Li Lu on The Prospect of Value Investing In China Summary

Li Lu on The Prospect of Value Investing In China Summary

I share my key takeaways of Li Lu’s 2015 lecture about whether value investing can be realized in China. Running the Himalaya Capital fund, Li Lu is known as the Warren Buffett of China.

In Li Lu’s October 2015 lecture at Peking University’s School of Management, he focuses on 4 main topics:

  1. Basic characteristics and fundamental ethics of the financial service and asset management profession.
  2. We need to know which financial assets can achieve sustained, effective, safe, and reliable growth in wealth.
  3. The preparation to provide value-added services to clients to grow their wealth is the right way and main path for investment.
  4. Investment theories that may or may not apply to China’s trajectory.

Topic 1: Fundamental Ethical Principles in the profession of investment management.

Most consumers don’t have a way of judging whether services in asset management are superior or not, unlike in many other industries where people can experience the quality of a car, restaurant, or hotel.

Since people can’t distinguish good products and services from bad ones, most investment theories are subject to the axiom “where you sit determines how you think and what you say.”

It’s very difficult to discern if someone is a good investor, even with a 5 or 10 year track record.

While the overall average compensation is higher in the asset management industry than others, it’s not necessarily tied to outcomes in client wealth. It’s often structured that you get paid regardless of whether you make or lose money for the client.

Li Lu questions whether professionals in this industry deserve the high compensation as it is one that lacks clear standards and is filled with half-truths and fallacies that many professionals fall prey to.

Many people will substitute their own interests for what is best for the client, and he says you should treat every penny entrusted to you as though it were the money your parents worked hard to save over their lifetime.

Fiduciary duty is either part of someone’s DNA or isn’t, and if someone doesn’t have it they will destroy others’ wealth.

“First, make it your ethical obligation to seek truth and wisdom, and consciously refrain from allowing where you sit to determine how you think. Second, develop a sense of fiduciary duty.”

He repeatedly emphasizes this again later in the talk.

Topic 2: What financial assets can produce sustained, effective, safe and reliable growth in value?

Since the Western economy matured the earliest and is the largest and has the most market data available over the last 200 years, Li Lu looked at data from 1801 through 2014 to understand the performance of various asset classes.

Professor Siegel of Wharton found that US stocks returned 6.7% in real terms to a real US GDP growth rate of 3.6%.

It’s no surprise that the US dollar lost 95% of its purchasing power over 200 years because of 2 main reasons of inflation and GDP growth. Returns for bonds and gold has also significantly trailed the returns of stocks.

Li Lu said many people tend to think of stocks as a riskier investment than other assets and therefore are less likely to retain their value. But after discounting for 1.4% annual inflation, in reality $1 of stocks in 1802 became $1.03 million in contrast with a $1 back then being now worth 5 cents or a nickel.

The power of compounding is still an 8th wonder of the world as Einstein put it.

Since stocks represent the large scale companies in an economy, the GDP growth is somewhat measured by the growth in revenue of these companies. Revenue tends to grow faster than costs, and then net profit will grow faster than revenue growth.

So Li Lu says when revenues’ nominal growth rates are 4-5%, net profit and cashflows will grow at roughly 6-7%.

Over the last 200 years, the average PE ratio was 15, and if we reverse the ratio we get 1/15 or 6.7%, which makes sense to get the earnings per share rate or cash return per share as Lu put it.

At the aggregate level, it should make sense then that if the GDP grows sustainably at 3-4%, then the stock market will grow at 6-7%.

Li Lu discusses the historical evolution of civilization over the last 16,000 years where basic economic activities revolve around the capture and expenditure of energy, and this measure of energy is closely correlated with the concept of GDP. He splits up human civilization into 3 eras and calls them Civilization 1.0 of Hunter Gatherers, 2.0 Agricultural, and 3.0 Modernization of science and technology.

Investing and the growth of wealth was enabled by sustained, cumulative GDP growth where a free market economy together with science and technology emerged and was allowed to thrive since about the 1750s.

He cites Adam Smith and David Ricardo in saying that the division of labor of 2 individuals or economies allowed them to engage in free trade and create more value than if they tried to on their own, thereby leading to an effect of 1+1>2.

Modern science and tech has acted as an accelerant to expedite the value creation process as ideas, rather than only commodities and services, began to be exchanged.

I like how Li Lu said that knowledge yields greater value in the free marketplace of ideas, and created what he terms as a 1+1>4 outcome.

Exchanging knowledge doesn’t require trade-offs as a barter system does because each party retains their own ideas while gaining new ones.

When knowledge is combined it generates synergistic and compounding growth, which can result in a burst of growth where society rapidly creates enormous wealth.

Thus the modern free market economy is born as exchanges between entities continue and this economic system unleashes human potential.

