A look into Munger and Li Lu's life & investment process Part 1

I have always wanted to look deeper into Charlie Munger and Li Lu’s holdings since they are both wise and respected. Charlie’s holdings/ net worth today comprises approximately a small part in Costco’s, three quarters Berkshire, and a quarter in Li Lu’s fund, Himalaya Capital. Himalaya is international, but focuses mainly on China, and some in Korea/South East Asia.

Charlie was born in 1924 and practically lost it all at 30 years old in 1954 due to his first son’s death from Leukemia and his divorce with his first wife. He then made his first million while practicing law. His client was in real estate. Charlie didn’t like the way his client was managing a certain project— “This is how I would do it”, Charlie would say, and his partner gave him a significant amount of shares and said, “show me.”

After this incident came the Belridge Oil incident/deal, which was in late 1970’s. Belridge was undervalued and eventually bought up by Shell. In 1977, Charlie only bought 300 shares at $115 and was offered another 1500 shares but was hesitant since the owner was an alcoholic. Munger described it as one of the most undervalued stock in the world, with his calculation of intrinsic value finding that the stock was worth somewhere in the thousands of dollars.

In 1979, the Belridge CEO put the company on the auction for a bidding war between Shell, Texaco, and Mobil Corporation. Ultimately, Shell was the high bidder at a price of $3,665 in cash. Munger nearly turned a 34,500 investment into 1,099,500. This allowed Munger to become a substantial Berkshire Hathaway shareholder.

note: the chart above is not accurate, it is just my attempt to plot out Charlie's investments and holdings

This was one of his biggest regrets in investment commission and he would always complain about it in speeches. Munger recalls, those extra 1500 shares would have turned 172,500 into 5,497,500. If Munger had purchased those Belridge shares and then put it into Berkshire, which was trading at 260 per share— 21,114 Berkshire Hathaway Class A shares that currently trade in the 300,000 range. This omission costed 5 billion to the Munger family. Since this was early on in his life, and since the return was significant— it could have greatly boosted his final net worth.

In 2017’s Daily Journal, Charlie revealed that in 2001, Monroe Springs (now Tenneco) was in a distressed situation with a lot of debt and nearly facing bankruptcy. Know how sticky shock absorbers and mufflers were in the secondary market, Charlie bought the junk bonds and a small chunk of equity. The debt was trading at a sharp discount to par value.

The 11.38% notes maturing in 2009 were yielding 35% to maturity, implying he bought the bonds for around 40 cents on the dollar. This situation such as Tenneco in 2001, shows that Munger considers both the upside and downside of all his investments. Tenneco was barely able to meet ends regarding its debt.  If bankruptcy occurred and there was a Chapter 11 filing, the value of the equity would be wiped out. The junk bonds were a good way to take advantage of Tenneco's disaster.

 Buying a smaller part in equity shows you that Munger carefully considered the downside. If Tenneco went bankrupt, the bonds would most likely be redistributed to shareholders as equity. Munger was paying less than par value for the bonds, a conversion of the debt to equity at even half of par value would be a premium to his basis cost. This is the “margin of safety” in Charlie’s investment.

Charlie found this deal in Barron’s magazine, which he had been reading for 50 years and only acted on a few times. This proves the point to only load up on sure things and great investments. Sit on your ass most of the time. Through this deal, Charlie made 80million dollars in 2004 through this investment.

With the 80 million dollars, he gave it to Li Lu in 2004 or 2003 and invested in his fund Himalaya capital, which grew to 500 million. Charlie met Li Lu at a Thanksgiving dinner. Li Lu seized on this opportunity by initially knowing one of the law partners at Munger, Olson, Tolles. It is incredible for him not to know a word of English and to graduate Columbia University with 3 degrees, one of them being in law. Charlie agreed to train Li Lu and was willing to invest in him, on the condition that he model incentive fee and philosophy of investing under Berkshire. This would be a fair structure, concentrated investing, no shorting, etc. etc.

Li Lu is successful because he is a master at utilizing his time well and knowing which connections are important to form. He knows how to focus and what activities and people to avoid. In business, certain deals and certain information are asymmetrical, and without certain connections, some insights or contracts are not obtainable.

This is not a blog on politics, so I will only touch upon this briefly. Li Lu influenced Buffett on BYD and was able to return to China without being banned. Why? How was he accepted back into China? It was through a letter from George Bush. This proves my point on connections.

 How did Charlie Munger get into Harvard Law School despite not having an undergraduate degree? He knew a dean. He graduated top 5 in his class, but without these connections, he would not have been able to attend.

