From the perspective of cash flow index: Why are A-shares flat while U.S. stocks keep rising?

In previous articles, I have recommended books by the two gentlemen, Buffett and Munger, such as Buffett's letters to shareholders and a collection of his speeches at shareholder meetings.

These books provide a detailed account of the experiences of these two predecessors in their investment journeys, as well as their investment philosophies and insights.

These books are excellent, but I always felt that the cases listed within were somewhat difficult to understand, and the investment philosophies of the two predecessors were rather scattered and not systematically summarized.

Recently, I came across a book titled "Advanced Guide to Value Investing" by Li David, which comprehensively organizes the understanding and thoughts of these two gentlemen and Duan Yongping regarding value investing. It systematically explains the author's understanding of these predecessors' concepts of value investing using cases and language styles familiar to Chinese readers.

This book is the one I mentioned at the end of my last online discussion.

The author, Li David, recently shared a viewpoint that explains a confusion I have had regarding the A-share Shanghai Composite Index over the years.

For years, we have often criticized the A-share market (Shanghai Composite Index) for remaining stagnant at around 3000 points for a decade.

In response, various explanations have been provided by both the public and experts.

Some criticize the stock market itself, such as:

A-shares are just a casino.

Listed companies are fundamentally deceptive.

The governance of listed companies is completely lawless.

The A-share market is not established for investors.

Some describe the companies themselves, such as:

Businesses are struggling.

Companies lack innovation.

There are too few tech companies.

…

There are countless criticisms and explanations.

Are these explanations correct?

Of course, they are.

However, many of the issues listed above have always existed.

So how did the A-share market perform earlier?

If we look back at the early history of A-shares, for instance, from 1991 to 2001 and from 2001 to 2011, we will find that in those earlier ten years, despite the Shanghai Composite Index experiencing ups and downs and the A-share market being murky, it did not remain stagnant as it has in the past decade.

Why has the past decade been so "special"?

Therefore, I always feel that the explanations above are somewhat superficial. I believe there should be a more intuitive method to succinctly explain this phenomenon from an economic or investment perspective.

This method should not only explain why the Shanghai Composite Index has performed so poorly over the past decade but also explain why the Nasdaq and the S&P 500 have performed so magnificently over the same period, and even predict how the indices will develop in the future.

Before sharing Li David's viewpoint, let me first explain how Mr. Buffett evaluates a company's intrinsic value.

His method is: the intrinsic value of a company is the future free cash flow that the company can consistently generate.

To make it easier for everyone to understand, we can also use net profit to replace free cash flow. This substitution is not entirely accurate, but I believe it does not affect our understanding of this principle.

The intrinsic value of a company lies in the free cash flow (net profit) it can continuously earn in the future. The more cash flow accumulated, the greater the company's value, which ultimately reflects in a higher stock price.

The intrinsic value of a company is only related to future free cash flow and is unrelated to total sales, total assets, and other factors.

Next, we will use free cash flow to evaluate the performance of the Shanghai Composite Index over the past 30 years.

The Shanghai Composite Index is a weighted summary of the market capitalization of some representative companies listed on the Shanghai Stock Exchange. Therefore, the Shanghai Composite Index can be roughly understood as being closely related to the stock prices of some typical companies.

According to the understanding of value investing, stock prices fluctuate around value, and over a long period, they will ultimately reflect the intrinsic value of the company.

As we mentioned earlier, the intrinsic value of a company is ultimately determined by its future free cash flow.

So we can understand that the Shanghai Composite Index is ultimately determined by the free cash flow of some typical companies.

From 1991 to 2001, our country's reform and opening-up entered a period of accelerated development. At that time, as long as you dared to start a business, you could reap substantial profits. Therefore, business was easy, money was easy to earn, and profits were high, leading to high free cash flow for companies.

The increase in free cash flow ultimately reflected in the companies, pushing up stock prices and consequently driving up the Shanghai Composite Index.

During those ten years, the Shanghai Composite Index rose from a low of less than 200 points to a high of over 2200 points, a tenfold increase. We can also understand that during those ten years, the free cash flow (net profit) of companies increased tenfold.

In 2001, China officially joined the WTO. From 2001 to 2011, our reform and opening-up entered a period of comprehensive development. At that time, various industries in China began to flourish, and wealthy individuals in China and Asia began to emerge in large numbers. Business was not only easy to conduct, but money was even easier to earn, and companies' net profits were highly coveted, with free cash flow being abundant across various industries.

The abundance of free cash flow continued to push up the Shanghai Composite Index.

During those ten years, the Shanghai Composite Index rose from a low of 1040 points to a historical peak of 6124 points, a sixfold increase. We can also understand that during those ten years, the net profit of companies increased sixfold.

Entering 2012, both domestic and international situations began to change dramatically, and companies across various industries in China started to face brutal competition. Especially after 2015, we have seen some industries being wiped out, compounded by a more hostile external environment. Corporate profits were devoured by the harsh environment, and even industry giants found themselves in a state of minimal profit. Not to mention net profit, even gross profit was barely covering costs.

The free cash flow of companies has become completely incomparable to the previous 20 years.

In this situation, after briefly rising from a low of 1944 points in 2013 to a high of 5100 points in 2015, the Shanghai Composite Index has remained flat for the next ten years.

We can also understand that after 2015, companies across various industries have been in an extreme state of competition, with free cash flow approaching negligible levels.

This situation reflects in the Shanghai Composite Index, which has remained flat for ten years.

Using this method to look at the Nasdaq and the S&P 500, we can easily understand why the U.S. stock market has experienced a prolonged bull market for over a decade. With the seven giants as typical examples, they earn substantial net profits globally and hold abundant free cash flow (such as Apple, Nvidia, etc.), which reflects in the U.S. stock indices, leading to continuous new highs.

Finally, using this method to predict the future direction of the indices becomes relatively easy:

We can focus on the future free cash flow of the listed companies included in the index (not sales, not gross profit, not price-to-earnings ratio…) to predict the future trend of the index.

If the companies in the U.S. indices can continue to generate substantial free cash flow (net profit), then the U.S. stock indices are likely to continue to perform well in the long term.

If the companies in China's indices continue to maintain a state of brutal competition and cannot generate substantial free cash flow (net profit), then the Shanghai Composite Index (or other composite indices) is likely to remain pessimistic in the long term.