Feng Liu's stock selection process and investment system

Compiled from Fund Newspaper (2020).

Feng Liu, Managing Director of Gaoyi Asset, is one of the earliest well-known value investors in China on the Internet, with unique insights and creative understanding of the market and investment methods. In an interview with Fund Newspaper, Feng Liu shared his in-depth thoughts on investment.

Qualitative Research Combined with Quantitative Analysis

Fund Newspaper Reporter: You have previously introduced investment frameworks and systems. Can you talk about the specific process and methods?

Feng Liu: I use qualitative research combined with quantitative analysis. The usual practice in institutions is for researchers to recommend companies to fund managers. I did this for a while, but the results were not ideal. Generally, when a researcher notices a stock, there is always a reason behind it. This reason may lead to the price being partially reflected, and by the time they dare or are eager to recommend it, there may be a process of becoming more determined, which may largely reflect the opportunity.

Therefore, I redesigned the process. Unless it is a certain major logic, I generally do not require them to actively recommend stocks. Instead, I adopt an assembly line approach, first qualitatively screening a potential list of opportunities with data, then having researchers select according to specific requirements, followed by me confirming which ones fit the framework for further discussion, and finally collecting targeted information and making joint decisions. Our process is very fast, and decisions can be made in a very short time.

Fund Newspaper Reporter: How did you establish the criteria for screening stocks?

Feng Liu: The criteria are the result of my "working in isolation." In the early stages of entering the stock market, I created several models. Initially, I created financial models, which I have disclosed online for many years, and they are not much different from the ones I use now. Later, I designed several non-financial models to combine, mainly to enrich the levels and avoid falling into the limitation of using one tool to solve all problems.

Fund Newspaper Reporter: Why have the early models remained effective for a long time? What is their core?

Feng Liu: I always think about how the world should be, what characteristics it has, and in what circumstances opportunities may arise. I advocate a priori logic and like "working in isolation." The stock market is unpredictable, and posteriori logic is easily led to repeated distractions, falling into illusions and delusions.

Bearing Real Risks, Avoiding Theoretical Risks

Fund Newspaper Reporter: You have said that your investment system is a system for the weak, but you have achieved very good excess returns. How do you understand this?

Feng Liu: Logically, my system should not have excess returns because I emphasize defense rather than aggression. Therefore, in the long run, I may not have significant irreversible losses, but not necessarily sustained excess returns.

I always assume that I will make mistakes, that I cannot grasp the best opportunities, so I have given up trying to be at the top and only want to survive. If there are occasional excess returns, it may be just a coincidence, encountering smart people making mistakes in the market. It should be noted that market fluctuations are significant, gains and losses are significant, and in the face of significant gains and losses, even smart people may lose their minds due to greed and fear.

So I look for risk points, where the significant gains and losses are, where smart people can be scared silly. I do not demand myself to be very clever because making clever judgments is too difficult. I just try to avoid being led by gains and losses and be an observer Even if a company is good, I rarely get involved if there are no risk points. I am willing to take risks and uncertainties. I may not have the ability to make money at the intellectual level, but I am willing to take risks. There are too many smart people, but not many are willing to take risks.

Of course, the premise of taking risks is that risks are fully exposed and priced. I am willing to take real risks but will avoid theoretical risks. When risks become a reality and everyone is worried, I will actively take them on. Theoretical risks are possibilities in theory, but everyone thinks they won't happen for the time being.

China Fund News reporter: Does smart people doing stupid things mean the market is making mistakes?

Feng Liu: I believe the market is always right. When it is wrong, then it is not the market. What is the market? Is it the exchange between you and me? No, the real market is diverse, with many participants exchanging within it.

When the market is dominated by one viewpoint and most people are considering the issue from one angle, the market loses its diversity, which is not a true market.

When the market is composed of multiple elements, it is unpredictable. When the main contradictions are reduced to a level that can be recognized, it becomes easy to judge and determine, and it is no longer in a stable state. So, I will consider the possibility of going against the trend when it is easy to judge, as this is often unsustainable.

Seeking consensus, relying on common sense

China Fund News reporter: How do you judge when "the market is no longer the market"? How do you judge when risks are fully priced?

