Long read: The Practice Of Value Investing

Li Lu is best known as the fund manager who the great Charlie Munger himself trusted with his investments. The 3L&3S featured the incredible backstory to Lu’s life here. This one is a translated speech that Li Lu gave to students at a Chinese business school back in 2019. This speech apparently is a follow up to another one from 2014 about ‘The Prospects of value investing in China” which talked about the theoretical aspect of value investing. This time he focuses on the practical aspects of pursuing the craft.

He begins with the difference in investing and speculating:

“If you invest in a company in a sustainably growing economy, your company’s profits and your investment return will also grow sustainably.  If you speculate on other people’s short-term trading behaviour, there can only be one result in the end:  gains and losses must equal because this is a zero-sum game.  If you add up the gains and losses of all speculators in the market, they will sum to zero.  This is the biggest difference between investing and speculating.  I’m not denying that there are some speculators whose chances of winning are higher and who can go on winning for longer; equally there are some who will always be the sucker at the table and never strike it rich.  If you give it enough time though, when you add the winners and losers together, the net result will be zero.  The reason is that speculating on short-term behaviour in the market adds nothing to the economy nor to corporate earnings growth.

….Relatively speaking, the speculative part of the market verges on being a casino.  From a social welfare point of view, we do not want this casino to be too big.  However, without it, the market would not exist.  We should therefore see speculation as a necessary evil – and a part of human nature – which cannot be removed.  We cannot deny the parts of human nature which love to gamble and speculate but we cannot let them overwhelm us.  Otherwise, society will sooner or later face the consequences.  The wounds of the 2008-2009 Global Financial Crisis from which we have just emerged are still fresh in our memories.  And once you understand the principle of a zero-sum game, you will begin to see these speculators as Mr. Market.” 

He then touches upon another Buffett concept, investing within your Circle of competence:

“…knowledge accumulates gradually but only if you maintain intellectual honesty.  This is important because it is hard for humans to be completely objective and rational.  We are emotional creatures and so are likely to be biased towards things in which we believe or in which we have self-interest.  We always predict that events will work in our favour.  But objectively, that’s not the way the world works.  Intellectual honesty is therefore vital.  When you have the right approach and are doing the right things, you will see that your knowledge accumulates in the same way the economy grows.  It’s a process of compounding.  All your past experiences will corroborate and reinforce each other so that you gradually develop a firm grasp of some topics. 

…Every value investor’s portfolio will be different and that’s OK.  You don’t need to communicate too often with other people.  You don’t need to invest in too many things.  Because you need to understand everything in which you invest, you can expect it to take a long time.  It will be the same for every stock and every company.  The circle of competence you ultimately build will be small, as will the number of companies whose future you can predict with a high degree of certainty.  If something is beyond your understanding, don’t spend time on it.  Your circle of competence will inevitably be small.  Making money doesn’t depend on how much you know; it depends on whether what you know is right or wrong.  If what you know is right, then at the least, you won’t lose money.” 

A large part of the speech is dedicated to why the most important trait for success in investing is not IQ but temperament. He goes onto highlight four aspects that drives temperament for a value investor:

“First, this person must be relatively independent.  He should judge himself by his own yardstick, and not others’.  For example, there are some people whose sense of happiness is derived from what others think of them.  If the handbag they buy isn’t admired by others, it loses any meaning.  Other people are different.  As long as they like the handbag themselves, they’ll be happy.  Independent people aren’t influenced by others.  This is an innate characteristic.  Independence is especially important for investors because they will face temptation every minute of the day.  Comparisons also create jealousy. 

Second, this person should be relatively objective and unemotional.  Of course, we are all emotional beings and so cannot completely escape our emotions.  However, some people make the search for objectivity and rationality into a value and a moral pursuit.  These people are better suited to value investing.  Investing is about objectively analysing all sorts of problems and assessing events far out into the future.  This is inherently very hard.  If we look from the perspective of a company’s income statement and not its balance sheet, then competition is the most important thing to consider.  Profitable companies will attract competitors who will try to snatch market share and profits.  It is therefore hard to forecast whether a company which is doing well today can maintain its profitability ten years from now.  Even if management can’t necessarily answer this clearly, those above the fray usually can.  It is therefore vital for you to maintain an extremely objective stance and be willing to learn continuously. 

The next attribute is relatively special.  You must be both extremely patient and extremely decisive, even though they are in contradiction.  When there are no opportunities, you might go for years without taking any action.  But as soon as an opportunity arrives, you must be able to become extremely decisive and act without hesitation.

Fourth, how could Charlie persist in this for 40 or 50 years?  It’s because he is intensely interested in business.  Warren and Charlie always talk about having money sense – that is, an intense interest in business and a natural predisposition to mulling over questions like, how does this business earn money?  Why does it earn money?  What will competition be like in the future?  Can it still make money in the future?  These people always want to get to the bottom of these questions, and their passion is their main motivation. 

These attributes aren’t especially common but when they are found together, they can make for an exceptional investor.  Some of them are innate and some can be cultivated.  For example, you can develop an interest in business over time.  However, some cannot be developed, like extreme independence, patience and decisiveness.”

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