Li Lu Peiking University (Grahamites from Guru Focus -- Transcript)

 

Attached is from a session Li Lu (founder of Himalaya Capital, Charlie Munger is an investor in his Asian Fund) at Peking University's Business School with CITIC Publishing (Li Lu’s publisher), in which he discussed about researching and understanding businesses and advice on investing in China.

All content was taken from Grahamites (Ning Jia) who transcribed it on to Guru Focus. Some of the content was modified.

 

 

1. What should investors do when a high quality company becomes overpriced?

Whether the stock of a business is overvalued or not depends on your judgment over the future growth prospects of the business. You need to come up with an estimate of future growth, and then calculate a range of intrinsic value. If the market price offers you a margin of safety, then it's a good investment.

This is the general framework to use.

Each investor's level of understanding of a business is different. Therefore, each investor will come up with their own conclusions. No one can make that decision for you.

 

2. Should investors hold on to a company in light of management team's moral scandal?

It depends on whether and to what extent will the scandal impact the long term competitive advantages of the business.

For instance, with consumer businesses, the image of the management team will impact how consumers view the brand. In this case, the scandal will have some negative effects on the brand. But it may not have a longer time impact.

It also depends on how competitors react and other external factors. It's not that straightforward. If you can't make such a judgment, you probably shouldn't be in the investment business.

3. If an investor currently holds a high quality company is priced at 40 to 60 times earnings and the future growth is estimated to be between 10% and 20%, should one sell the stock? When would you sell a great business?

This is an issue every investor faces during his investment career. Usually I sell a stock on one of three occasions.

First, I sell a security if I make a mistake.

The second occasion when to sell is when you find something that's better. By better I mean a better risk and return combination. You do that by constantly improving your portfolio's opportunity cost.

And the third occasion when to sell is when the valuation swings way too much to the extreme high, or when the market price deviates too much from the intrinsic value. When this happens your opportunity cost turns into cash.

Essentially it's all about opportunity cost. But it's not that easy because everyone's opportunity cost is different and everyone's understanding of opportunity cost is different.

Generally speaking, I would require a larger margin of safety when I buy a stock because this way when I'm wrong, I won't lose money. If I'm right I'll make money. But once you've held the business for some time, you start to understand the business from an owner's point of view.

You'll find out that the business either gets better or gets worse. And your ability to predict the future prospects of the business also gets better over time. Therefore, you might not need a large discount when holding on to the business.

The price at which you are willing to hold on to the business will be higher because you are more confident with your ability to predict the future growth. But when the price swings to the extreme high, you still have to sell because your opportunity becomes cash at some point.

It's an art. When it's at an extreme level the decision is easy to make. But there's a price range in which the decision to sell is relatively harder to make.

 

4. Traditional value investing has not been effective during the past few years in this extremely low interest environment. What should value investors do in this environment? Should investors lower the valuation standard? How should value investors get a margin of safety when everything is expensive?

We are talking about two questions here. First, what discount rates investors should use under the current interest rates? Secondly, what should value investors do during the period in which the traditional value approach doesn't work effectively?

With regards to the first question, yes we have experienced unprecedented low interest rates recently. We are talking about zero percent interest rates or even negative interest rates. Ultra-low interest rates reflect extremely difficult economic conditions. It's not a normal state. Low interest rates mean people are not optimistic about the future.

In other words, everyone thinks the future is worse than the present. If this is true, you should use a higher discount rate because if the future is indeed worse, the future growth will be lower and risk is higher. So you need a larger margin of safety, not a lower margin of safety. And secondly, it will take some time for the negative consequences of low interest rates to take place. It could be inflation or devaluation of the currency. Many things can happen (to force the interest rates higher).

If you use a low discount rate now, you may justify a high valuation of many businesses but you also price in much optimism.

The second question is about ineffectiveness of the value strategy during a certain period of time. If you study the history, it has happened a few times (value underperforms). But this doesn't mean you should judge whether value investing works or not by this standard. It certainly doesn't mean you should lower your standard for margin of safety.

I've been in the market for 26 or 27 years. What I've observed is that authentic value investors have always been the minority. But today, at least in China, I see more and more investors call themselves value investors. But they may not understand the essence of value investing.

As Ben Graham said, in the short term the stock market is a voting machine and in the long term it's a weighing machine. If you are a true value investor, you shouldn't care about the voting results because ultimately intrinsic value is determined by the long term profitability and growth. It has nothing to do with how market participants vote. If you care about how they vote, you are not a value investor. The market is there to serve you, not to guide you.

 

 

5. How do you pick what companies to do research on? Is it top down or bottom up?

It doesn't matter whether it's bottom up or top down. What matters is how you measure a business. You are investing in a business. This business competes in an industry with its competitors. This company has its advantages and disadvantages. The industry has its pros and cons. Your understanding and analysis should ultimately be focused on the future competitiveness of the business.