Feng Liu: I like to seek consensus. What is consensus? Why does a stock fluctuate? After researching for a while, the reasons found are controversial rather than consensual. You can glance at a forum and know the reasons in 5 minutes, that is consensus. Therefore, the less time-consuming the research, the more efficient it is. I rarely do in-depth research because something that requires so much effort to understand is definitely not a consensus, and the result may involve a lot of effort with no return.

Of course, finding consensus does not necessarily mean it is worth participating in. Consensus can be right or wrong, so we also need to rely on common sense, which does not require proof. I will go against the consensus when it contradicts common sense and follow the consensus when it aligns with common sense. Finding consensus relies on common sense, going against changeable consensus, and following unchangeable consensus.

Furthermore, some risks may be difficult to prove individually, but can be resolved from a statistical perspective, like a couple arguing. Most of the time, they argue but then it's fine, this is common sense. I won't dwell on whether they will divorce this time. I focus on the whole, not the right or wrong of a single instance.

China Fund News reporter: Do you tend to concentrate or diversify your portfolio?

Feng Liu: My system prioritizes odds over probabilities, not probabilities. A probability-based system is concentrated investment, such as in-depth research, which emphasizes the circle of competence and looks at the next 5 or 10 years. Odds prioritization does not care about individual right or wrong, only whether it follows its own system.

Of course, sometimes I may be very concentrated because of long-term holdings, which may gradually become in-depth research. If a situation arises where the probability and odds are unified, I will increase concentration. But because it is a fault-tolerant system, always assuming that I will definitely be wrong, there is an inherent tendency towards diversification When I am weak, I must be scattered; when I feel strong, I will concentrate. After holding a stock for a long time, I may become strong and can truly go against the trend, while the weak are just pretending to go against the trend.

China Fund News Reporter: How do you understand "pretending to go against the trend"?

Feng Liu: It means that internally, I believe the counterparty is correct, the counterparty thinks it's not good, and I also agree, I am just waiting for a change without being harmed because the risk has been exposed. This is the system of the weak.

The system of the strong is when I say it's bad, but I think it's good; you think it's expensive, but I think it's cheap. This is the real going against the trend, exchanging opposing views, having opinions and significant differences. The weak system, in the face of major differences, is to avoid them and just seek opportunities for change after reaching consensus.

China Fund News Reporter: Buying against the trend is because it's cheap and has enough safety margin. Is buying cheap important?

Feng Liu: My MSN signature more than ten years ago was "Good companies are more important than good prices," but later I gave up this statement because it deviated from the reality that we will definitely make mistakes. Although from the perspective of long-term investment, buying expensive is not a big problem, once you make a mistake, it can be enough to ruin your investment career.

We emphasize buying cheap, not to increase returns, but to retain the right to correct. Excellence can be judged during the process, while greatness can only be summarized afterwards and needs continuous observation to verify. However, a high price deprives you of the right to correct from the beginning.

Define the boundaries between yourself and the system.

China Fund News Reporter: You have always maintained a high position, why is that?

Feng Liu: High position is a comparison between stocks, with each adjustment based on the previous standard, while position selection is a comparison between stocks and cash, always returning to the starting point. The former's holding structure is optimized and iterated, following the principle of compound interest, while the latter follows the principle of simple interest.

In addition, some things may seem like a lot but are not actually. A general market drop of 30% is already significant; selling half in advance is a sufficient response, avoiding a 15% drop. However, you cannot always be right. Assuming a 70% success rate, 7 correct decisions offset 3 wrong ones, considering transaction costs, you may end up being right 3 times, only avoiding a drop of more than 4 points.

There are not many years when the index drops by 30%, on average maybe only 1 or 2 points. To reduce this slight drawdown, you have to take the risk of missing out, shift your focus from individual stock research to other aspects leading to impure investment logic, which is not worth it. And the above assumption is based on a 70% success rate, which is difficult to achieve. Personally, I am mostly wrong because once you participate, you will inevitably be influenced and will inevitably lose to human nature.

China Fund News Reporter: What if you encounter a market crash like in 2008?

Feng Liu: I suffered a huge loss in 2008, but looking back over these years, it's not that significant. If I am always worried, I may not be able to profit normally in other years. I have been in the market for 16 years, exchanging 1 year of losses for 15 years of ease, which is worth it. I can consider it as an entry ticket, as a cost of maintaining a good life and work state. I don't worry about it or take extra precautions against it. When it comes, I face it calmly, as it is an inevitable part of the system Many people cannot accept systemic collapses, try their best to prevent them, and end up ruining their normal work and life, which is not worth it. For systems that can be rebuilt, you just need to ensure that you can follow the system to rebuild, avoid leveraging and rushing for success, and refrain from behaviors that may force you to exit.

