first 9 days is still expanding.
The magic of 'compound interest' lies not in the 'interest' itself but in the 'compounding.' This 'compounding' has two meanings: the first is 'reinvestment,' which is relatively easy to understand. However, for reinvestment to yield the same returns, there is an important prerequisite—this is the second meaning of 'compounding': repetition—the act of endlessly repeating a simple and sustainable method.
All duckweed grows using the same method and requires the same raw materials, enabling it to replicate at maximum speed. The reason individual investors struggle to achieve compound interest is not due to a lack of 'reinvestment' but rather the absence of a 'repeatable investment method.'
A repeatable investment method essentially constitutes a 'profit model.'
02 The profit model is an optimization of investment methods.
That's correct. Just like business operations, investments also require a profit model.
Individuals have unique personalities, their own approaches to taking action, preferences for risk, and weaknesses that are difficult to overcome. If you cannot settle on one or two methods that suit you, you will feel lost when switching between various approaches.
Although lions on the African savanna are powerful and have almost no natural predators, their large size also means high energy consumption. Once they launch an attack, it's like a Boeing 747 taking off, burning tons of fuel. If the hunt is unsuccessful, it leads to a decline in physical strength, which further weakens their attacking power, making it even harder to catch prey, thus creating a vicious cycle.
Therefore, every time a lion launches an attack, it is extremely perilous for itself. It must follow the principle of 'minimum energy expenditure, maximum probability of success.' Over the long term, they develop a set of hunting 'profit models'—
First, it will observe a group of prey for a long time, identifying the most likely target, usually the old or weak ones;
Then, it will suddenly charge, scattering the entire group of prey, and quickly select the easiest target from among them;
Finally, it will head straight for the target, striking with precision in one decisive move.
All investment masters repeatedly apply a set of long-term effective profit models, waiting for the right opportunity before taking action.
Many experienced investors believe they have methods, but methods do not equate to profit models. A profit model is the result of optimizing methods. Many people’s methods are too demanding, non-repeatable, guaranteed to lose in the long run, or hide fatal risks. A profit model, however, must be a method that can consistently achieve satisfactory returns over the long term. Just as a lion may have ten thousand ways to catch prey, only a few are 'all-weather killers' or 'effective against all species.'
In an early article, I wrote about the differences between trend investing and value investing. It was mentioned that specific methods of trend investing change with the proportion of retail investors, regulatory policies, and the quality of listed companies, making it difficult to achieve compounding returns.
From 1996 when I started trading stocks up until today, trend investing has seen at least three waves of mainstream speculation methods:
The earliest method was the stock manipulation model; in the era of full circulation, when manipulators could no longer control the market, it shifted to a speculative short-term trading model, during which the bravest speculators thrived; after stricter regulations were enforced, it evolved into a 'limit-up' trading model based on continuous speculation by rotating funds.
I have never recommended readers to participate in 'limit-up' trading, not because of the high risk, but because it is unsustainable—perhaps in two or three years, the conditions for this type of trading will no longer exist, eliminating its compounding effect.
Value investing has become mainstream because it is sustainable, applicable to both small and large funds, and exhibits a long-term 'compounding' effect.
Many people enter the stock market with the intention of making a quick profit and leaving, but without a stable method, they find that the money they earn cannot be taken away. Many short-term trading experts, once their capital grows larger, find themselves unable to continue.
Based on my personal experience, I have summarized four highly suitable profit models for individual investors, which form the core of my investment system and will be the focus of my articles in the coming period.
Today, I will provide a general introduction.
03 Four Classic Profit Models
[First Profit Model: Turnaround from Distress]
Every collection of case studies on investment masters includes such stories of a remarkable turnaround. Coupled with the fact that once successful, the gains are often substantial, every investor wants to seize such opportunities.
However, 'turnaround from adversity' is not an opportunity but a specialized profit model. It requires strict screening criteria; only good companies in good industries that encounter 'bad luck' have the potential for a 'turnaround from adversity.' The other 90% of companies will simply drift along with the current.
The profit model of 'turnaround from adversity' also demands considerable investment skills. One must find companies with a high margin of safety, determine the timing of the company's performance reversal, and remain vigilant against good companies deteriorating into 'junk stocks' due to loss of morale.
'Turnaround from adversity' is a game of probabilities. Among five companies that meet the 'turnaround from adversity' criteria, only two may genuinely 'reverse,' and only one might present an opportunity you can seize. Therefore, this profit model must control position sizes, resulting in significant gains but generally modest profits.
Due to the high volatility of A-shares, most top-tier funds excel at 'turnaround from adversity.' Strictly speaking, this strategy is more suitable for institutional investors engaging in portfolio investment. However, retail investors should still pay attention to studying this model because once the reversal happens, the stock transforms into the second type of profit model.
[Second Profit Model: Growth Scaling]
Growth scaling represents the best investment approach during the performance enhancement phase of growth stocks.
Many people view value investing as researching one or two companies, then heavily investing from the bottom up and holding long-term, hoping to catch a 'tenfold increase over ten years' stock. In reality, this method is tantamount to gambling.
