Li Lu often gets left out of the roll-call of value investors, but he doesn’t deserve to be. Unlike leading value investors, such as Seth Klarman and Warren Buffett, Li Lu keeps a relatively low profile.
Lu was inspired to get into banking by Buffett after hearing him speak at Columbia in 1993. Upon graduation, he worked in an investment bank until late 1997, when he founded Himalaya Capital Management, known for its disciplined and value-oriented approach to investing. Li’s returns were so impressive, and his skill so evident that Charlie Munger, Vice-Chairman of Berkshire Hathaway became an investor and a “mentor and good friend” in Li’s own words.
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The China-based investor has had such a profound impact on Buffett and Munger that in 2010, the Wall Street Journal reported that he was the front runner to manage a chunk of Berkshire Hathaway's equity portfolio when Buffett retires.
In 2010, Lu returned to the Colombia Business School to give a lecture of his own, and as you would expect, it contains some great insights into his investing process, as well as tips for other value investors to help develop their processes.
Li Lu Value Investing: Developing Value Skill
The lecture begins with a warning from Lu. He declares that "Being a value investor means you look at the downside before looking at the upside." He goes on to say "Before becoming an investor you need to look at how you can fail at this game. There are all sorts of ways you can fail.You need to examine who you are and see if you could be good at it. If you could ever find something you can do well that you really like — that will be your best investment."
This is poignant point to make about investing. Any investor with experience will tell you investing is an art, not a skill. It requires years to hone your investing skills and even then, you can still get it wrong. Looking at how you will fail, protecting your downside is crucial if you want to survive for the long-term.
As Lu goes on to say, the best way to protect against the unknowns of the market is to invest with a margin of safety:
"This concept of margin of safety is an essential concept to be a good investor. The future is unpredictable; you will always be dealt surprises, some positive most negative.You need to build in a level of safety so that whatever happens, you will not get crushed."
Investing is full of unknowns. Even if you spend years researching a company, you can still be caught off guard. The game of investment, Li notes, is "continuous learning." To be able to beat the rest of the market, you need to "find a certain set up where you can know something that most people don’t know." This is something Howard Marks calls 'second level thinking':
"You have to think of something they haven't thought of, see things they miss or bring insight they don't possess. You have to react differently and behave differently."
"“The bottom line is that first-level thinkers see what’s on the surface, react to it simplistically, and buying or sell on the basis of their reactions. They don’t understand their setting as a marketplace where asset prices reflect and depend on the expectations of the participants. They ignore the part that others play in how prices change. And they fail to understand the implications of all of this for the route to success.”
Li's version of 'second level thinking' is to research each opportunity thoroughly but understand as well that there's always going to be something that he doesn't know. Investing with a wide margin of safety helps mitigate and potential impact from getting caught out by something he does not know, while rigorously researching each opportunity gives him the courage to "ignore the opinions of everyone else" and back up the truck.
"Finding an edge really only comes from a right frame of mind and years of continuous study. But when you find those insights along the road of study, you need to have the guts and courage to back up the truck and ignore the opinions of everyone else. To be a better investor, you have to stand on your own.You just can’t copy other people’s insights. Sooner or later, the position turns against you. If you don’t have any insights into the business when it goes from $100 to $50 you aren’t going to know if it will back to $100 or $200."