As for systems with risks that cannot be rebuilt, my opinion is not to escape. We are part of the system, and our fate is inevitably linked to the system. Just like when the earth is destroyed, what's the point of leaving alone on a spaceship? Some issues are not ones we should face and ponder over. We need to define the boundaries between ourselves and the system, not let the aspects where we are powerless affect the aspects where we can make a difference.

China Fund News Reporter: Do you study individual stock candlestick charts?

Feng Liu: I use charts as a supplement, but I don't judge the future based on the patterns. Instead, I use the patterns to understand the fundamentals. My chart analysis is more about historical attribution analysis, to define what kind of company it was in the past.

The historical market trends will tell you if a company is easily disturbed unexpectedly. For example, if every time negative news comes out and the stock price doesn't fall or falls but quickly recovers, it's called an unchangeable logic. If negative news comes out and the stock quickly drops until a reverse information appears to recover, it's called changeable logic. The market is a great helper, you need to learn to listen to the market's voice.

Some say chart analysis is like driving with the rearview mirror, but I think the rearview mirror shows a muddy road, and you are most likely on a muddy road. When you have no foresight, you can't easily give up the rearview mirror.

Accepting all kinds of imperfections

China Fund News Reporter: In the first half of 2017, blue-chip stocks soared, but the products didn't make much money. Did you feel a lot of pressure?

Feng Liu: I heard a saying before that I think is very applicable to investing, "Treat yourself as non-self when dealing with others, treat others with compassion, treat others as wisdom, and treat yourself as ease."

Treating yourself as non-self means not being swayed by your own needs, not getting caught up in gains and desires, observing your inner self, and understanding your true needs and thoughts.

Treating others as yourself means stepping out of subjectivity and limitations, thinking about issues from others' perspectives, breaking free from your own attachments and narrow-mindedness.

Treating others as others means maintaining independence, not being influenced by external factors. I fully understand you, but I won't follow you, chase hot trends, or be controlled by changing illusions.

Treating yourself as yourself means accepting all kinds of imperfections, letting go of greed, forgiving your mistakes, learning to reconcile with yourself, and finding a relaxed and sustainable state. When you are uncomfortable, your negative feelings will gradually accumulate. In the end, either your will collapses, your body collapses, or your companions around you collapse.

I have accepted my imperfections and potential failures. I rarely have very high self-demands. At the end of 2015 when I entered the Hong Kong stock market, some people said that everyone had high expectations for you, and it's your first time doing Hong Kong stocks, so you should be more cautious.

I said if everyone is disappointed because of this, then the one who should truly be disappointed is me because they had expectations of me that shouldn't have existed. I am just an ordinary person, following a system that I have thought through and believe is okay in the long term. I don't care about the impact of doing so, I don't care about short-term gains or losses, I accept my shortcomings, and I accept the regrets that this system may bring In the first half of 2017, my product performance was not ideal, mainly because I made some mistakes before, so I have been adjusting my positions. At that time, blue-chip stocks were in the middle of a bull market, and their trends could be changed by information and fund preferences, requiring a high level of sensitivity, which is not my strong suit. Therefore, I decided to follow my own system and not buy blue-chip stocks along with the market.

Although I didn't make much money in the first half of the year, I made up for it in the second half, but there was a period of half a year where I underperformed, which didn't look good. However, in terms of pressure, it was not significant because everyone has their lows, which is an objective law. I have always been mentally prepared for it. When I underperform the market, I reflect more, see where I went wrong, and if I did, I correct it. But many times, it's just a matter of timing being off, not really a mistake, so I can be more at ease. Moreover, most of the investors in my fund products are relatively stable and trust me, so I haven't felt much external pressure.

China Fund News Reporter: When investing, you have to face the ups and downs of the stock market. How do you control your emotions?

