On Value Investing in Li Lu's New Book 《文明、现代化、价值投资与中国》
August 27, 2020
(Part 2 of 2)
Recap: Four Big Ideas in Value Investing
We can sum up the idea of value investing into four bullet points:
- Mr. Market
- Stock as a piece of a business
- Margin of safety
- Circle of competence
The first three can be traced back to Ben Graham’s book The Intelligent Investor, the last one was added by his disciples Buffett and Munger. These concepts are so comprehendible that unfortunately, they are often substantially overlooked when people first started investing.
Mr. Market Analogy
The Mr. Market analogy is meant to teach us how to differentiate investing and speculating. One can think of the Mr. Market as someone who is extreme, moody, and without much thoughts. The first thing he does every morning is to shout out the latest prices. He does this continuously throughout the day. When he’s optimistic about the future, he acts like an excited auctioneer and frequently adds more to the prices; when he’s depressed, he drastically lowers the prices.
It’s easy to see Mr Market is a very irrational person. The market operates very much on the two extremes of the spectrum, continuously swinging from peaks to valleys and back again. Most people choose the path of speculation and call themselves traders. It’s the most obvious path, a path that can provide quick riches and fast cash. Most traders attempt to time the market, believing that they are a lot smarter and have a lot more insight than the rest of the traders. Some get lucky and make a lot of money in a short period of time. They feel validated, feeding into their own self-fulfilling prophecy, and believing that they are indeed gods of the market.
Value investing fundamentally discourages speculation, and the reasons are simple:
- One can think of market index (ie total stock market index) as a zero sum game, where its value is equivalent to the sum of all investments from both investors and speculators. If the index rises at the same rate as the output from all investors, then the total output of speculators must be 0.
- Speculators cannot have long term performance due to the point above. If they do better in the short term, what they are doing can be seen as some form of legalized front-running or the murky area of information exploitation or insider information.
The market is also a good judge of character.
The market is a mechanism for discovering human weaknesses, especially when the financial crisis comes. Only by being completely honest with knowledge can we survive, develop and grow in the market.
Stock as a Piece of the Business
Graham, Buffett, Munger, and Lu love the idea of being an owner of the businesses they invest in, as oppose to a trader (temporary holder). This ownership mentality is important for investors because it urges them to learn more about the business. Naseeb Talib talked about a similar concept in his book Skin in the Game. When an investor sees him/herself as an owner, the risk/reward ratio gets closer to 1 and becomes more balanced. This shift in mentality can also turn the investor into a helper of the business (time in addition to money) and a constructive critic when needed.
Margin of safety
Margin of safety refers to the built-in cushion for downside risk in an investment. As we have established with the Mr. Market analogy above, the market is irrational and can stay irrational much longer than most think. Leaving a big gap between what you pay and what you believe to be the intrinsic value, is therefore recommended in order to stay solvent during the treacherous waves of the market.
Circle of Competence
Circle of competence literally means finding the limit to one’s knowledge and ability. Value investors tend to believe that the act of investing should be a reflection of one’s knowledge/wisdom. Hence, the most difficult thing for value investors is to figure out their own limitations and set up boundaries. These boundaries are meant to discipline themselves, so they do not get distracted by the “greener pastures” outside of their circle of competence. The two main questions we should always ask ourselves are:
- Where’s my knowledge border? What area/field of study/industry in which I am truly an expert?
- How do I know that I’m actually competent in this area? How do I know if/when I have achieved true mastery?
These are very tough questions to answer. When the market moves against you and everyone else is making money while you feel like the only loser in town, how do you maintain your conviction and know that you made the correct bet?
Lu thinks that when searching for your circle of competence, you have to find the smartest person who has the opposing view and be your devil’s advocate. If you are able to convince the other person, then you are closer to the truth and competency. You have to welcome criticism, build a team of people who have opposing views, who can challenge you on your ideas. After all these efforts, when you’ve convinced all the smart people you can find that your idea is superior, it’s still possible that there are blindspots. You will have to spend a lot of time to perfect your logic and knowledge, to be able to better understand the world and predict. Lu encourages investors to think like an economist, a sociologist, and a psychologist — in other words, think broadly and deeply.
A Few Additional Gems from the Book
- Value investors are loners who stick to independent thoughts and opinions. People who pay less attention to popular trends and opinions are usually better value investors. Lu believes that investors’ circle of competence rarely overlap, so it’s unnecessary to over-communicate. Since value investors aren’t believers in diversification, they would not need to invest in too many ventures. Also, the less time we spend talking with others about the new hot thing, the more time we have to figure out the couple of companies we are researching.
