Last week, I wrote about how Charlie Munger drew inspiration from Rudyard Kipling’s poem If. At one point, the late polymath referred to Chinese-American investor Li Lu as “a guy who’s like Charlie Munger born again — except he’s younger”.
That’s just about the highest praise imaginable. (At least in my book.)
In a recent speech commemorating the tenth anniversary of Peking University’s “Value Investment” course, Li Lu laid out the six basic concepts of value investing.
These principles span from the discipline’s founding father, Benjamin Graham, up through Warren Buffett and Charlie Munger’s work in shaping Berkshire Hathaway into the exemplar of capitalism that it is today.
Many people still pigeonhole “value investing” as a skinflint search for cigar butts in the Graham style. But, here at Kingswell, I prefer the more expansive (and Munger-approved) view that all intelligent investing is value investing. That it really boils down to getting back more in value than you pay out in capital — and should not be limited to the working capital calculations that once dominated the discipline.
“The core of value investing,” Li Lu told the Peking University students, “is to understand value. What you pay is price — and what you buy is value.”
(1) Stocks are not just pieces of paper to be traded. They represent legal ownership of a company.
“The market is composed of individuals,” said Li Lu, “and human nature pursues short-term goals — so people tend to treat stocks as chips for short-term transactions, ignoring that it is [really] the long-term ownership of the company.”
This is number one for a reason. It’s probably the most important mindset shift that any investor must make. One that separates rank speculation from real investment.
If you can see a stock certificate (or even a little ticker symbol on your phone screen) as an actual piece of a real business — granting you a legal right to share in earnings for as long as you hold onto it — you’re already halfway home.
Suddenly, frenetic trading in and out of positions doesn’t look so attractive anymore.
This sort of leads into the next point, but Li Lu also pointed out an important aspect of his mentor’s life and career: Charlie Munger faced macroeconomic uncertainty with equanimity — and preferred to focus all of his energy and attention on the micro factors that he could control. Like identifying and buying wonderful businesses.
“The macro is what we must accept and the micro is what we can do something about,” said Li Lu. “With this understanding, you can calmly hold the most creative and excellent companies and no longer be shaken by fluctuations in the macro environment. Only by keeping peace of mind can you firmly hold your chips and your purchasing power.”
Speaking of which…
(2) Market fluctuations should serve you, not guide you.
Li Lu calls the stock market “a great test of human nature”.
When the inevitable chutes and ladders of the market arrive, will you panic and sell? Or stand strong and, maybe, even capitalize on the opportunities that crop up?
To make his point, Li Lu recalled that most famous Grahamian character himself. “Mr. Market’s role is not to tell you the true value [of a company],” he said, “but only to provide buying and selling prices. These prices are often far below or far above the value. For value investors, he provides service, not guidance.”
Volatility cannot be avoided, only managed. It will eventually come calling for all of us. Even Berkshire Hathaway, commonly considered the most stable company around, has seen its fair share over the years.
“We all think Berkshire is a castle-like company, managed by the world’s best investors, and has stood firm for more than sixty years,” said Li Lu. “However, its stock price has fallen by more than 50% three or four times. Whether you continue to hold it at that point depends largely on whether you have a deep understanding of the assets owned by the company.”
He also held up one of his own famous investments — BYD — as another example. The Chinese EV maker’s stock had dropped by 50% or more “at least seven or eight times” during his two decades of ownership — and even by 80% on one occasion.
“Every time the stock price falls sharply,” said Li Lu, “it will test the authenticity of the boundaries of your circle of competence. Do you really understand [the company]? Do you really know what its value is?”
(3) Investments must have a margin of safety.
“The future is difficult to predict,” Li Lu told the students. “There must be enough margin of safety because you may not fully understand a company, nor can you clearly predict the company’s future. But, if you buy at a low enough price and leave enough margin of safety, your investment will be more secure and you will be more likely to hold it for a long time.”
Li Lu raises two important points here:
Incorporating a margin of safety into your investments is an act of humility. It’s a frank admission that no one can ever know everything about a company — or the uncertain future that lays ahead of it. That bad things will happen that we never even considered. And that it’s imperative we be able to weather those inevitable storms and live to fight another day.
A margin of safety is not just a numerical advantage — buying a company for substantially less than you believe it is worth — but a mental salve, as well. “Only when the price is cheap enough can you hold it for a long time with peace of mind,” he said, “so that you have plenty of time to understand the company and the business.”
(4) Long-term investment returns come largely from the value created by excellent companies through their long-term performance.
“Excellent companies can continuously increase their intrinsic value,” said Li Lu. “The intrinsic value of [such] a company can grow infinitely with the progressive growth of the economy. Therefore, investing in such companies will also increase wealth faster than the market average.”
These excellent companies, though, rarely come cheap.
For decades, Warren Buffett and Charlie Munger (and others) defied the widely-held Efficient Market Hypothesis with their sustained success. But this much-needed acknowledgement that markets are not perfect does not, in turn, mean that they are utterly imperfect. In fact, on the whole, markets are pretty good at recognizing value.
Which means that you (usually) have to pay up for the very best companies.
Li Lu doesn’t come right out here and say it, but this principle lines up pretty well with Charlie’s maxim that it’s better to buy a wonderful company at a fair price than to buy a fair company at a wonderful price.
In the long run, buying and holding the jewels of the business universe will win out — as long as you didn’t get in at an outrageously high price. “Short-term overvaluation is not that important,” said Li Lu, “compared with long-term growth.”
“Once you find and understand such a company,” he continued, “I usually recommend not to throw away this chip easily.”
(5) Fish where the fish are.
I just wrote about this last month, so I won’t belabor the point here again.
Other than to say that Benjamin Graham was an expert at this. When he was making his mark, he could sift through the wreckage of the Great Depression and unearth numerous companies trading well below book value. And not only did he find these opportunities, but he shrugged off the pervasive fears of that era and invested in them.
Some critics hold the existence of that fruitful hunting ground against him, calling Graham a product of his time and only capable of his success due to the prevalence of these low-priced opportunities.
Hogwash.
Graham was just smart enough to go where the fishing was good.
(6) Wealth is all about purchasing power — and the goal of value investing is to maintain and grow wealth.
“Cash certainly has value,” said Li Lu, “but is it wealth?”
Not necessarily.
To illustrate the point, he noted that — some decades ago — a “10,000 yuan household” would have ranked among the economic elite in China. But if that family had parked its money in a bank and left it there, inflation would have reduced its purchasing power to comparatively little today.
“Having 10,000 yuan today,” he said, “is no longer as meaningful as having 10,000 yuan [in the past] because the actual purchasing power today has changed exponentially compared to 40 years ago.”
“Many people now earn more than this amount in a month. So, if you just save cash, it will no longer be wealth over time … The essence of wealth is to be consumed. Therefore, wealth is your share of the purchasing power of the entire economy.”
In other words, it’s not about an absolute number — like, say, $1 million or 10,000 yuan — but what that money can actually buy today. And the best way to protect, maintain, and grow that amount is through intelligent value investment.
I like Li Lu style!
Brilliant. I really like the point about margin of safety - cannot emphasize that enough in probabilistic vocational like investing.