Based on Liu Zhe (ๅๅฒ), Excess Returns (่ถ ้ขๆถ็๏ผไปทๅผๆ่ตๅจไธญๅฝ็ๆไฝณๅฎ่ทต)
Liu Zhe is a practitioner of value investing in the Chinese A-share market, a context that many Western-trained investors consider hostile to fundamental analysis due to heavy retail participation, regulatory unpredictability, and historically weak corporate governance. The core thesis of Excess Returns is that value investing not only works in China but can produce superior alpha precisely because the market's structural inefficiencies create persistent mispricings that disciplined fundamental investors can exploit.
The book bridges the gap between classical Buffett-Munger value investing and the practical realities of investing in Chinese equities. Liu argues that the principles of value investing are universal โ buy good businesses at reasonable prices โ but that the application must be adapted to Chinese market characteristics: different accounting norms, state-owned enterprise dynamics, policy-driven cycles, and a retail-dominated investor base prone to extreme sentiment swings.
| Principle | A-Share Adaptation |
|---|---|
| Intrinsic value | Must account for SOE governance discounts and policy risk premiums |
| Margin of safety | Needs to be wider in China due to higher uncertainty |
| Competitive moat | Often comes from government relationships, scale in domestic market, or brand in consumer sectors |
| Long-term holding | Works but requires more active monitoring due to faster industry change cycles |
| Contrarian buying | Especially powerful in A-shares due to extreme retail herding |
The author identifies several structural reasons why excess returns persist in the Chinese market: (1) the investor base is still predominantly retail, creating systematic behavioral mispricings; (2) analyst coverage is shallow for mid- and small-cap stocks; (3) index construction and fund mandates create forced buying and selling; (4) policy shifts create temporary dislocations between price and value; and (5) the IPO system historically created supply-demand imbalances.
Liu defines excess returns not merely as beating an index but as the compounding of returns above the risk-free rate over a full market cycle, adjusted for the risk taken. He distinguishes between three types of perceived alpha:
The book identifies four genuine sources of excess returns in A-shares:
Information advantage โ Not insider information, but deeper fundamental research than the market consensus. Visiting factories, interviewing suppliers, understanding unit economics at a level that most retail investors and even many analysts do not.
Analytical advantage โ Looking at the same information as everyone else but drawing better conclusions. Understanding which financial metrics matter for which industries, and how to interpret Chinese accounting standards.
Behavioral advantage โ The ability to act rationally when others panic or become euphoric. In a market where 80% of trading volume comes from retail investors, this advantage is exceptionally powerful.
Time horizon advantage โ Willingness to hold through drawdowns and wait for value realization over 2-5 years, while most market participants operate on days to weeks.
Liu emphasizes that while the intellectual framework of value investing is Western in origin, the practitioner must understand Chinese specifics:
Liu proposes analyzing every potential investment through three overlapping circles:
Only stocks that pass all three tests simultaneously are candidates for investment. A great business at a terrible price is not a buy. A cheap stock with bad management is not a buy. All three circles must overlap.
| Metric | What to Look For | Red Flag |
|---|---|---|
| ROE | >15% sustained over 5+ years | Declining ROE with rising leverage |
| Free cash flow | Positive and growing | Consistently negative despite reported profits |
| Accounts receivable days | Stable or declining | Rising faster than revenue |
| Gross margin | Stable or expanding | Sudden jumps (possible accounting manipulation) |
| Cash flow / Net income | Ratio > 0.8 consistently | Ratio < 0.5 for multiple years |
| Debt/Equity | Industry-appropriate levels | Rapid increase without clear investment rationale |
| Dividend payout | Consistent and growing | Sporadic dividends despite high reported earnings |
Liu adapts Buffett's moat concept to the A-share market and identifies five primary moat sources:
Brand moat โ Consumer-facing brands like Kweichow Moutai (่ดตๅท่ ๅฐ) and Haitian Flavouring (ๆตทๅคฉๅณไธ) that command pricing power. In China, brand moats are especially powerful in baijiu, traditional Chinese medicine, condiments, and luxury goods where cultural relevance creates switching costs.
Scale and cost moat โ Companies like CATL (ๅฎๅพทๆถไปฃ) or Hengli Petrochemical (ๆๅ็ณๅ) that achieve unit cost advantages through massive scale. In China's manufacturing economy, scale moats are perhaps the most common source of durable advantage.
Network effects โ Platform businesses like Tencent and Alibaba where each additional user increases value for all users. Also applies to payment networks, logistics platforms, and certain fintech companies.
Switching costs โ Enterprise software, ERP systems, and specialized industrial supply relationships where changing vendors is costly and risky. Less common in China than in Western markets but growing in importance.