The long term prospect of business depends mostly on its competitive positions. If the business earns a high profitability and has a promising growth prospect, it will attract more competitors. If the business earns a lousy return on capital and has a poor future prospect, no one wants to enter the field. You probably don't want to spend any time researching it either.

So if you are interested in a business, you'll find out that you should focus on the long term competitive advantages of this business. What would the business look like in 10 years or longer? Can it sustain its competitive advantages in 10 years? Can it sustainably grow? Will it continuously earn a high return on capital? You'll find out that you will always circle back to the same question – the long term competitiveness of the business.

 

 

 

Q & A session

Question 1: For someone who has worked in the sell side for more than a decade, how can one transition from sell side to value investing?

Answer: You have to adjust your mindset, which is very hard. A good way to start the transition is to manage your own money for a while before formally moving to the value investing profession. But the good thing about the sell side is that you have accumulated valuable industry and company knowledges and experiences, which are very useful. And the framework of research analysis is also very useful.

 

Question 2: Do you know any young value investors who have failed? If so, why have they failed?

Answer: Lack of interests and passion is one key reason why some have failed. Passion is very important. The key to success in value investing is to combine competency with passion.

 

Question 3: How can you tell whether you really understand a business or not? Are there any standard metrics we can use?

Answer: Asking this simple question when you analyzing a business - can you tell what the worst case scenario is for the business during the next ten years? In other words, if some day during the next 10 years, everything that could go wrong does go wrong, what the economics of the business will look like?

If you can answer this question, then you can say you understand the business. Human psychological biases make it really hard to be completely honest with ourselves. 

Charlie’s idea is very useful – always seek disconfirming evidence from someone who’s very knowledgeable about the business. Someone who has the opposite view about the future of the business.

“I’m not equipped to comment on a subject until I can state the arguments against my conclusion better than the other side. If you’re looking for disconfirming evidence all the time and putting yourself on a grill, that’s a good way to help remove ignorance.” – Charlie Munger

Question 4: What is the best way to learn value investing? 

Answer: It’s better to let your own personal interests to guide you and just let the knowledge accumulate over a long time. This way you can also learn more efficiently.

 

Question 5: What are the most important sources of a business’s moat?

Answer: It depends on the time horizon. In general, the longer the time horizon, industry characteristics are the most important source of moat. But in the shorter time horizon, the people factor is more important.

 

Question 6: What traits do you look for in successful entrepreneurs?

Answer: It depends. Each company and each entrepreneur is different. What works for one may not work for another. The question you should ask is why is this entrepreneur so successful in creating this specific business?

How did he build the business? For instance, why was Jack Ma so successful in building Alibaba? He might not be successful in building another business. Ditto to Steve Jobs. There are many examples of entrepreneurs with great qualifications who have failed to succeed.

 

Question 7: What advice would you give to students? Should we get a job at a large institution first?

Answer: It’s true that you can accelerate your learning if you work for somebody who’s experienced in the field. But the problem is there are very few authentic value investors out there.

And the authentic value investors rarely need to hire analysts. It’s unfortunate but that’s the reality. So the best way is to learn by yourself. You can also keep in touch and get together with other value investors. Otherwise, go work for someone who you admire and respect.

 

Question 8: Can you talk about how Mr. Munger formed his investment framework?

Answer: Munger established his mental model framework very early in his life, before he got into the investment business. He’s always curious about how the world works, what works and what doesn’t work. He’s interested in learning about outstanding businesses from an early age.

 

Question 9: Can you share your perspective on life, family and health?

Answer: Investing is a long term endeavor. The most important thing is to do what you love, keep a good habit, and a calm mindset. Physical health is obviously very important as without it, you won’t be able to compound for a long time.

The other important thing to keep in mind is to minimize the pressure, especially from LPs. This means only partner with people who share the same philosophy. Himalaya only manages money for endowments and charitable foundation because they share the long term view and they create value for the society.

It’s also a good idea to live in a place like Omaha, which is far from Wall Street. You’ll get less noise. Avoid people you don’t want to be associated with. You also want to always try to create win-win situations. Be kind to people around you.

Lastly, don’t be afraid to go slow. In the long term, slow is fast.

 

Question 10: What’s your view of the impact of indexing investing?

Answer: This is less of a problem in China because China’s main index such as the CSI 300 index doesn’t properly reflect the underlying economy. Chinese government is working hard at making the stock market a better proxy of the economy. In the U.S, the index is a good proxy of the economy.

But the problem of passive investing is that it isn’t the best pricing mechanism for different businesses. And the pricing mechanism is very important for capitalistic market. It’s hard to say at what point passive investing will be counter-productive to market-based pricing mechanism.

 

Question 11: How important is balance sheet based margin of safety analysis?

Answer: It depends on the market. In China, it’s hard to find such opportunities but in other Asian markets there are still such opportunities. It’s true there are fewer net-net opportunities now compared to when I started. If I were to start over again, I’ll probably start with this approach because it offers more certainty and it helps protect the downside. But nowadays you’ll have to look harder for net-net opportunities.