Li Lu on the prospects for value investing in China from October 28th, 2015 t- notes on the lecture by Graham F Rhodes
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 money to someone in the industry, you must see if you have this trait or else find someone who does. Those without cannot be taught it by any means. And it really will be tragic if you give your money to someone like that. So if you want to enter the industry, you must ask yourself if you have this sense of responsibility. If you don’t, I urge you not to because you will most certainly become the wrecker of countless families. The financial crisis of 2008-09 was in large part the result of the so-called ‘success’ of people who did not understand their fiduciary duty. This kind of ‘success’ is extremely harmful to all of society.
These are the two moral bottom lines I wanted to share today with everyone thinking of entering the asset management industry.
2. As the asset management industry, we must know, from a long-term perspective, which financial assets can grow in a sustainable, effective, safe and dependable manner?
In what follows, we will answer the second question: from a long term perspective, which financial assets can really deliver for clients and investors a dependable return? We’ve just experienced a stock market crash and many people feel that cash or even gold are the most dependable assets. Do we have the means to assess the past performance of these assets? And how long is ‘long term’? I think the longer the better. And the best statistics will be the oldest, most continuous statistics. Because only with this kind of data will we have any persuasiveness. In modern society, the developed western countries are the birthplace of the modern economy and saw the earliest development of modern markets. Because they have the largest volume of market data, and the largest economies, they can shed the most light on this question. And for this reason, we will focus on America because it has good data which goes back for almost two hundred years. So in what follows, we will look at America’s performance.
Professor Jeremy Siegel of the Wharton School at the University of Pennsylvania has worked hard over the past decade to compile a set of reliable statistics showing the performance of various financial assets in America going all the way back to 1802. Today we will look to see which financial asset performed best over this time.
The first major category of asset is cash. Recent volatility in the stock market has increased many Chinese people’s awareness of the importance of cash. Perhaps many people now think that cash can best preserve its value. So let’s look at cash’s long term performance. If you had a dollar in 1802, how much would it be worth today? What could it buy? As you can see from Figure 1, the answer is five cents. Over two hundred years, cash has lost 95% of its value, of its purchasing power! We should all be able to guess the reason why: inflation. Now let’s look at the other asset classes.
For many traditional Chinese people, gold, silver and heavy metals are an excellent means of preserving wealth. Western countries held to the gold standard for many years during which time gold did hold its value. However, the 20th century saw a continuous decline in its value. Using gold as the best representative of precious metals, how much would a dollar of gold two hundred years ago be worth today? What would its purchasing power be? We can again see from Figure 1 that it would be worth 3.12 dollars today. So gold has kept its value and even appreciated 3-4 times over two hundred years, beating expectations although not really appreciating that much.
Let’s look at the performance of short-term government bills and long-term bonds. The yield on short-term government bills is a good proxy for the risk-free rate, never too high and just above the rate of inflation. Over the last two hundred years, bills have appreciated by 275 times and bonds by 1600 times, a little bit more.
And on to equities, another of the major asset classes. Many people perhaps think that stocks add risk and cannot hold their value, especially after the ups and downs seen in the stock market over the last three months. Having gone through both a bull and bear cycle in the last eight months, many people will now be much more aware of the risk of equities. So how have equities performed over the last two hundred years? If we had invested a dollar in the American stock market in 1802, how much would it be worth today?
The result is that a dollar invested in the stock market, even after allowing for inflation, would have appreciated a million times to be worth 1.03 million dollars today. Even that remainder is worth more than what other asset classes have returned. And why have equities been able to produce this perhaps surprising result? The answer is that even after the effects of inflation, equities have returned a compound average rate of 6.7%. This is the power of compound interest and the reason why Einstein could call it the eighth Wonder of the World.
These results raise an important question: why does everyone think that cash, an asset which over two hundred years has lost 95% of its value, is safer than equities, an asset which has appreciated a million times over two hundred years? And that million times is even after allowing for inflation. Why have the performance of cash and equities diverged to this degree over two hundred years? This is a question all of us professional investors must consider.
There are two causes of this phenomenon.
The first is inflation. Annual inflation in America over the last two hundred years has averaged around 1.4%. This is equivalent to saying that your purchasing power has declined by around 1.4% every year. Over two hundred years, this 1.4% has made a dollar worth just five cents, eroding 95% of its value. We can understand this very easily from a purely statistical point of view.