This allows for sustained economic development to happen, which is manifested in sustained GDP growth.

Li Lu explains how inflation is a currency phenomenon because it is a situation where the money supply is greater than the aggregate total output of an economy, so prices go up.

In order to grow the economy, the money supply has to increase to fund investment, which eventually leads to the output of finished goods and services. But the time lag between when investment is made and when GDP grows is inflation, and explains why cash loses purchasing power while investments in stocks tend to gain over the long run.

Topic 3: What is the right way and main path for investing? How does one become a great investor?

If Li Lu’s observations hold true, then it would be better for individuals to invest in stocks rather than holding cash but there’s the issue of volatility in the stock market. If someone needs money in the short term, they could lose money because of fluctuations in stock prices. It can take a long time to achieve the desired rate of stock market return.

He breaks down various time periods over the last 200 years and identified the real rates of return for US stocks, with the average rate of return being around 6.6%.

There were stretches of anywhere between 10-20 years where average rates of return fluctuated between 0% to 13.6% after 1946 but in the 66 years to 2012 held relatively true at 6.4%, close to the long term trend.

“Most investors have about a dozen, or 20 years at the most, to invest,” which I found interesting because this kind of assumes that people are really only beginning to invest in their 40s if they expect to retire in their 60s.

He said as an investor we only need to invest in a stock index if we want to have the long term 6.6% average performance.

But we should be aware that even over 10 years, our returns could be continuously negative, but in other time periods we could look like a genius without lifting a finger.

However, “If you cannot discern how you achieve your return, you will not be able to determine if it good fortune or your own ability,” which is a well-made point.

He asks the question that some of us are thinking, which is there a better way to invest than in an index fund?

“Is there an investment which outperforms the stock index, and provides more reliable protection for client wealth at different time intervals, as well as during years in which we need money?”

“Is there a means of investment which will allow clients’ assets to ride the wave of compounding economic growth for long-term, reliable, and outstanding returns? Do we have such an investment strategy, outside of shortcuts and devious measures, which is replicable and teachable, and will continuously provide such returns in the long run?”

He doesn’t just immediately say “yes” but says there are a variety of theories and practices, but then says there is one philosophy and strategy “that can bring reliable, safe and outstanding returns to their clients over a long period of time: value investing.”

He said he found that “very few can sustain an outstanding performance record over the long haul, and those who can are almost all value investors”

“Contemporarily, we have Warren Buffett, with a track record of 57 years. There are others with 20 to 30 years of successful records. They all have one thing in common: value investing.”

Li mentions how he happened to be at Buffett’s first Columbia University lecture and wanted to understand what value investing was all about. The mentor of Buffett was Ben Graham who taught at Columbia and between the two of them there are 4 ideas the students must remember.

  1. Think of stock as fractional ownership in the company and not just a tradable security because the company grows as GDP grows. As shareholders, we’re supporting this growth. He says this is a sustainable way to invest and is “the right way and main path for investing. Unfortunately, few people understand stocks this way.”
  2. Mr. Market exists as a service provider to offer tradable securities that can be bought and sold freely, so value investors should see the market as existing to serve them in offering opportunities to acquire ownership in companies. But Mr. Market cannot tell you what the true value of a stock is, it can only tell you the current price. We should treat the market as a tool at our disposal and not as a teacher unlike what some people believe.
  3. Margin of Safety. While the nature of investing is to predict the future, predictions cannot be 100% accurate so we need to leave a margin for error in our judgment. We should make sure our purchase price is much lower than the intrinsic value of the company. “Since stock is fractional ownership in the company, as the company is valuable and has intrinsic value, so does its stock.” So even if our predictions are wrong, we won’t lose as much money, but if we’re right we will be rewarded much more handsomely than others who paid full retail price.
  4. Circle of Competence. Adding to the above 3 Graham concept, Buffett contributed that we should build this circle to give us insights and understanding of industries and companies. The most important idea is to know the boundaries of our circle. If we have an argument for why we should invest in a company, we should also have an argument that disproves the investment case. Mr. Market will expose human weakness in the fallacies of our logic and our lack of understanding. Mr. Market will then destroy us and we will be laid bare in the market if our circle has no boundary.

If we invest outside of our circle of competence, the real risk is that we permanently lose capital, which has nothing to do with the conventional idea of risk being the ups and downs of stock prices aka volatility.

So if we buy companies within our circle of competence, we can buy companies at low prices and hold them for the long-term, achieving reliable returns through the organic growth of companies’ intrinsic value. Eventually the stock price regresses to the company’s intrinsic value if we’ve done this correctly.

In this idea of the “right way and main path of investing,” I like how Li Lu said “If what you get is what you deserved in others’ eyes, your way is sustainable.”

Value investing allows us to “partake in value created through the continuous growth of the company” while respecting the fact that the future is full of uncertainties and we diversify risk by building in a MOS.

