I’ve taken some notes on Li Lu’s speech he did at San Francisco State University in 2012.
Here’s the original video. There are no slides, so could be worth downloading an MP3 version of the file to listen to.
Li Lu Quick Bio
Born in China in 1966 at the dawn of the cultural revolution. Survived the Tangshan Earthquake that killed over 240,000. One of the student leaders of the Tiananmen Square protests. Later founded Himalaya Capital Management, which today manages both LL Investment Partners and Himalaya Capital Ventures. Li is the only individual Charlie Munger is invested with. Read more here.
The Speech
Li believes that Value Investing is just as relevant now as it was back with Graham.
Value Investing Boils Down to 3 Concepts:
- Stock is not a paper you trade, it reflects ownership in a company. You need to assess the company as a whole before buying.
- You have to predict the future, through discounting earnings. But the future is notoriously difficult to predict. Therefore you want to leave yourself a margin of safety. It’s a bet on probabilities.
Investing is a long game. You want to stay in for the long run. - Mr Market is emotional and irrational. Think for yourself. Don’t get caught up with what others think. Think differently than others to take advantage of what others miss.
Value has traditionally outperformed. So why do so few people do it?
It’s not like value investing is an unknown endeavour. Value investing has been well practised and well-publicised for a while now. But Li believes it comes down to simple human psychology.
You need to have a frame of mind where you are comfortable standing alone against the crowd.
It’s hard. It feels unnatural. And when everyone thinks you’re stupid and wrong, it’s tough. You look ridiculous and feel uncomfortable.
Evolution requires us to conform to the crowd. Our ancestors hunted in groups. The ones who disagreed and did not conform were less likely to survive.
So peoples mindset, in general, is to aim for conformity. Usually, it’s great.
But conformity in investing isn’t ideal.
Reasons why markets may not be efficient?
The future cannot be predicted with any great certainty. So there’s always going to be an element of guessing, gambling and speculation.
Traditional gambling has a disadvantage against players and an advantage towards casino owners who define the rules.
But people still love it. They know the odds are stacked against them. And this has never stopped them.
There are some aspects of this in financial markets. But it doesn’t mean we have a better way of dealing with it. A free market when it comes to financial assets doesn’t work perfectly but is probably the best idea we have.
So the financial markets don’t work too well. But most of the time they work reasonably well.
You want to wait for the situations where the market isn’t functioning well before you make a bet so:
A) You have a margin on safety, and
B) You can stand alone against the market.
Virtually all successful investors have this trait of being able to be a contrarian.
They don’t bet often, but when they do they require a large margin of safety. Most people don’t have the mental discipline required for this type of investing.
How to learn?
The best way to learn is to study successful practitioners and real-world examples.
Li talks about Russian oil companies and the Asian financial crisis.
In 97/98 oil traded below $10. And 5-year average was probably $20.
The cost of producing barrels of oil in Western nations was over $10. BP, Exxon Mobil and the like we all unprofitable.
Plenty of Russian companies at the time were not losing money but also had strong balance sheets too.
So look for uncommon, unloved situations, and look for a margin of safety.
If he was starting all over again, Li would study all the great examples of the past where the market went to extremes on small segments of the market. Those are situations that gave you a tremendous margin of safety. Invest where even if you lose money you’re still in the game. Then study what’s around today. There are always opportunities around. As long as humans remain the same behaviourally, these opportunities will exist. Li would be very excited today as a young person starting his investment career.
Intellectual honesty is key for being a good analyst and a good investor.
What type of business does Li want?
Most of all Li wants enduring earnings-generating businesses. Compounding machines.
You want to combine a cheap priced asset, which is still of quality but then add the ability to generate cash on a consistent basis. It’s the holy grail. And you want to hold on for the longest period of time. No matter what the market does, you can ignore it. You’ve found your unicorn.
Do situations like that even exist?
Li argues it does. Maybe not for large amounts of capital but they are around.
If he was a student investing now he would be extremely happy with the opportunities presented. With smaller pools of money, there’s plenty of pockets of opportunities like that.
Li mentions the situation with Korea shares that have dual classes. Sometimes trading about 70-80% discount to their common equivalent.
In that group of their securities, there are several companies with enduring business, that have been growing earnings over multiple decades.
And with their earning power, they’re fortress-like. But the second class of shares are trading at prices at tiny fractions.
Often the family controls the majority of voting in common shares anyway. So there’s no difference owning the common and the discounted shares.
When to sell?
Well, it depends on the source of the value.
If the source of valuation is largely based on asset valuation, you want to reevaluate the upside and downside every once in a while because the situations can change.
If the source of value is earnings, then you probably hold for longer.
When earnings are strong, there’s less of a rush to sell. By not selling the stock, you avoid state and federal taxes that come from selling. And if the underlying asset continues to grow on a compounding basis, that’s less of a reason to sell. If it truly goes overvalue, then sure sell it. But holy grail companies like that don’t come around too often.
Source of Margin of Safety?
You have to know something that others don’t. Or be able to understand parts of the business better than others.
Whether it’s understanding the cash flows better or the makeup of the balance sheet. Find something that others are missing and that can be your margin of safety.
If you have no insight on future earnings power and no growth, what do you pay?
Each situation is different, but understand the external forces, general biz practice in that culture, demand a higher margin of safety like 70-80%. But it’s very situation-specific.
You don’t have to swing a lot in investing for success. You have to endure a long period of time of doing nothing, it’s the key to value investing.
When you don’t have a margin of safety, that’s when you lose. That’s worse than doing nothing. When you do something, if you have a higher margin of safety, your upside will be much larger.
Stay within your circle of competence. You will eventually find your circle. And stay in it. It’s not intellectually honest to venture out. The last thing you want in investing is arrogance. Li has never met someone intellectually arrogant that’s had a good career.
The more intellectually honest you are, the more prosperous you will be
How to find ideas?
There are many kinds of sources.
If you have a curious mind, you tend to have many interesting ideas.
Li believes you can find a lot of great ideas just by reading public information. It’s judging what is a good opportunity that is the difficult part.
Portfolio sizing and allocation?
You always have to have some kind of diversification. Because,
A) You can always be wrong, and
B) Even if you’re right, you’re betting on statistics. The future is a range of possibilities. If your prediction has a 90% success rate, you don’t want that 10% to wipe you out.
It’s extremely rare to find absolute no brainer ideas.
But again you don’t want to diversify away from the opportunity of a lifetime that you’ve patiently waited for because you’ve diversified into other inferior opportunities.