A company’s business condition is constantly evolving, and its stock price typically aligns with its operational status, rarely being undervalued for extended periods. Therefore, buying a company essentially means having a differing opinion from the market — namely, an 'expectation gap.' The key to profitability lies in your perspective being validated by the market, ultimately reflected in a rising stock price.
Growth scaling follows the principle of 'certainty determines position size.' When we identify a company with an 'expectation gap,' we first purchase a partial position. As the company’s operations improve in line with our expectations, we continuously scale up to the preset maximum position. If the 'expectation gap' cannot be confirmed for a prolonged period, we maintain the current position or reduce it. If the market disproves this 'expectation gap,' we should pragmatically liquidate our holdings.
Growth-oriented position building is also a mechanism of 'self-interest-driven' behavior. Only when you hold a position in a company and achieve modest profits will you be motivated to study it more intensively. Leaving room for future position increases can also prevent the situation where emotions override rational judgment.
[The Third Profit Model: Value Benchmark]
This method targets investments in steadily growing companies, especially well-known large-cap firms.
These companies are characterized by thorough market research, with their stock prices nearly reflecting fundamental conditions. Their valuations are more significantly influenced by market sentiment. Price fluctuations are often difficult to predict. If we exclude the interference caused by valuation volatility, stock price increases depend solely on earnings growth.
Thus, the returns from blue-chip stocks consist of two parts: one part comes from continuous earnings growth, while the other part stems from valuation changes due to shifts in market preference — either moving from undervaluation to overvaluation (gains) or vice versa (losses).
Therefore, our investment allocation in such companies is also divided into two parts. One part aims to benefit from earnings growth, while the other seeks to capitalize on valuation fluctuations. The first part of the allocation remains stable over the long term, while the second part adjusts based on the company’s value benchmark — overweighting when the stock price is below the benchmark and underweighting when above it.
Two key issues should be noted when applying this method:
First, the value benchmarks of growth-oriented blue-chip stocks tend to rise continuously, so the first part of the allocation should not be discarded lightly.
Second, even blue-chip stocks experience earnings fluctuations. When stock prices fall below the value benchmark, it is crucial to determine whether the decline is due to valuation correction (which warrants增持), performance deterioration (requiring下调价值中枢), or fundamental breakdown (which calls for清仓).
[The Fourth Profit Model: Industry Trends]
Previous articles have compared the differences in development trends between consumer goods companies and technology companies:
Branded consumer goods possess consumer stickiness, making it easy to exhibit a 'Matthew Effect' where the strong get stronger. However, tech stocks are highly susceptible to technological changes, which can cause leading companies to lose their advantages overnight.
This results in a significant difference in investment approaches between consumer stocks and tech stocks: the focus of research for consumer goods companies is on the company itself, while for most tech stocks, the emphasis is on industry trends. Apart from a few exceptionally outstanding companies, most TMT firms require an investment approach based on 'industry trends.'
The profit model of 'industry trends' first involves identifying the most significant industry trends over the next few years, then finding the companies that align with these trends and are most likely to deliver strong performance, and finally purchasing shares before the trend takes shape and realizing profits before the performance materializes.
'Industry trends' differ from 'trend investing' or 'speculative stock trading,' where performance is not required, and the worse the stock, the easier it is to speculate. 'Industry trends' represent value investing, where performance is essential, and the magnitude of gains correlates directly with the explosiveness of future earnings.
However, unlike typical value investing, 'industry trends' involve first driving up all related concept stocks, leaving only those with actual performance at higher levels while those without returning to their starting points.
Therefore, the core competency of the 'industry trends' profit model lies in predicting which companies will generate performance in the future. For example, whenever there is an opportunity to invest in Apple's supply chain, people often look to Guo Mingqi’s views because he is very familiar with the industry chain.
04 Transforming the profit model into instinct
In value investing, 'value' emphasizes thought, while 'investment' emphasizes technique. The 'profit model' must become an instinctive part of investing, developed through deliberate practice.
Lions’ highly efficient hunting patterns are honed from a young age by following the pride, progressing from imitation to hands-on practice.
First, one must have an awareness of the 'profit model.' All stocks in your self-selected portfolio are like a group of prey. Those that fit the 'turnaround from distress' model are certainly not suitable for the 'value anchor' model. From the outset, you must know which model you will use to 'hunt.' Avoid meaningless judgments such as 'this company has value, while that company is overvalued.'
Value investing is mostly about tedious research and boring waiting; real opportunities are fleeting. Every process of a profit model must be broken down into the simplest actions, repeated over and over again until they become instinctual reactions, allowing the profit model to operate efficiently.
Possessing at least one profit model is a hallmark of an investor’s maturation and is arguably a necessary step toward becoming a professional investor.
Having a stable profit model is like finding a job after graduation. Although during university, the future held infinite possibilities, they were all just floating ideas. Only with formal employment and a steady cash flow income does life truly begin, enabling one's Return on Equity (ROE) to continually improve.
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Editor/KOKO