Li Lu says “This will allow your portfolio to continuously and steadily provide higher and safer returns than market index in the long run.”

He says there’s little traffic on this main path of investing because many “investors take shortcuts because the right and main path takes too long” even though “in theory, value investing is a sure way to reach your goal successfully.”

Li Lu says one basic requirement for professionals is to be completely intellectually honest because “from where you sit” you can tell people all kinds of lies until you believe them yourself.

Those who willing to take this open but long path not only have the opportunity to succeed, but when they reach their destination would be regarded as true and well-deserved.

He regards the two cardinal moral principles as setting higher ethical standards through always seeking truth and wisdom and having a sense of fiduciary duty.

Topic 4: Can value investing become a reality in China as we look out 30 to 50 years?

He said many say that “China is special” because of differences between how things are done in China compared to the West. Though China took many paths over the last 200 years, in 1949 it became a centralized planned economy with nationalized properties for 30 years. China embraced “Civilization 3.0 as the free market economy + modern technology” at the end of the 1970s or beginning of the 1980s and opened up to the global economy.

The economic outcomes for the Chinese economy have been almost identical to other nations that chose Civilization 3.0, Li Lu asserts.

From 1991 through 2014, Li Lu shares charts of US and China stock market returns, with the Chinese indices returns around 10-11% to the US’s 7% while the Chinese currency Renminbi has significantly declined in purchasing power in a similar way to the USD.

China’s higher GDP growth explains both higher stock values and inflation.

Since the early 1990s, the government of China has achieved annualized returns of 12% because of its lion’s share of the investments in Chinese stocks from the establishment of stock exchanges. These state-owned shares had returns of 1,000 times.

Being that China had already been a very powerful and stable nation in the past 2,000 years, “it was not the culture, or economic system, which was transformed in China, but its civilization” embracing a free market economy and modern sci-tech in its human nature as Lu puts it. “There has been no significant change in her political system or culture.”

Before answering the central question, Lu states we need to examine what the essence and iron law of Civilization 3.0 are, which is that a global system will eventually emerge in the essence or nature of modernization.

“Iron law of modernization. It states that when there are two competing market systems, with the interaction of two forces of 1+1 >2 and 1+1>4; the one with greater trade volume will see greater growth. When one system has greater volume, it will have greater velocity in its growth, and eventually create a single system.” This phenomenon of the global market started coming about in the 1990s for the first time in history.

This unified and global market possesses economies of scale where the more there are participants, the more value is created and wherein modern science and tech will continue to produce more products at falling costs to meet human demand and promote sustainable economic growth.

Lu believes that “China is at interim stage between Civilization 2.0 and Civilization 3.0,” or at 2.5.

He said “If you have a good understanding of China’s culture, people and history, you will agree that China will forge forward.” And that “There is almost no chance of China leaving the common market, and the probability of China changing its market rules is also very small.”

He says there’s a high probability that China will remain on the course of Civilization 3.0, which “has little to do with political and cultural factors, and a lot to do with science & technology, as well as the free market.”

The returns on the main classes of assets will then continue to track the trends of mature markets over the past 300 years and stocks will continue to outperform other assets.

“Value investing will provide sustained, stable, safer, and more reliable returns for her investors. This is why I believe value investing can be realized in China.”

Li Lu goes on to say that “value investors have more advantages, despite the fact that the market is still immature. 70% of the players in the Chinese capital market are retail investors focusing on short trades, even institutional investors. Prices are detached from intrinsic value, thus creating very unique investment opportunities.” If we can avoid being lured by short-term gains and we can hold onto long-term investments, we will have fewer competitors and a higher probability of success.

I also find it really telling how “China is at the midst of an economic transition. Financial reform will allow financial markets to play a greater role in financing rather than relying on indirect bank lending.”

“Given this new landscape, the scale of development, institutionalization and maturity of the financial market will be greatly improved in the near future. Many with short-term vision may complain that the government has been too heavy-handed in market intervention, or that it should not bail the market out, in addition to other criticisms. However, with longer-term vision, we find the Chinese capital market is continuing to move towards a more market-oriented, institutionalized, and mature system. It will play a more important role in China’s economic development. Genuine value investors should play an increasingly important role as well.”

Given that the government of China has such a large investment stake, you would think that it has a vested interest to continue getting foreign investment in Chinese companies rather than turning it away in this global market place.

He told the students he believes they are in the right place at the right time as value investors. “First is to understand and live up to your fiduciary duty. Second, consider it your moral duty to acquire knowledge and seek wisdom.”

Li Lu ends the talk with “If you stay the course for 15 years, you will become stellar investors.”

If you’re interested in learning how to take control of your finances and start becoming an investor like Warren Buffett, check out my free PDF guide.

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