Li Lu on the prospects for value investing in China from October 28th, 2015

First, thank you to the Guanghua School of Management and thank you to Professor Jiang Guohua for establishing a course like this to focus on the principles of value investing. Launching a value investing class at this time, in my opinion, is of great significance. As I understand, this is the first and only class of its kind in China. There aren’t many similar classes around the world either. As far as I know, the class at Columbia University may be the only other – that is, the class first offered some 80 or 90 years ago by Buffett’s teacher, Benjamin Graham. Himalaya Capital is proud to support this class.

I would like to discuss four topics with you today:

First, since many of the students enrolled in this class are likely to join the financial services or asset management industries, I would like to begin by touching on the unique features of these industries, and the moral bottom line required of practitioners.

Second, as asset management professionals, we must know, from a long-term perspective, which financial assets can grow in a sustainable, effective, safe and dependable manner?

Third, are there any effective means by which through hard work you can become an outstanding investor capable of providing your clients with an honest and dependable service to protect and grow their wealth? What is the ‘true path’ in the world of investing?

Fourth, are the investment techniques proven in mature, developed countries suited to China? Or is China an exception? Can value investing be practiced in China?

I have considered these questions for several decades now and will discuss them with you today.

1. Unique aspects of the asset management industry and the moral bottom line required of practitioners

Asset management is a service industry. Compared with other service industries, what are its distinguishing features? In which aspects does it differ? I believe there are two differences.

The first is that in the overwhelming majority of cases, the consumers of this industry have no means or idea of how to judge its products. This is different from almost every other industry. For example, someone can easily tell you if a car is good or not; or if they out eat out, they can tell you immediately what the food was like and if the service was good. If you stay in a hotel or buy some clothes… in almost every case, you can evaluate a product just by using it. However, consumers of asset management products in most instances have no way of knowing if a product is good or bad, or if the service they are receiving is poor or outstanding.

Not only consumers and investors but even practitioners – including some of the industry’s top stars who have joined us today – will have a hard time evaluating an investment product
or service. This is the key difference between finance – and especially asset management – and practically every other industry. If you give me a year or two of results, I will have absolutely no way of evaluating whether they are outstanding. It would be similar even with five or ten years of results. You must look at what investments were made, and still you can probably only make a useful judgement after an equally long period of time has passed. Precisely because there is no way to properly evaluate products and services, the overwhelming majority of theories get things ass-backwards.

Another key difference is that overall compensation in this industry is higher than others, and often detached from results. In fact, the actual service provided to clients in most cases is very limited, and many products often deliver the best return to practitioners. The industry’s pricing structure fundamentally reflects the benefits of practitioners, not clients. In most industries, one hopes to lift one’s standards in a way that is obvious to clients and which will allow for some kind of premium pricing. But in asset management, irrespective of good or bad performance, everyone uses a method of calculating fees based on a percentage of net assets. So regardless of whether one makes money for one’s clients or not, one will still get paid. The worst is private equity where the percentage of net assets charged borders on the outrageous. If your client makes money, you get paid; if your client loses money, you still get paid. Even though clients can buy passive index products, as a fund manager, you can still earn a lot of money even if you underperform your index by a wide margin. This is very unreasonable.

I think everyone thinks about joining this industry is in part for the intellectual challenge and in part for the compensation. While the compensation is undoubtedly very high, it’s very hard to determine whether most managers are worth it.

Taken together, these two unique characteristics create some obvious drawbacks. For example, abilities are mixed, bad products are passed off as good ones, and many managers seem to be there just to make up the numbers. Standards in the industry are confusing. There is a flood of specious statements and fallacies which confuse consumers. Even some managers cannot see things clearly.

These characteristics pose two fundamental moral requirements on all members of the industry.

I would like to discuss this issue first today because many of the students sitting here today will become practitioners in the future. Moreover, since one of the ultimate goals of this class is to train the future leaders of China’s asset management industry, I would like before you enter the industry to keep in mind two unbreakable, bottom line moral requirements:

First, make the pursuit of knowledge and wisdom your moral responsibility. You must consciously reject any ass-backwards theories. Once you enter the profession, you will quickly realise that almost all theories are of this kind. If you don’t think about this closely, you will soon confuse your interests with the client’s. This is just human nature; no one can avoid it. Because this profession is complicated, it is full of specious points of view. Even though there are many judgements, it is not an exact science. So I really hope that any young people who are wholeheartedly trying to enter the profession can let this kind of moral bottom line take root; you must make the continuous pursuit of knowledge, truth and wisdom your moral responsibility. As an informed practitioner, don’t knowingly trot out those theories which are good for you but not your client. Don’t let yourself be confused by specious theories. This is very, very important.

The second is to firmly establish an awareness of fiduciary duty. What are fiduciary duties? You must treat every dollar of client money as though it were the fruit of your own parents’ labour, saved up piece by piece over a lifetime of diligence and thrift. Even if it’s not much, it took years of struggle and sacrifice to accumulate. If you can understand the responsibility this entails, then you can start to understand the meaning of fiduciary duty.

I think the concept of fiduciary duty is innate: people either have it or they don’t. Everyone sitting here today, whether you enter the industry in the future or entrust your

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