Li Lu is a successful value investor and a disciple of Charlie Munger and Warren Buffett. He is founder and chairman of Himalaya Capital. He is well known for influencing Charlie Munger to invest in BYD a Chinese company that specializes in electric cars and batteries. The following is my notes from Li Lu’s rare public presentation posted in www.gurufocus.com
The three key concepts of Benjamin Graham
Stock is not a piece of paper :
It is a fractional ownership of a business. In the long run the value of the stock will be true reflection of the underlying business.
Margin of Safety :
In valuing any financial asset you should be able to predict the future, hence you should leave your self a margin of safety. This will ensure that if your prediction is out of range or wrong you have some downside protection. By demanding a margin of safety you demonstrate humility as an investor.
Mr. Market :
Market is not efficient and rational rather it’s the opposite. In his book Intelligent Investor Benjamin Graham has the following to say about market
In the short run market is a voting machine but in the long run it is a weighing machine
Inverse of Graham / The non-value investing Philosophy
Stock is a piece of paper :
It’s a piece of paper you can trade all the time, success full investing lies in successful guessing of the movement of a stock. Buy and hold is dangerous as you can’t be sure of long term.
Market should be respected & feared :
You rely on market rather than your own thought about the stock price. You respect the market and you believe in the wisdom of the market. You don’t bet against the market if you are in this camp.
Why Value Investing
True value investors properly practiced have out performed the market and other investors. If the empirical studies conclude over overwhelmingly that value investing is a successful approach, why not more people follow what they do ?
It turns out it has more to do with psychology
- You should be willing to stand alone when rest of the market and investors are against you. It’s very unnatural thing to do, it can even look delusional. Evolution requires conformity. When our ancestors were hunters and gatherers , an individual who was not part of a group would risk his life. Hence conformity is at the heart of a social animal.
- Free market economy has been very useful for the society but it has been disastrous for the financial markets. When there are lots of companies and traders interacting with each other there is an element of guessing and speculation which is similar to gambling. even though it’s clear to everyone that the house always wins in casino, people don’t stop gambling. This again is in our nature.
- The most challenging aspect of value investing is to refrain yourself from trading too often. You should decisively bet when odds are heavily in your favor. These kind of opportunities are rare and you would be lucky if you see more than ten of them in your life time as Charlie Munger , Vice President of Berkshire Hathaway would like to say.
Before you make a bet
- You should have enough margin of safety
- You should be able to stand against the market. You can do it, provided you have a large margin of safety
Most people do not have the necessary mental fortitude to practice value investing. Many people will run when the market turns against them. Investors who have studied successful investors, market history and their investments can develop the fortitude to stand alone with their bet when the entire market disagrees with them.
The most interesting thing you would want to do is not think about the asset rather focus on a the ability of a company to consistently generate cash, basically a compounding machine. You are now dealing with a quality franchise with deep moat and lots of opportunities for expansion.
Arbitrage & value investing
In korea you have a non-voting securities known as preferred stocks, usually these preferred stocks were trading at 80% discount on the common stock of the same company. Some of these companies were great franchises run by a family and hence there was not much voting power if you held common stocks either. these kind of arbitrage opportunities with high margin of safety are ideal for someone working with small capital.
When do you decide to sell a stock ?
You should re-evaluate the business model and market realties of the companies you own. If you see the hypothesis on which you invested in that company no longer is true, you should sell. On the other hand you should not sell a stock due to short term fluctuations in earnings, revenues and other factors.
What is the margin of safety you should look for ?
You should have a unique insight about the business and its future returns. Hence the margin safety depends on your knowledge of the business and the quality of the business. If you are not sure about a business you should demand a very high margin of safety.
Secrets of successful investing
- If you want to be rich by investing in stock market, you should be able to endure long periods of in-activity
- It’s hard to be successful in investing if you are intellectually arrogant . You should be intellectually honest and recognize your limitations. This means you will have a small circle of competence.
How do find great ideas ?
If you study all the time and if you have a quality network of investors, you will find a lot of great ideas. Information about great ideas are availably publicly. You need to develop judgement and unique insights. This will help you to see the business in different light then others.
Portfolio Construction and Diversification ?
You should have some kind of diversification, because
- You could be wrong
- Even if you are wright, you are betting on statistics. In other words future is a distribution of all probabilities. If you are 90% confident about your bet, but you can be wrong 10% of the time and you don’t want to be out of the game in case your bet goes wrong.
- It’s truly rare to find no-brainer opportunities, but when they do arise you bet heavily and not think about diversification.
In the end it boils down to opportunity cost. Cash is a fundamentally important asset, if i don’t find any good opportunity then I would be in cash. You should not be bothered to hold cash when you don’t find good opportunities.