Government/regulatory moat โ Licenses, concessions, and regulatory barriers that limit competition. Banks, insurance companies, telecom operators, and certain resource extraction companies benefit from this. Unique to the Chinese context: government relationships and policy alignment can constitute a genuine moat.
The author provides a framework for assessing whether a moat is widening, stable, or narrowing:
Liu emphasizes that industry selection is the single most important determinant of long-term returns. He maps Chinese industries onto a life cycle framework:
The author argues that the ideal industry for value investing has these characteristics:
In the A-share context, industries that best fit these criteria include: baijiu and premium spirits, condiments and food seasoning, traditional Chinese medicine with proprietary formulas, property and casualty insurance, certain banking niches, and water/gas utilities with concession agreements.
Liu provides a systematic approach to reading Chinese company financials:
Revenue quality assessment: Break revenue into core operating revenue vs. non-recurring items. In Chinese financials, look specifically at "other business income" (ๅ ถไปไธๅกๆถๅ ฅ) and "investment income" (ๆ่ตๆถ็) โ if these are large relative to core revenue, earnings quality is suspect.
Margin decomposition: Track gross margin, operating margin, and net margin over at least five years. Liu warns that Chinese companies frequently engage in expense timing games โ pulling costs forward in good years and deferring them in bad years to smooth earnings. Compare reported margins to cash flow margins (operating cash flow / revenue) as a check.
Asset quality: Liu emphasizes that Chinese balance sheets require special scrutiny of several line items:
The cash flow statement is the most reliable of the three statements because it is the hardest to manipulate. Liu's key cash flow checks:
Liu uses PE as a primary screening tool but with Chinese market adjustments:
The author acknowledges DCF as theoretically correct but practically difficult:
PSEUDOCODE: Simplified DCF for A-Share Company
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normalized_fcf = average(last_3_years_fcf)
growth_phase_years = 5
growth_rate = min(historical_revenue_growth, 15%)
terminal_growth = 3% // China GDP long-term nominal growth
discount_rate = 10% // opportunity cost in A-shares
intrinsic_value = 0
for year in 1..growth_phase_years:
projected_fcf = normalized_fcf * (1 + growth_rate)^year
intrinsic_value += projected_fcf / (1 + discount_rate)^year
terminal_value = projected_fcf * (1 + terminal_growth) / (discount_rate - terminal_growth)
intrinsic_value += terminal_value / (1 + discount_rate)^growth_phase_years
margin_of_safety_price = intrinsic_value * 0.7 // 30% margin of safety
Liu advocates the PB-ROE framework as especially useful for A-shares because it connects the price paid (PB) with the return earned on equity (ROE):
Compare a company's current valuation to: (1) its own historical valuation range over 5-10 years; (2) comparable companies in the same industry; and (3) global peers listed in other markets. This three-way comparison provides triangulation on whether the stock is cheap or expensive.
A stock can remain undervalued for years without a catalyst to close the gap between price and value. Liu emphasizes that identifying catalysts is what separates profitable value investing from "value traps":
Earnings inflection โ The most powerful catalyst. When a company's earnings begin to accelerate after a period of stagnation or decline, the market re-rates the stock rapidly. The key is identifying the inflection before it appears in reported numbers โ through channel checks, industry data, and management signals.
Policy tailwinds โ In China, government policy shifts can create enormous catalysts. Inclusion in a Five-Year Plan, favorable regulatory changes, subsidy announcements, or anti-corruption campaigns that benefit compliant companies.
Industry consolidation โ When weaker competitors exit an industry (through bankruptcy, M&A, or government-mandated capacity cuts), survivors capture share and gain pricing power. This has been a major catalyst in steel, cement, chemicals, and increasingly in technology.
Management change โ New management with a clear strategy for improving operations, capital allocation, or shareholder returns. Especially impactful in SOEs undergoing reform.
Valuation re-rating events โ Index inclusion (MSCI, FTSE), Stock Connect eligibility (northbound access for foreign investors), analyst initiation coverage, or major institutional investor disclosure of a position.