It proves a Chinese saying, “識人比識字更好”, meaning it is better to know someone and have connections than to know words. I agree with this only to a certain extent. I think it is important to be financially literate and read a lot to get a clear view of reality and couple this with great connections. You need both to be successful and it is obvious Li Lu has this in spades.

Another thing I want to touch upon is how Himalaya is structured by comparing it to Baupost, Seth Klarman’s fund, and Arlington Capital, Alan Mecham’s fund. I am in no way criticizing Baupost or Himalaya, or Arlington. I am just comparing how things are structured.

Baupost has a small management fee which they take from AUM (assets under management). This allows them to have a team of over 200 people in Boston. Yet Himalaya’s staff is slightly larger than a dozen people with no management fee (they follow the 6 % hurdle and 25% incentive fee which Munger recommends). There is no right or wrong. With 200 people, you can scale different activities and open multiple funds like Oaktree. With less than 20 people, you have to pick your opportunities well.

When I met with Alan Mecham’s employee through a value investing group, he mentioned that colleagues are free to pursue their own investment topics, even though some are proposed by Alan. In contrast, Li Lu picks all, if not most of the companies to look at, and assigns 3-5 companies for each of his colleagues to do in depth research. And when I mean in depth, I mean really in depth. After they finish a field trip and go back to Seattle (originally Pasadena, they must have moved due to tax reasons); they are required to write in Chinese an essay of 1,000,000 words. Why is this exercise good? When you come back from a trip, it is still fresh in your head. When you write things out, you need to be logical and articulate your thoughts to others in a clear manner. It forces your thinking to be straight.

Again, there is not “right” or “wrong” in both Li Lu and Alan’s methods. It just shows you different ways funds are structured and how they get the most from their staff.

Also, I want to give a shout out to Himalaya’s employees. There are really discrete. I got a chance to know one employee and became good friends. Since I am not an investor in Himalaya, he has never told me Li Lu’s holdings and he has never told me about his interaction with Li Lu or Charlie. This shows that Li Lu’s employees are first class in that they protect the basic interests of the fund. When you hire someone, you want to hire someone with integrity and character. It is obvious all of his employees are loyal and capable.

Most of Li Lu’s investments which I know of, are either publically announced, such as the greater than 5% interest in CRRC through the stock exchange of Hong Kong or by originally attending the AGM. These are listed below. Some holdings are just my guess though his publically listed letters on his site. It is obvious that Li Lu does a lot of due diligence himself and through his team, and knows every nuance of the business, such as the competitive advantages, risks, etc,-- as if he were the owner himself. He then looks for an inflection point— an event that results in which a significant change in the progress of a company and can be considered a turning point after which the company accrues significant competitive advantage to consider it safe long term investment.

If you think about it, it is quite simple. You can always have your cigar butts and special situations when your fund is small, but long term, you want a long runway with compounders. And by definition, a great company is a company you can hold on to for more than a decade. So this means that pharmaceuticals with its unpredictable clinical trials, silicon chip fabrication and certain technologies which are impossible to predict with so much change and where the winner is not preordained--- these companies are all out of the question. It has to be simple, predictable, and in an industry or business with good prospects.

Then you have to remember that you are a minority owner participating in a company passively. Who are the owners? Do they have the same incentives as minority shareholders? Will they liquidate my shares or screw me over? Warren always says in a card game, if you don’t know who the patsy/idiot getting fooled is, it is most likely yourself. How can I get conned through bad accounting or management? Remember, to unethical and selfish owners, the game is not to benefit shareholders or to create shareholder value through buybacks. The game is to raise money through cheap cost of capital by making the company look better than it really is. With a higher multiple, it is easier to acquire companies and raise capital. Bad owners never worry about issuing too many shares and diluting their company through stock options. They never think about funding projects through cash and debt, they issue shares without an afterthought.

Auditors always list their rating and opinion in 4 categories. “Unqualified” is unequivocally passing with flying colors, but you still have to investigate yourself as an investor. Then comes “qualified”, “disclaimer”, and finally “adverse”. I would suggest to only look at “unqualified” annual reports. It is a pity that CapitalIQ doesn’t show this, but Bloomberg does. Also, by the way, CapitalIQ, which was sold to S&P was actually one of Li Lu’s early venture capital investments.  

I will continue this topic in possible a few other posts. I want to analyze some of Li Lu’s investments. After all, Charlie calls him the “Warren Buffett of China”.