96-year old Charlie Munger is a true investing great.
But, even he gave a part of his money to someone he calls, “The Chinese Warren Buffett.”
Luckily, I stumbled upon this talk Li Lu gave at Columbia Business School, in 2006.
And once he shows how he picks his stocks, you can see what Charlie Munger means.
Sharing some notes:
1. What is Value Investing?
There are 3 main concepts:
A. Business owner’s mindset: This is the key concept. And also the source of B & C.
B. Margin of safety: Needed for self-defense. Because you’re a minority owner.
C. Mr. Market: Needed, because you don’t trade all the time.
Note: What’s really useful is how Li Lu identifies the concept of “business owner’s mindset” at the very center of value investing. All other principles flow from there. It was an aha moment for me!
2. Types of Market Participants
There are 2 types of participants in the stock markets:
A. Traders (95%): The stock market is created for them. They keep it liquid.
B. Value Investors (5%): The stock market is not created for them. They don’t trade often. They want fat margins. Markets will shut down! 😀
Key Lesson: Understand who you are – the 5% or the 95% – because you’ll be tested throughout your career.
3. Traits of a Value Investor
There are 2 common traits of value investors:
- You have to be very comfortable in a minority. Which goes against our evolutionary need to stick with the group.
- You’ll spend most of your time as an academic researcher, instead of being a so-called “professional investor”. As a journalist. Have an insatiable curiosity to figure out how everything works.
Note: The second point will be of great comfort for you, if you, like me, wonder how your ideal day should look like as a value investor.
4. Li Lu’s Investing Checklist
- 1. Is the opportunity cheap?
- 2. Is the business a good one?
- 3. Can I trust the management?
- 4. What am I missing? Why is this opportunity presented to me?
- 5. If comfortable, overcome the last psychological barrier and just do it!
Note: When I first heard Li Lu’s investment checklist, I made the mistake of thinking, “It is so simple”. But, when he discussed the 3 case studies (see below), I realized how useful it is. What’s more, he’s kept only the core steps and cut out the fluff.
5. Timberland Case Study
- Aug, 1998. It is during crises, you tend to have more interesting opportunities.
2. Search Strategy
- Go through “Value Line” page by page. Check out the “new low” list. Low P/B. Low P/E etc. This is the 1st thing to look at. If it doesn’t fit, move on.
Note: This step is now much easier with online databases. My current favorite for Indian stocks is Screener.
- Stock price was $28.
- Shares outstanding were 11.5 million.
- Hence, market capitalization = $28 * 11.5 m ≈ $300 m
Important: Market capitalization was less than book value.
4. Book Value
Every time you see it’s below book value, you ask, “What’s the constitution?” i.e. “What’s in the book?”
- Working capital was ≈ $300 million. This was end of Q3. In Q4, retail companies convert inventory to cash. In the last 2 years, that was about $100 million.
- Fixed assets were $100 million. Mostly buildings / real estate.
Note: You’ll find true value investors, like Li Lu, often pay as much attention, if not more, to book value as they do to earnings. And, it took me 2 decades to realize this fact! 😂
5. Downside Protection
- Roughly, you got $200 million liquid assets + $100 million real estate. So, you have a pretty decent protection on the downside.
6. Return on Capital Employed
Pay attention to the earnings before interest and tax (i.e. unleveraged earnings).
Compare it with the unleveraged capital that is needed in the business.
- Sales = $850 million
- Operating margin ≈ 13%
- Earnings before interest and tax (EBIT) ≈ $110 million
- Capital employed ≈ $100 million (liquid assets) + $ 100 million (real estate) ≈ $200 million
- Return on capital employed (ROCE) ≈ $110 million / $200 million ≈ 50% (Not a bad business!)
Note: There is some confusion about Li Lu means by “Liquid Assets”. But the valuation logic is 100% solid.
7. What Am I Missing?
Q1. Not a bad business. Also, Timberland is a known brand. What has the thing fallen apart, then?
- This was at the height of the Asian Financial Crisis. Nike’s and Reebok’s sales in Asia were falling off a cliff. All apparel/retail stocks were affected.
Q2. What were other people thinking about this? (Even if you don’t listen to their advice.) Were there any analyst reports?
- Nope. There weren’t.
Q3. For a company almost a billion dollars in sales, a big brand, why wasn’t anyone covering the company?
- A. They don’t need the financial markets anymore. If you go back 10-15 years in value line, you’ll see it’s been growing. And profitability has improved dramatically in recent years.
