Chen Guo: The non-bank financial sector is currently significantly undervalued.

1. Mismatch Identification Framework Based on Economic Cycle: Earnings Upgrade and Stock Price Divergence This week (from August 10 to August 14), the A-share market is further diverging at the industry level. From the weekly fluctuation and turnover data of Shenwan's primary industries, the structural characteristics of the market are quite clear: among the primary industries, the communication sector leads the gains. Following our previous suggestions to pay attention to the "carbon-based sectors," the pharmaceutical biotechnology, real estate chain, and food and beverage sectors are closely behind, highlighting the characteristics of sector rotation. Conversely, the non-ferrous metals sector leads the decline, with non-bank financials, beauty care, transportation, and basic chemicals experiencing varying degrees of pullback. At the aggregate level, after three weeks of continuous gains, the Shanghai Composite Index slightly fell by 0.33% this week, showcasing some degree of market volatility and divergence. For instance, while the ChiNext index saw positive returns this week, the Sci-Tech 50 index recorded negative returns, indicating a divergence in market sentiment regarding future upward momentum and structural main lines. We believe that since the Shanghai Composite Index has undergone a certain degree of correction from 3741 points, it will require continued patience going forward, avoiding excessive aggression, and emphasizing the excavation of structural opportunities from a mid-term investment and value investment perspective. Therefore, looking ahead, with relatively limited weekly marginal changes, we view the high-quality blue chips as the core focus for mid-term in the A-share market. The "mismatch" in the A-share market typically refers to the sluggish or even reverse pricing reaction of the market to the improvement of a certain assets fundamentals. Using consensus forecast data, we constructed a simple yet powerful framework: Earnings Upgrade Magnitude Year-to-Date Price Change. If the difference is positive, it indicates that the market has raised its earnings forecast for the industry by 2026, but the stock price has not kept pace with this increase and may even have decreased, serving as a quantifiable signal of a mispricing event. Specifically, "earnings upgrade magnitude" represents the average change rate between the consensus forecast for attributable net profit for 2026 and 2027 compared to the prediction made on January 1, 2026, filtering out single-year forecast adjustments' noise and proxying the market's directional judgment regarding earnings trends. Year-to-Date Price Change is represented by the year-to-date return rate of Shenwan's primary industry indices, ensuring comparison within the same time window. It should be noted that a positive difference does not inherently imply a "buy." We further dissect: if earnings upgrades are positive while stock price changes are negative, it constitutes the classic "mispricing; if earnings upgrades are positive and significantly surpass the stock price increase, even if the stock price has risen, it still falls into the category of "relatively undervalued." Conversely, industries displaying a negative difference may face risks of earnings downgrades without stock price declines, or simultaneous declines in earnings and stock prices, necessitating differentiated treatment. 1.1. Non-ferrous Metals Non-ferrous metals stand out significantly within the aforementioned framework. The consensus forecast for the industrys attributable net profit has been raised from 256.5 billion yuan at the beginning of the year to 381.9 billion yuan for 2026 (+48.86%), and further to 449.9 billion yuan for 2027 (+50.66%), with an average upgrade magnitude over two years reaching 49.8%. Yet, the year's price increase stands at -0.2%, yielding the largest divergence in the entire market. Since non-ferrous metals are driven strongly by macroeconomic factors, their intrinsic value can be approximated as a function of interest rate trajectories, rather than being determined solely by supply, demand, and profitability. Whether the current valuation of the sector can recover is largely contingent upon the future interest rate path of the Federal Reserve. The long-term underlying logic of the non-ferrous metals sector that the market has focused onwhether it be the tightening supply of related metal ores, de-dollarization, continued global central bank gold purchases, or the new demand driven by AI and grid investmentsremains ongoing. The recent decline primarily stems from concerns regarding the controllability of U.S. inflation, the resilience of the U.S. economy, and whether the interest rate cut cycle has definitively ended following the outbreak of the U.S.