Feng Liu: Having emotions and struggles is a good thing. It will drive your thinking. Don't go against or control human nature. Because the market has countless ways to amplify your emotions, and there will definitely be times when you can't bear it. So, not only should you not resist it, but you should actively amplify it. When you feel uncomfortable, you should immediately address it. Make good use of your emotions. This will make you pay more attention to the stock. Where the money is, there your heart will be. So, while others research before buying, I buy first and then research, just to let my heart go first and bring emotions into it. Never accumulate your needs, but quickly satisfy them. This way, you can go beyond your needs to experience things.

Of course, comfort is related to understanding. It's uncomfortable when others speak ill of you, but if you understand why they do it, it won't be as uncomfortable. So, when I feel anxious, I constantly examine what is making me anxious. If I can understand and explain it reasonably, I increase my position. If I can't understand it, I cut it off. This has nothing to do with facts, but with my inner feelings and capabilities.

Building a good foundation of trust with investors

China Fund News Reporter: As the size of the products you manage grows, will it bring challenges to your investments?

Feng Liu: Although our size is not small, the workload is not large because I don't operate on an information-driven system. I also hope the team reduces its reliance on information. Most of the workload is in tracking and processing information. If it's just about frameworks and logic, the workload will be much smaller.

In theory, my system has a relatively large throughput for scale. Firstly, I don't pursue in-depth research or have style preferences. Additionally, with a self-built model for screening, the coverage will be broader. Secondly, I am very contrarian and independent, without buyers or sellers in the same direction, so I can get the maximum volume. Thirdly, my system prioritizes odds, with a large scale and a diverse portfolio of stocks, making it less prone to surprises. Of course, a large scale will definitely affect concentration, preventing you from increasing the proportion of familiar stocks, which is not conducive to explosive performance. But this is a trade-off, not a challenge.

China Fund News Reporter: Currently, the vast majority of the products you manage are sold directly to customers. Why is that?

Feng Liu: Most of my products are subscribed through direct sales by the company, mainly by investors who are familiar with and approve of my investment style. Their lock-up periods are very long, up to 8 years, and there are no stop-loss lines This kind of benefit is that we have a good foundation of trust with investors, the relationship is very stable. When there are fluctuations in product performance, investors not only do not criticize, but even actively add funds.

I prefer the current structure of investors. Investors will study you, actively get to know you, without external hype and misleading, the sense of trust is stronger, the accumulation of scale is closer to compound interest, steady and gradual, and there will be no sudden changes in scale. Therefore, within the scope of the current management size, I still welcome funds from long-term investors who can accept my investment style and a longer lock-up period.

Rome wasn't built in a day. In asset management, there will definitely be lows or times when the rhythm doesn't match. So, I am not very willing to do active marketing, I don't want the other party to come in under my push.

What I can convey to the other party is only honesty and goodwill. Many common practices are not included in my product design, even if they would greatly benefit me, simply because they could harm fairness or trigger suspicion. I believe that to accompany a group of people in a highly uncertain world for a long time, it relies on genuine goodwill and thorough trust, and temporary gains and losses are not important.

Encountering enough problems due to low talent

China Fund News Reporter: How do you evaluate yourself? Is investment success due to talent or character?

Feng Liu: Many people think I have good talent, but it's actually the opposite. This is not being humble, because we naturally compare and self-assess in a crowd. The higher one's talent, the fewer problems they encounter, and their system may be less complete and less applicable to others. Poetry must be poor before it becomes skilled. People with low talent will encounter enough problems to possibly build a more complete system.

Munger said, "Know where you will die and avoid going there." So I have drawn many boundaries for myself, trying to hide in them as much as possible, while those with high talent live well wherever they go, so naturally they have fewer self-imposed restrictions.

Many people make mistakes not because they cannot see, but because they believe they can perceive and act ahead of the market. However, things change, and the market will always punish in an unexpected way. Having too much talent may not necessarily be a good thing.

China Fund News Reporter: You are now very famous and highly followed, how do you view this?

Feng Liu: Unsettling, there is a sense of unease that the name does not match the reality. Investors should be wary of all things that are inflated, including reputations. Of course, I can understand the origin of this attention, because the theory of the weak gives the illusion that even the backward can succeed, satisfying the psychological need to take shortcuts, but it is not really a more advanced theory, just a self-awareness and positioning.

The weak cannot easily defeat the strong, otherwise it would be anti-intellectual, which is unscientific. In-depth research will definitely produce huge advantages. If I have the research ability and opportunity, I will definitely join that group without hesitation