- B. Ownership structure: 40% ownership. 98% vote. Turns off people.
- C. Lots of shareholder lawsuits. If you’re a trader (see point above about 95% of market participants), you might worry about corporate governance. Siphoning-off of funds.
Q4. What would you do next?
- Download all the court cases. And read all of it. All cases were just 1 complaint, but filed multiple times. “The management used to give guidance. But didn’t deliver,” they said. So, the owner got pissed off. And stopped analyst calls/guidance.
Q5. Ok. Maybe they’re not crooks. But are they good managers? Are they decent people? How do we go about finding that?
Ans. Most people who build businesses, also have a big personality. They leave a trail of evidence. And have a history you can audit.
You go to see their community. You go to see their church or synagogues. You go visit everybody. And you introduce yourself to all their friends and families and neighbors.
What has he done for his community. What do his friends and neighbors say about him.
Don’t just call them. Go there. Spend a few weeks. It’s worth it.
And you want to find the family dynamics. The owner’s son was to be the new CEO. He also happened to be on the board of my friend’s company. So, I invited myself to be on that board. And he became a close friend.
I found them to be admirable, high-integrity, wonderful people who also happen to be brilliant businessmen.
Note: This is the classic scuttlebutt or grapevine, that Phil Fisher popularized.
I’ve tried this is the past. And in my experience, this requires an outgoing personality to pull it off. So, unlike Li Lu, I just stick to speaking to friends and family wherever possible.
But an ex-colleague and dear friend, has the right personality to talk to complete strangers. And he’s found some really great stocks in the past.
Q6. Why had margins improved in recent years?
- Went to stores to check. Store managers couldn’t get enough stocks. There was a fad going on. Inner-city little kids wanted Timberland shoes & jeans.
Q7. What was the exposure to Asia?
- Less than 10%
Q8. So, did I miss anything?
- Probably not.
8. Summary: Timberland Case Study
- Virtually no downside
- Trading at ≈ 5x P/E
9. Portion – size
People in fund management use “basis points” to make numbers sound big. It’s funny.
After so much effort, I put in a “shit-load” of money. (Li Lu didn’t share the actual percentage.)
Timberland went up 7x in 2 years.
It was propelled by earnings growth of 30% year-on-year. Multiple was never more than 15x earnings (up from 5x). So, you still didn’t have any risk.
Also, the new CEO (the son) was articulate, and didn’t mind talking to analysts. So, he initiated analyst meetings.
11. When to Sell?
In the 1st analyst meet, there were 3 people – CEO, I (i.e. Li Lu), and another analyst.
When I went in 2000, there were 50-60 people. Major brokerages had initiated coverage. That’s when I knew I have to sell. So, I sold everything.
12. Time Spent on Research
No more than a couple of weeks. But you have to devote day and night into it.
Opportunities like this don’t come very often. So when they do, you have to seize it. You have to do everything complete, but you have to do it fast. It doesn’t take all that long, but it takes intensive work for a short period of time.
That’s why you have to train yourself all the other time. Put your money in the bank meanwhile. It’s OK. You don’t have to buy anything.
But when the opportunity comes, you have to jump on it.
Note: This is one of most useful passages of Li Lu’s talk because it tells you exactly how it is like, when you’re working on a promising stock pick.
6. Hyundai Case Study
2. General Points
- Search strategy: US stocks → Value Line. Others → S&P book.
- Owner’s Mindset: As an owner, don’t think in the per-share numbers. Train yourself to think in totals.
- Calculations: Just do rough mental calculations. Don’t use calculators.
Note: Interesting that these points are mentioned by not just Li Lu, but also by Warren Buffett on several occasions.
3. Valuation – Basic Calculations
- Market cap ≈ $12 per share * 5.5 m shares ≈ $60 million
- Pre-tax earnings ≈ $30 million
- Price to earnings (P/E) ratio ≈ 2x
- Net earnings ≈ $25 million
- Book value ≈ $240 million
- Constitution of book value:
- Debt = 0
- Fixed assets = $180 million
- Current assets = $70 million. Current liabilities = $10 million
- ∴ working capital = Current assets – current liabilities = $60 million
- Price to book (P/B) ratio ≈ 0.25x
4. Valuation – Quality of Numbers
- What is the next step? We suspect, it is cheap. Verify if it’s actually cheap. Check the constitution of the numbers.
