Source: China Securities News
Recently, market themes in Hong Kong and U.S.-listed Chinese stocks have taken turns in the spotlight. The battle between bulls and bears—and which direction the market will take—has become a key focus for investors. However, 'what something is truly worth' is a more important question than 'where it is headed next.'
From a temporal perspective, the duration of market pessimism and euphoria may exceed expectations. Particularly when a trending sector coincides with a listed company announcing favorable earnings news, share prices can surge dramatically—like 'flowers embroidered on brocade' or 'cooking over roaring flames.' During periods of heightened market sentiment, listed companies are more inclined to release positive earnings updates, which may precisely coincide with key windows for major shareholders to reduce their holdings or raise capital.
However, companies that consistently fail to deliver cash returns to shareholders over the long term are fundamentally hollow. Prudent investors who aim for enduring success always maintain an internal 'balance scale,' enabling them to avoid being swayed by fleeting trends or short-term earnings and to refrain from exposing themselves to irreversible risks. As Graham once said, 'Drawing upon my two decades of turbulent experience on Wall Street, I caution readers: surface appearances and immediate phenomena in the financial world are nothing but mirages and bottomless abysses.'
What kind of company truly enriches its shareholders?
Short-term earnings boosts act like pouring oil on fire, propelling trend-driven companies to take off. However, assessing whether a company merits investment requires looking beyond short-term earnings growth. One must evaluate the company’s fundamental quality—such as its capital structure, business model, and its capacity and willingness to return value to shareholders. Growth lacking a competitive moat, failing to generate abundant cash flow, and offering no shareholder returns is ultimately meaningless to shareholders.
The book *Poor Charlie’s Almanack* notes that when Buffett lectured MBA students in the 1990s, he typically used two examples: AT&T and Thomson Publishing Company.
Munger explained that it was evident that investing in AT&T, a telecommunications company, yielded no profits over several decades because it constantly required additional capital injections, repeatedly issued new shares, and reinvested all its earnings back into the business. Its profit growth depended entirely on pouring in more capital, leaving no cash available for distribution to shareholders. AT&T was later broken up and is now an entirely different company.
In contrast, Thomson Publishing Company—a newspaper group operating numerous local papers—generated a steady stream of cash. Except when acquiring another newspaper, Thomson’s operations required virtually no additional capital investment. Naturally, Thomson’s shareholders grew wealthy, while AT&T’s shareholders did not.
Munger added that this stark divergence stemmed primarily from one company’s ability to grow without requiring additional capital, versus the other’s dependence on constant capital infusion for growth. Many companies appear to deliver acceptable returns on equity on the surface, yet shareholders receive no real economic benefit. These firms cannot generate distributable cash for dividends—they are traps for investors and fundamentally hollow.
Over the long term, even during severe bear markets, companies with strong organic growth continue to reward shareholders through dividends and share buybacks, steadily lifting the floor of their stock prices. Conversely, companies that rely on repeated capital raises and external funding to sustain growth are easily forgotten by the market once the tailwinds subside.
Why is focusing solely on short-term earnings performance inadequate?
Looking back at China’s A-share market, solar energy leaders from 2020 to 2021 and mobile internet-related stocks from 2013 to 2014 once shone brightly. However, after just two or three years of prominence, these companies faced a 'double whammy' of declining earnings and falling valuations, or saw their earnings grow while their valuations collapsed—often resulting in stock prices being halved, or in extreme cases, dropping by more than 90%. Hot stocks in popular sectors carry two major risks: the risk of valuation contraction and the risk that earnings growth proves unsustainable.
From 1964, when John Neff became portfolio manager of the Windsor Fund, he generated a 55-fold return for investors over the next 30 years—more than double the return of the S&P 500 Index. John Neff observed that some momentum investors tend to pin their hopes on high-growth companies, yet any quarterly earnings disappointment from such firms can devastate the market. This is especially true for stocks where bulls and bears are locked in intense contention and prices are temporarily balanced; if actual earnings fall short of expectations, it can trigger a price collapse. Stocks trading at high P/E ratios are highly vulnerable—even a minor shortfall in expected growth can drastically alter market sentiment toward the company. Regardless of the actual magnitude of the miss, the mere uncertainty alone can severely damage the stock price.
Investors often excessively extrapolate a company’s growth trajectory in a linear fashion, assigning extremely high valuations to fast-growing firms. Yet once high-growth stocks stop growing, they frequently suffer simultaneous declines in both earnings and valuation—a painful outcome that also explains the sharp drop in mobile internet-related stocks in 2013. Similarly, after 2021, even though some solar sector leaders continued to report earnings growth, their growth rates fell short of expectations, causing their valuations to contract from 40–50x down toward 10x. In fact, the valuation anchor for most manufacturing companies hovers around 10x.
Moreover, looking across global equity markets, only a handful of companies have managed to sustain annualized growth above 15% over the long term. For example, among the once-celebrated 'Nifty Fifty,' only three companies—including Philip Morris International and Merck—maintained such growth consistently over the long run. Once market participants begin to question a listed company’s growth prospects, its valuation can plummet rapidly. Even if earnings remain unchanged, a valuation contraction from 40x to 10x would imply a 75% decline in the company’s share price.
Graham also cited an example: U.S. Steel Corporation’s stock rose to $126 per share in July 1937, but within 12 months, it had fallen to $42 per share—a two-thirds decline—because investors had based their assessment solely on one year of strong performance, while the company delivered only mediocre or poor results over the subsequent six years.
Investors should focus on the long-term, consistent earnings performance of listed companies.
Relying solely on recent operating performance to evaluate a company places investors in a highly disadvantageous position.
John Neff stated that investment candidates must demonstrate a stable historical track record. Aside from cyclical companies whose fortunes swing between peaks and troughs, capital markets are highly sensitive to short-term events—but ultimately, it is long-term financial outcomes that drive sustained investment performance.
Graham recommended that investors limit their purchase price for a stock to a specific valuation range, using an average of earnings per share over the past seven years as the benchmark. Each company should also have a long, uninterrupted history of dividend payments—preferably spanning more than 20 years—and should be large, well-known, and financially sound.
Graham noted that for defensive investors, growth stocks entail excessive uncertainty and risk. While extraordinary returns are possible if the right stock is selected, purchased at an appropriate price, and sold before a potential steep decline following a substantial rise, such outcomes are largely a matter of luck rather than replicable strategy for most investors. Instead, large, less-hyped companies with reasonable valuation multiples represent a more suitable choice for the majority of investors.
Editor /rice