PSEUDOCODE: Catalyst Assessment
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catalyst_score = 0
if earnings_inflection_expected_within_2_quarters:
catalyst_score += 3
if positive_policy_shift_announced:
catalyst_score += 2
if industry_consolidation_underway:
catalyst_score += 2
if management_improvement_initiated:
catalyst_score += 1
if valuation_re_rating_event_pending:
catalyst_score += 1
if catalyst_score >= 3:
signal = "Strong catalyst present โ proceed if valuation is attractive"
elif catalyst_score >= 1:
signal = "Moderate catalyst โ position size should be smaller"
else:
signal = "No clear catalyst โ risk of value trap, require deeper margin of safety"
Liu argues that A-share investors need wider margins of safety than their Western counterparts for several reasons:
| Company Type | Minimum Margin of Safety | Rationale |
|---|---|---|
| Blue-chip consumer with 10+ year track record | 20-30% | High visibility, low governance risk |
| Growing mid-cap with 5+ year track record | 30-40% | More uncertainty in growth trajectory |
| Cyclical company at trough | 40-50% | Cycle timing uncertainty |
| Turnaround or special situation | 50%+ | High fundamental uncertainty |
| SOE undergoing reform | 30-40% | Policy execution uncertainty |
Liu advocates a concentrated portfolio of 8-15 stocks, arguing that in A-shares:
PSEUDOCODE: Position Sizing
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max_single_position = 15%
max_industry_exposure = 30%
for each stock in portfolio:
base_weight = 1 / number_of_holdings
// Adjust for conviction
if quality_score == "A" and valuation_score == "A":
weight_multiplier = 1.5
elif quality_score == "A" or valuation_score == "A":
weight_multiplier = 1.0
else:
weight_multiplier = 0.7
// Adjust for catalyst presence
if catalyst_score >= 3:
weight_multiplier *= 1.2
target_weight = base_weight * weight_multiplier
target_weight = min(target_weight, max_single_position)
// Check industry constraint
if industry_total + target_weight > max_industry_exposure:
target_weight = max_industry_exposure - industry_total
Liu identifies only three valid reasons to sell a holding:
Thesis broken โ The fundamental investment thesis is no longer valid. The competitive advantage has eroded, management has changed for the worse, or the industry structure has shifted against the company.
Full valuation reached โ The stock price has reached or exceeded the estimate of intrinsic value and there is no reasonable basis for further upward revision of the valuation.
Better opportunity โ A clearly superior opportunity exists that offers significantly higher expected returns at similar or lower risk. The bar for this should be high โ do not trade frequently.
Chasing themes (่ฟฝ็ญ็น) โ The A-share market is famous for theme-driven manias: AI, lithium, metaverse, chips. Retail investors pile into whatever concept is trending, driving valuations to absurd levels. The value investor must resist.
Anchoring to purchase price โ Refusing to sell a losing position or adding to a winner because of the purchase price. The market does not care what you paid.
Herd behavior amplification โ With 200 million retail accounts, herding effects in A-shares are extreme. The temptation to follow the crowd into popular stocks is intense but must be resisted.
Short-termism โ Average holding period for A-share retail investors is measured in weeks. The value investor must operate on a fundamentally different time horizon of years.
Overconfidence in macro calls โ Many Chinese investors attempt to time the market based on macro or policy predictions. Liu argues this is futile and recommends staying fully invested in quality stocks through cycles.
The quintessential A-share value investment. Liu analyzes how Moutai demonstrates every principle of value investing: brand moat, pricing power, high and sustained ROE (30%+), minimal capex requirements, and massive free cash flow generation. He examines the 2013-2014 anti-corruption sell-off as a case study in contrarian buying โ when the stock fell over 50% on fears that government austerity would permanently destroy demand. Investors who recognized the moat was intact and bought during the panic earned extraordinary returns.
A case study in identifying superior management within a state-dominated industry. Liu shows how CMB differentiated itself through retail banking focus, technology investment, and risk management discipline, producing an ROE consistently above peers. The stock has compounded at high rates for investors who recognized the management quality moat.
Liu also examines companies that appeared cheap on traditional metrics but destroyed value โ typically due to deteriorating competitive positions, governance failures, or industry disruption. These cautionary tales reinforce the importance of business quality and management assessment alongside valuation.
"Excess returns do not come from predicting the market, but from deeply understanding businesses and buying them at prices that imply failure when success is probable."
"In the A-share market, the margin of safety is not a luxury โ it is a survival requirement. The market will test your conviction in ways you cannot anticipate."
"The best time to buy a great company is when the market has temporarily confused a short-term problem with a permanent impairment of the business."
"Value investing in China is not about imitating Buffett. It is about applying the same principles of rationality, patience, and independent thinking to a market with its own unique characteristics."
"An investor who understands competitive advantage and valuation but ignores catalysts will be right eventually but may run out of patience or capital first."
"The A-share market rewards patience disproportionately because so few participants are willing to wait. Time horizon arbitrage is perhaps the most reliable source of alpha available to individual investors."
"Portfolio concentration is the price of conviction. If you are not willing to put meaningful capital behind your best ideas, you do not truly believe in your analysis."
"The three most dangerous words in the A-share market are 'this time is different.' Cycles always return. Valuations always revert. Human nature never changes."