Since the beginning of 2023 Q3, the market has revised downward its expectations on the strength of economic recovery. There’s no sign of consumers’ strong willingness to spend, and we observed the pressure on real estate sales and investment. On policy side, a series of measures have been announced following the analysis and discussion on the current economic situation and work during the Politburo meeting on July 24th. On August 21st, the People's Bank of China (PBoC) authorized the National Interbank Funding Center (NIFC) to announce a 10 basis points reduction on one-year Loan Prime Rate (LPR). On August 25th, the Ministry of Housing and Urban-Rural Development, PBoC and National Administration of Financial Regulation (NAFR) rolled out a policy to allow mortgages on second homes to be treated in the same way as a first mortgage, as long as the buyer has paid off the first loan. On August 28th, the Ministry of Finance and the State Taxation Administration announced a halving of stamp tax levied on securities trading. On August 31st, PBoC and NAFR issued policies on housing loans: the minimum down payment ratio for first-time homebuyers' commercial individual housing loans was standardized at no less than 20%, and for second homebuyers at no less than 30%; the lower limit for the loan interest rate on first-time homebuyers remains no less than LPR minus 20 basis points, while the lower limit on second-time homebuyers was adjusted to no less than LPR plus 20 basis points; homeowners with outstanding mortgage loans can apply for refinancing and financial institutions can issue new loans to replace the outstanding ones. On September 15th, PBoC decided to reduce the reserve requirement ratio for financial institutions by 0.25 percentage points. With the introduction of the abovementioned policies, the economy is expected to stabilize in the future. On stock market, there has been significant differentiation in the third quarter, with sectors such as energy and telecommunications performing well, while sectors such as manufacturing and real estate construction lagging behind.

For fundamental investors, much effort is often spent on analyzing and evaluating future net profit of a company. However, net profit is not the ultimate measure of shareholder returns because there are two additional steps of transformation: firstly, from net profit to free cash flow; and secondly, from free cash flow to shareholders. The first step could be demonstrated clearly by the statement of cash flows under indirect method. Net profit serves as the starting point and the most crucial factor in generating returns for investors, but it is not the final state. Additionally, the intensity of capital expenditure across cycles is also an important consideration.

For the second step, it is more common to encounter difficulties in transforming to real returns. Many companies may show a good return on net assets, but in reality, they invest a large portion of their retained earnings in projects that have mediocre or even poor returns. Their outstanding performance in core business every year overshadow the failures in asset allocation in other areas. For fundamental investors, it is important not only to focus on the company's profitability but also on the quality of its prudent investments. Lack of prudence in investment has become one of the largest value destroyers for shareholders. During internal meetings of listed companies, CEOs usually ask subsidiary executives to provide a detailed analysis explaining why earnings should be retained within the subsidiary for reinvestment instead of being distributed to the parent company. However, CEOs themselves rarely provide and present similar analysis to the shareholders of these listed companies.

Similar to extravagance, hoarding cash can also damage shareholder’s value, although to a lesser extent. For companies that prefer to hoard cash, every year of delay in distributing returns to shareholders means that these shareholders will lose approximately the equivalent of the discount rate of returns. This results in the intrinsic value of the company being much lower than the valuation based on discounted cash flow (DCF) method. Furthermore, in most cases, if a company has a large amount of cash, the management is prone to impulsive investments. When a company has a substantial cash reserve, there are few management teams who can resist the temptation and execute prudent investment principles. Therefore, for fundamental investors, a company's attitude and ability towards investment are crucial factors when evaluating its intrinsic value.

In addition, some listed companies often lack prudence when issuing new shares for financing. Take the acquisition through share issuance as an example, it is commonly known as the "buyer buys the seller," but in reality, it is the "buyer selling a portion of themselves to buy the seller." For a well-performing company, considering compound interests, selling a certain proportion of its equity can often result in a significant long-term cost unless the quality of the seller is exceptionally high. In most cases, acquiring through the issuance of new shares often incurs much higher costs compared to cash acquisitions.

We are also pleased to observe that an increasing number of listed companies are adopting stock repurchase and cancellation. One advantage of stock repurchase is that it clearly demonstrates the management's attention to shareholders’ interests, rather than neglecting it in pursuit of expansion, which could lead to actions that are detrimental to shareholder interests. Compared to companies where the management solely focuses on expansion, investors should be willing to pay a higher price for companies where the management has proven to care about shareholder interests. In the current state where valuations of high-quality companies are attractive, we believe that stock repurchases offer greater value appreciation for long-term shareholders compared to dividends. We also look forward to seeing a continuous reduction in the number of shares of high-quality companies, which allows long-term investors to increase their ownership in these companies over time. 

(Excerpt from Kun Zhang's 2023 Q3 quarterly report)