- Current assets: $70 million. All cash and tradable securities.
- Fixed assets: $180 million
- Hotel (100% stake) → $30 million
- Department store (13% stake) → $30 million
- Was in the very next page of the S&P book
- Market cap of $600 million. 13% of that ≈ 80 million
- Similar profile to Hyundai. Roughly trading at cash value. P/E ≈ 2x.
- Owns a whole bunch of different assets. 2nd largest cable operator in Korea.
- Department store is not like those in the US. It works more like a hotel. They don’t take any inventory. They charge a % of the merchant’s sales.
- Cable companies: 3
- Real-estate. Bunch of it. No revaluation in 10 years. Even though Korean real-estate had gone up dramatically.
I went to Korea. And looked at the hotel. I looked at all the department stores. Looked quite decent.
I checked recent real-estate transactions in the neighborhood. Value is like 2 to 4 times what’s on the book.
6. What did I miss?
- Nuclear threat from North Korea.
- What are other local investors in Korea thinking? Etc. Etc.
There are a whole bunch of negatives. And there are a bunch of things in your favor. We don’t have the time to cover them all today. You have to go through all of it rationally, carefully. And then come up with a decision.
The department store went from $22 to $100.
Our stock went from $12 to $70. Both went up about 5 to 6 times.
7. Key to Success is Grunt Work
I gave a couple of examples (Timberland and Hyundai) to tell you:
- This approach is not natural to an investor.
- However, if your personality is in the 5% (see “Types of Market Participants”, above) there’s a lot of money in it. As has been repeatedly proved by people from Ben Graham to Warren Buffett.
- But you have to do the work. I’ve made tens of hundreds of thousands of dollars just by taking this class (“Value Investing with Legends“, by Prof. Greenwald at Columbia Business School). Just listening to the 14-15 people. But I did a lot of work. I’m telling you, you can make a lot of money if you’re really into this. But, do the work.
- This class is different from any other class, because there’s no bullshit theory. All everybody’s telling you is what works. If you don’t really use this thing, shame on you. You’ve gotta do it. What do you have to lose?
Note: Love the passion with which Li Lu speaks about how you can still make money from value investing. Efficient market hypothesis, be damned!
8. Key to Good Analysis/Investing
A. For deep-value stocks: Information
- Accurate information. Complete information.
- Most people fail on both. Big time.
- You just have to go to that extra length to get it done.
- If you can’t succeed here, you can’t succeed in investing. Because most of the time, you stand alone, against just about everybody else. So, if you’re not confident about what you know, and your estimation about what other people know/don’t know; you can’t possibly be putting that kind of money, when the thing’s going into a free-fall. When it looks like you’re losing all your money. When everybody is laughing at you. All the smart guys.
B. For high-quality stocks: Insight
- If you don’t have the insight, you’ll make a mistake.
9. Two Kinds of Mistakes
A. For deep-value stocks
- Usually, if happens when you haven’t finished all your work, but you like the stock enough, and you feel the probability is with you and so you buy it. Sometimes, as you’re finding more and more, you prove your thesis wrong. But, by then you’ve lost 20%-30%. So what? Take your mistake. Move on.
- But the odds are with you, if you buy with sufficient margin of safety.
- Do it long enough, with relatively small amounts of capital, and you’re not likely to lose a lot of money.
B. For high-quality stocks
- When you have an insight and others don’t have it. But you still don’t bet. That’s the biggest mistake.
10. Two Types of Value Investing
- Use: Gets your basic business going.
- Returns: Basic returns. 10% to 15%. That’s better than 95% of market participants.
- Masters: Ben Graham. Tweedy Browne.
- No. of chances: Many
- Ease: Relatively easy
- Driver: Valuation reverts to mean
- Use: Most money is made here
- Returns: Outsized returns. 100x, 1,000x, 10,000x
- Masters: Warren Buffett, Charlie Munger.
- No of chances: In 50 years, you’ll may be get 10 such stocks.
- Ease: Not easy
- Driver: Lollapalooza
11. How to Find High Quality Stocks?
Tremendous insight is needed that others don’t have.
To build such insight, you need intense curiosity, continuous study for your whole life. You must be intensely interested in everything – Physics, Maths, Economic history, Law, Politics, Biology, Psychology…
You might develop one insight over many, many years of study. I studied an American company 15 years ago, and now I find an Asian counterpart. And I like the valuation. But I studied the business for 15 years in between.
