The game of investing is a process of discovering: who you are, what you’re interested in, what you’re good at, what you love to do, then magnifying that until you gain a sizable edge over all the other people.When I first encountered him many years ago, I didn't know how good of an investor Li Lu was. Now, it seems like he is one of the top ones. I don't consider him a superinvestor (yet) but that's partly because his record and his stockpicking is unclear to me. In any case, Charlie Munger is a big fan of him so Li Lu is definitely in the top 25% of the investing world.
-- Li Lu, Graham & Doddsville newsletter, Spring 2013
I ran across a very good interview with him in the Spring 2013 Graham & Doddsville newsletter (Columbia Business School). Some of you may have seen it already but it was the first time I read it--I was away from investing the last few years around the time of this report--and it is an excellent interview. If you haven't read it before, I highly recommend it. Even if you don't care for Li Lu or his investing style, the content is very insightful.
The good thing about Li Lu is that he is very open and tries to explain his thoughts so newbies and amateur investors can learn a lot. In contrast, there are many other successful investors who don't really say anything insightful and I hardly learn anything from them. In fact, I think this interview might be one of the best investment pieces I have read in my investing career. It covers so many important topics and Li Lu's thoughts are worth pondering. For future historical purposes, I thought I would extract the key points and post briefly about them. I recommend that you read the full interview though.
(as is usually the cast on my blog, anything in bold is by me and my comments within quotes are in square brackets)
G&D (interviewer): You don’t short stocks at Himalaya, correct?I don't short so I don't have much to say. The only time I ever did was through an inverse ETF about 10 years ago--it was more like a bet against a market--and I said that I would never do that ever again. I actually made a positive return and it contributed to better performance during the stock market sell-off in 2008 but it was an unpleasant experience. The problem for me was that I had no idea what was going on (regardless of whether it went up or down) or what the end result was. It is completely unlike a long position where you have some idea of why a position is rising or falling. The market rises in the long run so you are really fighting against time.
LL (Li Lu): That’s right; not any more. That change occurred nine years ago. Shorting was one of the worst mistakes I’ve made.
G&D: Is your lack of a short book due to your desire to be a constructive third-party for companies and their management teams?
LL: Yes. But also, you can be 100% right, and you could still bankrupt yourself. That aspect of shorting just frustrated me too much! [laughs] Three things about shorting make it a miserable business. On the long side, you have 100% downside but unlimited upside. On the short side, you have 100% upside and unlimited downside. I do not like that math. Second, the best short has some element of fraud. However, a fraud can be perpetrated for a long time. Of course you borrow to short, so they could really just wear you down. That’s why I could be 100% right and bankrupt at the same time. But, you know what, you go bankrupt first! Lastly, it screws up your mind. Shorts just grab your mind and take away from the concentrated effort that is required to do proper long investing. ... economy overall has been really growing at a compounding rate for 200-300 years, ever since the modern science technology era. So, naturally, the economic trend favors long positions rather than short.
As Li Lu also points out, short selling sort of messes up your mind and is totally distracting. If you are betting against anything--in my case I was betting against the market so it was even worse--it just clouds your long positions and any positive thoughts you may have. For instance, it's easy to second-guess any bullish thought if you also have any sort of short position.
Finally, short selling is very expensive for small investors (whether you are borrowing shares, using inverse ETFs, or buying/writing put/call options). I never actually short sold directly because whenever I inquired, the costs seemed really high. It seemed like it wasn't for small investors. It sort of reminded me of bonds, where I'm quoted really high costs (bid-ask spread for instance) and feel that bonds aren't cost-effective for small investors.
Sourcing Investment Ideas
G&D: Can you talk about your investment process?
LL: Ideas come to me from all sources, principally from reading and talking. I don’t discriminate how they come, as long as they are good ideas. You can recognize good ideas by reading a great deal and also by studying a lot of companies and constantly learning from intelligent people...
G&D: Are the people that you talk to fellow investors or are they people like customers, suppliers, and management?One interesting thing is that Li Lu says he doesn't rely on investors for ideas. Instead, he gets ideas from management, media, etc. This is sort of opposite of many others I have read who ignore management and instead rely on other investors. I think this depends on your investment style and your personality and thought processes.
LL: All of them. I don’t talk to as many investors – very few. I am more interested in talking to people who are actually running businesses and entrepreneurs or CEOs or just good businessmen. I read all of the major newspaper publications and annual reports of the leading companies. I get a lot of ideas out of those too.
Always Need to Beat Opportunity Cost
I really like how Li Lu thinks about portfolio management:
You start out by holding cash, and that is a pretty good opportunity cost, because it doesn’t go down. So any time you find an investment, it has to be an improvement on an overall risk-adjusted basis. You may find some very interesting things, and now you’ve got a basket of a few interesting securities plus cash. That is a pretty good opportunity cost, and the next time you add another security, it better make the portfolio better than the existing one. You just constantly improve your opportunity cost.Sounds obvious but I have a feeling many don't think about this much. I see a lot of people just adding money to whatever position or selling something because it has gone up, and then seemingly pursuing even worse ideas. I think people often go off on tangents and weaken their portfolio.
For small investors, it's probably better to follow some rigid approach that forces you to think about whether you are actually improving your opportunity cost. I like some of the things Geoff Gannon has said, such as limiting yourself to five stocks at a time or one new stock purchase per year (this is along the same line as Warren Buffett's thinking that small investors should limit themselves to 20 picks--punches in a punchcard--over their life). Even if you don't follow that perfectly, some approach like that will definitely force you to think about whether you are indeed improving your overall portfolio.