- Value investors are rational and objective. People who are less affected by emotions are usually better value investors. There are countless books and articles warning beginner investors about their emotions, leading them to buy and sell at the exact wrong time.
- Value investors are patient. Extremely patient. Berkshire is the perfect example of this, where they are willing to sit on a pile of cash for years or decades when they believe that there’s no attractive deals on the market within their circle of competence.
- Value investors are also decisive. Decisiveness (quickness in action) is often seen as a characteristic that contradicts patience (slowness in action). However, a good value investor must possess both qualities. He or she must be willing to wait for as long as necessary (years) without making a move, but pounce on an opportunity boldly with big wagers when it presents itself (usually during bear market).
- Value investors are passionate. Passion for learning is arguably the most important thing to a fulfilled life. As an investor, having passion for all aspects of business is certainly important as well. Charlie Munger often credits his success and longevity to his interest in **money sense **— his passion for business in general. He often says that a good investor must also be a good businessman. He or she needs to have a grasp on and curiosity in a business’ operations. This interest will largely guide research in questions like:
- What makes a company successful? Why does it make money?
- What would the future look like for an industry? What’s its competitive landscape?
Lu: Intellectual honesty
Research questions usually yield no quick answers. Investment can be seen as a prediction of the future, and the future cannot be predicted most of the time. Therefore, researching for a future prediction is an activity with such low probability of success that one must be content with not finding any answers. Having low expectations, having a scientist’s mindset, and having a healthy relationship with failure and uncertainty are crucial for value investors.
A large part of a value investors’ time should be spent reading. Readings should consist of everything and anything, but especially history, business history, and a lot of a company’s annual reports over the years. Munger is famous for being a biography nut. Buffett is known for spending 80% of his waking hours reading. By doing vast amount of reading, research, and analysis, one will have many past predictions formulate in their brain. This type of practice creates a particular smell for good investment that will become second nature for good value investors, helping them make more educated predictions in the future.
Lu: When to sell
- When you realize that you’ve made a mistake with your evaluation of the company through your research, sell immediately
- When you see a better opportunity with better bang for a buck, aka when the opportunity cost is becoming too high
- Valuation becomes too drastic, significantly derailing from the intrinsic value
Value should not be a number, but a range.
Lu: Avoid short selling
Three characteristics of short selling that people may overlook:
- Theoretically, a stock can lose 100% of its value, yet the percentage of increase can be infinite. If you short a stock, you have to understand the asymmetric risk you are taking on.
- The best time to short a stock is usually when a company experiences some type of crisis. It can come in the form of a discovery of accounting fraud, insolvency, or otherwise. Oftentimes, fraud can exist for a long time for a company while the market continues to carry the stock forward, and since one must pay interest to short sell, the pressure of short squeeze may bankrupt an investment before the company goes under.
- Short selling exerts exuberant amount of pressure and occupies all mental capacity of an investor. Lu believes that the confusion and lack of mental clarity short selling creates is actually its deadliest sin. An investor often discount the opportunity cost of the disruption of concentration and sharpness that he/she should always possess. Lu believes that he lost many great investment opportunities during his time of being a short seller because of it.
Insight and frequent transactions are incompatible with each other. This is my biggest mistake
Lu: Interest rate today & margin of safety
Low interest rate environments are historically rare. However, it is even rarer when all major countries around the world are doing the same QE / low interest rate / central bank interference. If one sees low interest rate as some sort of “discount rate”, then one may be wrong about his/her assessment of their “margin of safety”. The low interest rate environment 1) is usually temporary 2) should be seen as a warning sign, as it does not prevent the economy going further south. In this environment, one should set their margin of safety requirement to be a lot higher, not lower.
During a company’s infancy, or during a phase of transition, management is key when it comes to evaluating a company. During a time of normalcy, management hold relatively less importance in the value of a mature company. In china, most companies are still in its infancy, thus it’s more important to consider management as a part of the process of valuation.
When people start to talk about cycles, they stop being value investors. Nobody who is intellectually honest can predict cycles. When you get into the business of predicting cycles, you will find that besides longer cycles of bubbles, there are infinitely smaller cycles, down to weeks, and days. People fall into the trap of wasting more time chasing cycles than doing actual homework.