Occasionally, you’ll stumble into one big opportunity. Meanwhile, you’ll have plenty of things like Timberland, Hyundai.
12. How Many Stocks in a Year?
In some years you might not have a lot of opportunities. And in some years you’ll have a lot.
But I guarantee, they don’t come in a steady pace. When I was at Columbia – College, Law School & Business School – for 5 to 6 years, maybe I had 3 to 4 big ideas that really paid off big.
13. Ability Compounds
You progressively get better, and better, and better. To the point, you look at a page in S&P and it takes you a couple of minutes to tell you right away whether something jumps out. You can smell it.
Even if the market is not cooperating and you don’t have any good ideas and a year goes by. That’s okay. But it shouldn’t be the case that you didn’t learn anything. You didn’t establish a good insight or destroy an insight you had.
You want to go through everyday learning something. It’s a good mental discipline to have.
14. Time Management
1. Work: Searching for Ideas
Reading physics, biology, history, etc.
2. Work: Actionable Ideas
When one idea jumps out. That’s all I do. If not, back to reading.
3. Family time
Rest of the time, I’m with my wife and kids.
15. Buying Businesses Outright
Since the key concept of value investing is “Business-Owner’s Mentality”, sooner or later you’ll expand beyond only the stock market to owning unlisted businesses.
That’s why Buffett and Munger eventually closed their partnerships. And ran a real company.
16. When to Sell
A. Earlier: Deep Value Stocks
If I don’t want to buy at that price, I sell.
B. Now: High Quality Stocks
Occasionally, I find an insight. I like a business so much. My hunch is, the probability is with me that over the next 10 years, the business will get better and better and better.
Leaders take a disproportionate amount of capital and in certain industries, that advantage gets bigger and bigger and bigger and bigger.
If you sell such a business:
- (A) You might not get an opportunity to buy it back, and
- (B) You pay capital gains tax, which in a sense is an indefinite, interest-free loan from government until you sell.
Such superb businesses earn ROCEs of 50% to 100%.
Caveat: Only if you study your entire lifetime, you’ll get 5 to 10 companies you can confidently project for 10-20 years with overwhelming odds. At that point, you don’t sell. Why do you want to sell?
Note: Investment banking projections of 5 years, next 5 years, terminal value is bullshit!
17. Finding High Quality Businesses
Look for this in a business: An advantage that is getting stronger, and stronger, and stronger.
Ask: “Why do some companies keep succeeding, while others fail?”
The only way to find the reasons, is by studying the ones that have succeeded.
Note: Network effects is a common term these days, for the kind of moat Li Lu refers to.
18. Bloomberg Case Study
Q. When Bloomberg was introduced, there were long-established players like Reuters. Why did it succeed?
High switching costs: You rely upon it for your work. It takes a long time to learn all the functionality of Bloomberg. So, you don’t want to learn it again. And since everyone else is using it, you have to be able to communicate with your colleagues. The winner takes all.
What’s interesting is how they made small inroads and then reached an inflection point. And then, they became a monopoly.
That point was maybe when they introduced it to every B School.
Also, they visit traders and ask, “What do you use on a daily basis?” And they develop a function for it.
How many functions does Bloomberg have? 10’s of thousands. But they don’t have a menu. They want to get you individually hooked.
When you develop such an insight about the inflection point of a listed company, that insight is worth a “shit load” of money.
And such dynamics are there is all sorts of businesses. Like Microsoft’s success over Apple initially.
As a value investor, you should study businesses all the time. And observe the trends. And occasionally, you’ll get an opportunity.
You don’t need to sell such stocks. Even though they’ll always trade at premium prices. Like 30x earnings.
19. How Involved with Management
A. Private Investments
Capital IQ, Bloomberg for engineers, etc. Very involved.
Met the management. Became friends. Involved.
Couldn’t get anybody to even talk to me. Not even a receptionist. Not involved.
Lesson: You always try. But sometimes, it’s not possible.
20. Business Keeps Changing
You can observe. You can learn. Nothing is constant in business. So you have to constantly re-learn things.
Bloomberg could change in a few years. Like Microsoft has.
And that’s a good thing. Because people with an active mind, who are actively prepared and have the temperament to act when they see an insight/opportunity will always, always have a chance to be fabulously rich.
Note: While I’ve done my best to note down Li Lu’s fabulous talk, it cannot capture the passion with which he speaks about value investing. Highly recommend that you watch the talk.