Another reason is growth in the economy, measured by growth in GDP. America’s GDP has increased by about 33,000 times over the last two hundred years, equivalent to an annual growth rate of a bit more than 3%. If we can understand economic growth, we can understand other phenomena. Stocks are a proxy for large companies and their sales growth is in turn a function of GDP growth. All companies incur expenses, some of which are fixed and bear no relation to sales volumes. In this way, profits can grow at a faster rate than sales. If a company can grow sales by 3-4%, its profits should increase by about 6-7%; and so the value of the cash the company generates should also increase at the same rate. Actual results seem to confirm this. The core value of a stock is the value today of future profit growth. Over the last two hundred years, stocks have been priced at an average of 15x price to earnings, the inverse of which is about 6.7%, reflecting the growth rate of the market’s earnings. In this way, equity prices have also grown at 6-7% for two hundred years, resulting in an appreciation of a million times. So statistically, we can understand how equities in aggregate will grow at this rate.
This is the initial conclusion then: inflation and GDP growth can explain the difference in performance between cash and equities.
Another important question is how was the American economy able to produce two hundred years of long term, continuous compound growth? All while there has been a persistent inflation? How did the economy grow almost every year? Of course, there were contractions in some years, and in other years, growth was stronger. But overall, the direction of the economy over the last two hundred years has been upwards. If we take the year as the unit of measure, then GDP increased almost every year in a way that was cumulative and compounding. How should we explain this phenomenon? Were the conditions unique to America? Have they existed throughout history? Obviously, in China’s three or five thousand years of recorded history, they have never appeared before. They are indeed a modern phenomenon without precedent in China until about thirty years ago. So do we have a way to estimate the pattern of GDP growth throughout human history? Is
there a phenomenon of continuous economic growth?
We need to refer to another Figure to answer this question. We must make clear what kind of changes occurred in mankind’s history after the dawn of civilisation to overall GDP, overall consumption and the level of production. If we were to increase the timespan of our study, to go back to the days of the hunter gatherers, early farming and early agriculture, how much would we find mankind’s GDP growth to be? This is a very interesting question. Fortunately, I happen to have just such a figure. It was produced by a team at Stanford University led by Professor Ian Morris and uses modern scientific methods to estimate the progress of mankind over the last ten thousand years. This only became possible thanks to advances made over the last twenty or thirty years. For the vast majority of mankind’s history, economic activity consisted of finding energy and using energy. Correlation between this and the GDP growth we are discussing is extremely high. So in the last sixteen thousand years, how have the conditions been for mankind’s economic growth?
The figure above (Figure 2) shows the results of the Stanford team’s work. The most important comparison is between Eastern and Western civilisation.
From Figure 2, we can see civilised society’s economic performance for the last ten thousand plus years. The blue line represents Western civilisation, from the earliest times in the Fertile Crescent to ancient Greece and ancient Rome, and finally to Western Europe and America. The red line represents Eastern civilisation, from its earliest times in the Indo-Gangetic plain and China’s Yellow River basin, later entering the Yangtze River basin, and finally emerging in Korea and Japan. The left hand side is from sixteen thousand years ago; the right hand side is from today. Without using any special knowledge of statistics, you can say that these two civilisations have been quite equal over history. There have been minute differences over time and you would be able to see even more minute differences if you really dived into the statistics. But overall, growth has been very similar throughout history. Yet over as much as sixteen thousand years of history, you wouldn’t say there was no economic progress but you would have to say it was minimal. There have been ups and downs, but overall it has been as though we were unable to break through a glass ceiling.
We came close three or four times but always reverted to fluctuating in a narrow range. However, once we arrive in the modern era, we can see that in the last three hundred years, radically different conditions emerged and human progress shot up. You can see this looks almost like a ‘hockey stick’; it looks like one dollar becoming a million.
If we enlarge Figure 2 and zoom in on these two or three hundred years, you can see that this segment is very similar to Figure 1. The performance of equities over the last two hundred years strongly resembles GDP growth over the same period. And if you zoom in again, you can see that the line is almost vertical. Mathematically speaking, this is the power of compounding. But the conditions allowing for compound growth have never before existed in human history; they are a purely modern phenomenon.
Original source: http://36kr.com/p/5040874.html
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