-Iran conflict, which is suppressing non-ferrous metal valuations within the narrative of macro liquidity. Since August, the market has begun to trade on the marginal strengthening of interest rate cut expectations, corresponding to a slight decline in U.S. Treasury yields rather than continuing to rise; additionally, analysts have continued to upgrade the sector's profit expectations, indicating substantial recovery on the numerator side. However, stock prices reflect only a minor recovery in sector valuations. Under the DCF framework, stock prices are determined jointly by both the numerator (earnings/cash flow) and denominator (discount rate). Non-ferrous metals are currently in a state of significant improvement on the numerator side while being suppressed on the denominator side due to interest rates, with the degree of improvement on the numerator far exceeding the compression on the denominator. In the past, when the market held high expectations for Federal Reserve interest rate hikes, both valuation multiples (denominator) and profit forecasts themselves (numerator) would be suppressed simultaneously. We believe that due to the considerable magnitude of the earnings upgrades in the non-ferrous sector, even if there are subsequent interest rate hikes, some degree of "mispricing" is still present. Since September 2024, the average real yield of U.S. long-term treasuries has risen by approximately 100 basis points. Based on the DCF valuation framework \(P = \frac{E}{(r-g)}\), where the discount rate \(r\) is comprised of the actual yield of U.S. treasuries plus the industry risk premium. Non-ferrous metals belong to a high-volatility, strong-cyclical sector, corresponding to a relatively high risk premium; here we assume that the risk premium is 5%, and the long-term perpetual growth rate \(g\) is set at 5%, yielding a current denominator of \(r-g\) of approximately 3%. In an extreme scenario, if the Federal Reserve raises rates an additional 100 basis points, \(r-g\) would expand to 4%; provided the earnings \(E\) remain unchanged, sector valuations would be passively compressed by 25%. In contrast, on the numerator side, the average consensus forecast earnings upgrade magnitude for the sector reaches 49.8%, with profitability nearly raised by 50%. Compared with the extreme interest hike scenario causing a 25% valuation compression on the denominator, the profit increase significantly offsets the impact on the denominator, showcasing characteristics of mispricing at the stock price level. From the perspective of the internal structure of non-ferrous metals, we believe that the U.S. debt problem and concerns regarding the long-term credibility of the U.S. dollar support the valuation of precious metals, while constrained supply of industrial metals, along with structural expansion in demand due to re-industrialization and new energy, supports demand for industrial metals. 1.2. Non-bank Financials Non-bank financial stocks have dropped by 15.6% year-to-date, with an earnings upgrade magnitude for 2026E/2027E of just -2.5%, indicating almost no change in expectations and an upgrade magnitude trailing stocks by 13.1 percentage points. Currently, the pessimistic logic regarding non-banking typically posits that a decline in transaction volume would lead to a decline in non-bank profitability; hence, following the tech downturn, the market prices non-banking as a reasonable valuation of the cyclical peak. This viewpoint neglects two variables: first, the balance of margin trading rebounding again after adjustment to a relatively high absolute value, indicating stable interest income; secondly, we are optimistic about a rebound in the A-share market in the second half of the year, which is expected to improve returns on insurance investments. 1.3. Secondary Industry Mismatch Observations The defense and military industry has declined by 15.9% year-to-date, yet the average earnings upgrade magnitude for 2026E & 2027E is +2.7%, yielding a difference of +18.6 percentage points. The mispricing of the military industry may relate to a recent easing of geopolitical risks, as well as the "drain effect" of the high crowding-out nature of AI hardware in the first half of the year. However, the fundamental logic of the military sector does not completely synchronize with geopolitical risks; evidence of upgrades in military electronics information, military trade exports, etc., reflects fundamental changes. With current valuations at low levels and improvements in ROE, we believe this sector exhibits characteristics of "mispriced assets" and has a foundation for recovery. Due to the limited granularity of primary sector classifications, we have drilled down into Shenwan's secondary industries to compare the "changes in consensus forecast attributable net profit" (on a FY1 rolling basis) with "price fluctuations" as of early Q2. The sorting of differences among secondary industries can reveal divergences within primary classifications; simultaneously, the difference is a relative comparison of "changes in expectations stock price fluctuations," making it comparably relative across different industries rather than relying on absolute amounts. Charts 11-12 depict that the expectation changes versus stock price fluctuations