On Bubble Watch

Investment Memo: Integrating Risk-Reward Dynamics & Momentum into a Value Framework

I. Executive Summary
Our investment philosophy centers on the exchange between risk and reward in different period of the cycle. We don’t know when the cycle will turn, nor do we know what caused the turn. One interesting fact I observed in the market is whenever the stock index drops consecutively, the amount of bearish sentiment significantly increases on media, like a self fulfilling prophecy, the more the market drops, the more media circulates bearish news. The only thing we can control is adjusting portfolio exposure to preserve capital in down cycles and capture growth on upcycles. This is the only way we can achieve compound returns that outperforms the market.

Our investment framework combines fundamental investing (selecting stocks with reasonable valuations, strong earnings, and steep moat) with robust technical signals/momentum indicators, which help us pick companies and chose proper entry points. To be a good investor, Charlie Munger said you have to fish where the fish are. We tend to avoid fallen angel scenarios unless we have conducted deep research and have an edge to market consensus. The comeback story that comes with buying fallen angels is exciting and the lower stock price gave investor a false sense of safety, ignoring the crumbling fundamentals or market trends underneath. We are in much better hands buying a growing companies that outperforms market consensus and are gaining further momentum.

Even when the company/market has reached the fair value range, one should be cautious to act because market always move in tandem, there will always be periods when investor panic and everything went on sale. These are the time when Warren Buffett said “when it rains, put out the bucket.” Technical indicators have shown that the index rarely reverses in V shape, as such a rapid reverse in market sentiment is unlikely. It takes time for people to regain confidence, so it’s always better to wait for the bottom to confirm itself and buy on the rise. It’s incredibly hard to be a contrarian investor, but at least you can rest easy knowing that your cost basis is lower than 90% of the investor.

Market always move in cycles. We don’t feel it from day to day, but looking back we realize the magnitude and intensity of cyclical turns that effect all of us.

II. Risk and Reward Exchange & Thoughts on EM v US equities

• Concept and Philosophy:
  As highlighted in Howard Marks’ work, risk is the likelihood of permanent capital loss and must be exchanged prudently for reward. Rather than chasing every rally, we emphasize controlling portfolio exposure, especially during periods when the odds are stacked against us. This disciplined approach helps ensure that, even if we are forced to sell at times, our overall returns are driven by sound, repeatable processes rather than luck.

• Exposure Control for Compound Growth:
  Maintaining a flexible exposure—reducing positions when valuations are high or market sentiment is overly exuberant—protects our capital from severe down cycles. This risk control is critical to preserving the gains necessary for long-term compound growth. As our notes remind us, it’s not about whether you buy or sell, but about being “right” in the context of the market cycle.

• We believe currently US equities is in cyclical peak, as seen in Shiller adjusted PE ratios, retail investor sentiment, and household allocation to equities reached an all time high. The law of nature told us that trees cannot grow to the sky and money is a finite resource that cannot be generated infinitely, making everyone rich. The superb returns since Covid driven by Quantitative Easing and hype around AI is unsustainable and deemed to return to reality. We are not saying that AI is a bubble, in fact we believe AI will be the main driver of productivity growth. It’s just in the short term, investor sentiment have exceeded reality, they have to be patient and allow technology to evolve. Scientific breakthroughs does not happen everyday, it takes time and endless effort.

• That’s why we chose to over-allocate to Chinese equities (EM equities). We found much better risk to return opportunities there, and we have a natural advantage as international investors to have a less biased view on the world, as US exceptionalism have never been stronger in the past decade. We believe China is not “uninvestible,” the idea that the second largest economy in the world is uninvestible is quite ridiculous. China has unrivaled manufacture capabilities and ranks in second in terms of technology innovations. We believe if we can cherry pick the best of both countries, our portfolio should include some of the best Chinese manufacturing companies that have barrier of entry and increasing portion of revenue coming from export market (See Market Commentary - China economy forecast 2025), and the best US companies that drives technology innovation and AI applications. The collaboration of both worlds will produce the greatest surplus and be complementary to each other.

One can never buy at the lowest and sell at the peak. It’s wishful thinking. However, we do have an idea of risk to reward. At cyclical lows, there isn’t much room to go much lower, but the upside is significant once cycle turns, and vice versa for cyclical tops.

III. Stock Selection: Value, Earnings, and Technical Indicators

• Valuation Focus:
  We prioritize stocks that trade at lower multiples (e.g., a P/E of 10× versus 30×) as they provide a margin of safety and an attractive entry point. This approach is in line with the notion that even if we made mistake at times, our downside exposure is limited.

• Fundamental Strength:
  A strong earnings report is a key indicator of a company’s operational excellence and resilience. Companies that consistently beat earnings expectations tend to have robust underlying businesses, which can drive sustainable growth. If there is a earnings gap (explosive earnings that serves as a wake-up call to all investors), we are not afraid to chase the highs as it’s just the beginning of more to come.

• Technical Signals as Confirmation:
  Technical indicators—such as moving averages, volume trends, or breakout patterns—serve as confirmation that market sentiment is aligning with the fundamentals. These signals help us screen for outperformers while paying attention to fundamentals.

Historical PE Ratio for SOX (Semiconductor Index) that can be used as a gauge on cyclical position.

A 10x opportunity if you buy at cyclical lows and cash on top. Index FNGU

By buying at cyclical lows as companies earnings are about to rebound, we can capture the Davis double tap opportunity on both earnings growth and valuation expansion, coupled with long term holding period and careful risk management at cyclical peaks. This is where the greatest gains will be realized.