Change & High Technology Companies
G&D: How to you get comfortable with the risk/ reward of a high tech company like BYD that is undergoing pretty rapid technological change? Do you think you have a good sense of what BYD will look like 10 years from now?Many value investors mistakenly think that it is high-tech (or similar) companies that change rapidly but as Li Lu alludes to, almost every industry can change. In fact, right now, I think the retail industry is going through even faster change than most technology companies. There is probably more innovation and disruption at Macy's and Ralph Lauren and Under Armour than at Oracle, Alphabet or Intel.
LL: Most businesses are subject to change if you stay with them long enough. There’s not a single business that I know of that will never change. ... Every company in today’s age is a technology company somehow, but the technology may not be on the cutting edge, and may not play an important role in the success or failure of the overall business. ... So culture really plays an important role in those faster-changing environments, enabling certain companies to always surge ahead of everybody else.
One thing I learned from Bill Miller is that some technology companies actually don't change much, even if they appear to. The products might change but their market share doesn't. In other words, just because some company introduces a new product every year doesn't mean the company is changing rapidly. A company like Intel might introduce a new microprocessor every few years but it isn't really changing much and the relationship with customers isn't really changing.
When to Sell
G&D: How do you make your sell decisions?Li Lu goes over three reasons one should sell:
LL: One should make sell decisions on one of three occasions.
Number one, if you make a mistake, sell as fast as you can, even if it’s a correct mistake...Let’s say you go into a situation with 90% confidence that things will work out one way and a 10% chance they work out another way, and that 10% event happens. You sell it. Then there’s a mistake that your analysis is completely wrong. You thought it was 99% one way but it was actually 99% the other way. When you realize that, sell as fast as you can. Hopefully at not too much of a loss, but even if it is a loss it doesn’t matter – you have to sell it.Easy to say but many people, including me, hang on to mistakes way too long. I haven't done it but one thing I plan to do, based on advice from others, is to write down why I would sell (the negative scenario) and do it if that scenario develops. Easier to think about it when you buy the stock than trying to do it when the adverse scenario is unfolding.
The second time you want to sell is when the valuation swings way too much to the other end of the extreme. I don’t sell a security because it’s a little overvalued, but if it is way overboard on the other side into euphoria, then I will sell it.Warren Buffett obviously doesn't sell even if the valuation is extremely high (likely to preserve his reputation and relationships e.g. Coca-Cola in late 1990's) but most other investors should.
The third occasion when to sell is when you find something that is better. Essentially, a portfolio as I said is opportunity cost. Your job as a portfolio manager is to constantly improve on your basket. You start with a high bar. You want to increase the bar higher and higher.
Li Lu's Intellectual Honesty
The most important thing in our business is intellectual honesty. What I mean is four different things: know what you know, know what you don’t know, know what you don’t have to know, and realize that there is always a possibility that “you don’t know that you don’t know.” Those four things are distinctly different. In a crisis, things emerge that test you on all four categories.
That’s why people freeze in the midst of a crisis. People freeze because they were not intellectually honest before. They never quite distinguished certain issues or questions and put them into the appropriate basket.
Christopher Davis’s grandfather used to say that you make the most money out of a bear market financial panic – you just don’t know it at the time.Probably the hardest thing for newbie investors like me is to understand what I know and what I don't know. This is probably the hardest thing to develop and probably takes time and experience.
Macro Thoughts or Lack Thereof
G&D: How do you view the overall attractiveness of equities today?You could tell Li Lu is a pure value investor: he doesn't really care about the macro situation or where market valuation is at. The advantage of ignoring macro stuff is that you don't get confused by macro thoughts and don't waste time sifting through macro data/arguments/etc. The downside is that you are vulnerable to macro-driven "storms," such as when many value investors suffered huge losses on real estate and financials in the financial crisis (many macro investors were bearish on housing due to price run-up in mid-2000s but value investors piled into financials/homebuilders/etc because they were very cheap), or how numerous value investors were exposed badly to oil&gas a few years ago but many macro-oriented investors were very concerned.
LL: I also put that into "too hard" and "I know I don’t have to know." ...
G&D: A lot of smart people believe that renewable energy is the next big revolution. You’ve done a lot of work on battery technology and BYD, so is that something that you think about beyond batteries? What do you think the energy revolution will look like?
LL: I pay attention to those macro trends only in the hope that I can have comfort that they’re a tailwind as opposed to a headwind. Now, how much they can help if they’re a tailwind, or how much they can hurt if they’re in my face, I don’t know. But I want such macro trends to be behind me rather than in front of me. So that’s the extent that I want to know mega trends.
I don't think being macro-oriented is necessarily better. One just needs to figure out what they are good and try to get good at it. Macro is definitely distracting and confuses you more.
Advice for upcoming investors:
LL: Understand one business and what really makes it tick: how it makes money, how it organizes its finances, how management makes its decisions, how it compares to the competition, how it adjusts to the environment, how it invests extra cash, and how it finances the business.The way I categorize what Li Lu is saying is sort of like the following:
- how it makes money [business model, business analysis]
- how it organizes its finances [structure of the corporation, financial analysis]
- how management makes its decisions [corporate culture, management incentives]
- how it compares to the competition [competitive landscape, moat]
- how it adjusts to the environment [employee capabilities, culture]
- how it invests extra cash [capital allocation, ownership]
- how it finances the business [capital structure]
These are all important things one should keep in mind! If I get some time, I might write a post on this alone. I think I'm going to incorporate this into all my future investment evaluations. I should use this as a broad checklist going forward.