for photovoltaic equipment and semiconductor sectors exceed 100%; furthermore, some sub-sectors within chemicals (agricultural chemicals), military (aerospace equipment II), home appliances (black household appliances), food and beverage (snack foods), and media (games II) also demonstrate a strong configurational cost-effectiveness within the granularity of secondary industries, complementing the aforementioned primary industries. Notably, whether at the secondary or primary industry level, electronic-related directions are virtually "pulling ahead," with expectation growth rates far outpacing stock price increases. However, the contradiction within electronics is that valuation levels are comparatively high (this similarly occurred for another market-leading sector, communications, prior to June this year), and structurally there is considerable divergence among various sub-directions within the electronics secondary industry. Therefore, we believe the primary contradiction in sectors like electronics and communications isn't currently in short-term prosperity but is vastly influenced by trading dynamics, AI capital expenditure narratives, and whether critical price hikes are experiencing diminishing returns. With this consideration in mind, we introduce a mismatch identification framework based on quality factors and valuation: observing divergences in PB and ROE. 2. Mismatch Identification Framework Based on Quality Factors and Valuation: Divergence between PB and ROE Utilizing a scatter plot framework built on PB percentile (horizontal axis) and ROE percentile (vertical axis) since 2012, we study the valuation-profiting matching situation of primary industries. For key industries where ROE percentile is high while PB percentile has yet to adequately reflect it (upper-left quadrant), the prosperity framework still holds configurational value; however, when both ROE and PB enter historical highs (upper-right quadrant), the likelihood and odds of the prosperity framework may simultaneously wane, necessitating the introduction of valuation protection and prosperity turning point confirmation mechanisms to revise the original framework. Chart 13 depicts that using PB percentile since 2012 on the horizontal axis and ROE percentile since 2012 on the vertical axis, both dimensions draw on long-term percentiles rather than absolute values, eliminating the comparability issues stemming from different industries' absolute profit and valuation levels. Percentiles measure the relative position of the current indicators over the past decade: the higher the percentile, the closer the current valuation or profitability approaches the upper bounds of historical ranges. Starting in 2012 as the retroactive point allows us to account for multiple complete economic cycles and A-share bull and bear cycles. ROE comprehensively reflects profitability, asset efficiency, and leverage levels, serving as one of the most stable metrics for measuring industry prosperity quality, being less susceptible to disturbances from base-effect disruptions than one-quarter net profit growth rates; we choose PB as a proxy valuation variable, as PB is sensitive to asset replacement cycles and effectively captures the valuation fluctuations of cyclical and growth sectors. Dividing the coordinate system at the 50th percentile, we have four quadrants, corresponding to different correspondence states of prosperity and valuation. 1) Upper left: high ROE but low PB, indicating that prosperity has been realized while valuation hasnt followed, making this the highest probability opportunity area on the left. 2) Upper right: high ROE and high PB, signifying resonance between prosperity and valuation, in a strengthened trend area but requiring caution for diminishing timeliness. 3) Lower right: low ROE but high PB, suggesting that the valuation may already be overextending future prosperity expectations, which could face valuation downsides if prosperity does not materialize. 4) Lower left: low ROE and low PB, indicating dual lows in prosperity and valuation, potentially requiring patience for a turning point in prosperity. The PB-ROE framework, combined with the aforementioned earnings upgrade-stock price divergence framework, has jointly validated the current significant undervaluation of the non-bank financial sector. Current ROE for the non-bank financial sector is at the 84th percentile since 2012, comparable to the high prosperity levels of telecommunications, electronics, and military sectors, yet its PB percentile operates below the 10th percentile since 2012. If focusing only on valuation and ROE situations since the 924 period, Chart 7 shows that the current valuation percentile of the non-bank sector falls within the 3% range from when the 924 market initiated, being the most "affordable" direction among 30 primary industries, while ROE has increased from 6.25% to 11.37%, indicating potential for future recovery. This article is excerpted from the WeChat public account Chen Guo Investment Strategy, edited by GMTEight: Chen Yufeng.