Bruce greenwald value investing lecture 18

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Shareholders are welcome to go along for the ride but may never see a catalyst. And then that leads me to look for good businesses in Asia, and eventually for businesses with an enduring competitive advantage with a long growth trajectory ahead of it. Now, I have been very fortunate to be influenced at the very beginning by the investment giant Buffett and Munger and later on I was really, really lucky.

He has been a mentor, an investor, a business partner and a great friend all these years. And for many, many years we have dinner every Tuesday night. That lasted for years until just around a pandemic. And we talk a lot more. So obviously, I had a great deal of influence by him. But I have to say that the greatest influence from Charlie was really beyond just investment.

It was more of a role model in the way he conducted himself in real life. Now I think for every profession, for everybody, it is wonderful to have role models in life. And it is always a risk of disappointing. But in my case, I got really, really lucky in the sense that my role model never failed and instead continued to inspire me, right into his 97th year, basically. That is extraordinarily hard, and it is a bit against our natural tendencies. And I have been very, very lucky in that regard.

Bruce Greenwald: Ok, so, in this concentration, in sort of now investing in great businesses, can you be specific about what kind of business you look for? What are the characteristics of a great business in particular, what detailed characteristics you look for and how you put a value on those businesses?

Li Lu: Yeah, well, great businesses are the ones who really have above average returns on invested capital. But that kind of a business traditionally attract imitators, competitors, everybody wants to have above average returns on reinvested capital. And so truly good businesses are the ones who can fend off competitors, who can really have an enduring competitive advantage and have that higher than average return on invested capital and hopefully also have a long run-rate of continuous growth.

And they could really come in all industries, in all shapes and forms. But over the longest period of time, if you do own them through the ups and downs, your return roughly approximates basically the actual business return to actual capital invested in the business itself over the long term. The two tend to really converge pretty closely.

And so understanding and studying the nature of that business, the dynamic of the competition is of really the most important thing as the investor, and as a student of the business. And if they prove to be exactly as you predicted over the years, we really want to stay on them through the up and down, thick and thin, not to be really dissuaded easily. If you think about a moat, there are probably only two elements to that moat.

So think of it from the point of view of a company trying to get into the business. One is economies of scale. How big do you have to get? How big a market share do you have to capture in order to be viable as a competitor? So the first thing is economies of scale. Which is all about customer captivity in a contested environment where unique technology will help you with that and so on.

Do you look at those two elements explicitly? Li Lu: Well, that and more. Bruce Greenwald: Ok. Li Lu: Scale is important in there, actually, there is a scale economies in those businesses, not everything actually has a scale.

Sometimes that scale becomes a counterpoint, they could actually be more difficult to really manage. But in a scale economy, scale does really become a competitive advantage. Things do change. New product categories would come along, and brands get tired and old, and not refreshed.

All great business changes over time. But some of the businesses can really keep it for a very, very long time. Take example with Berkshire. It started out as a lousy business, losing business of textile in New England. But over time, some of those businesses began to lose its competitive advantage and then they took that capital and allocated to the ones that…so obviously the management capability of allocating capital also plays a very important role.

So in every specific businesses, what really make them successful are very, very different and they change over time. And so that is the most fascinating aspect of the competitive dynamics and those are the most fascinating aspect of being an investor as well.

Bruce Greenwald: As of today, how do you view this differently, would you say from most other investors? Are there things that you look at specifically? Are there ways that you approach companies? So in what other ways do you do things differently from most other value investors and investors?

You invested with me or you begin to invest in me. So thank you for your continued trust and confidence. No, back then we were looking for smaller businesses because those are the businesses I feel I can understand them. And as we evolve, we began to look for big businesses that we can also understand. That bigger business does come with a whole set of advantages, that if they are right in a sense, they also come in with a whole bunch of problems.

There are big businesses that because of a certain dynamic, are still growing at a robust pace that are becoming even more entrenched as they become bigger. And they still have long runs of growth. So that just exist. You know, the most recent phenomenon of the technology platform, because of the network effect, some of the business are fitting that characteristics.

And so just the size itself is certainly not the most determining factor. Bruce Greenwald: But then what other dimensions do you do things differently today than other investors who are less successful? We spend most of our time studying industries, study specific companies. Try to answer what really make them successful. Can that success be continued? We just continue to really study them and continue at it, until we have an answer.

In other words, if we claim a circle of confidence, we have to understand the edge of the competence. You have to know what falls in and what falls out. You have to be very honest with yourself. At least I want to know, at worst case scenario, what the business would look like 10 years from now.

And so we do have a long-term horizon in terms. Sometimes we study for years and years before we see, ok, we really get it. And so that makes our selection very, very difficult. And so when we do select them, we tend to own them for a very, very long time because the businesses that are really good and we really fully understand are very rare. Inaudible So anything that we would buy a lot more as they go down.

Bruce Greenwald: Ok, so what about the market today? I mean, it seems highly valued. I mean, if you look at fixed income, it seems unprecedented. That said, does the market today remind you of any historical periods you lived through in good ways or bad? And this happens to be one of the more extreme periods of time. It is truly, in many ways, somewhere in unchartered territory.

All of those are quite really remarkable in this period of time. So how do you really deal with them. And so every time is slightly different. Instead of guessing the patterns of history and whether they would repeat, we focus on selecting companies that can really live through the thick and thin, whatever the environment, business will continue. Somebody will do well. So we just want to really be invested in those companies who are capable of dealing with those extraordinary set of uncertainties.

Inaudible Bruce Greenwald: And how much is management a part of that. And how do you look for managements that have that capability? Li Lu: Well, in a lot of the companies, the management will make a big difference. The culture of the management will make a big difference. But in a small set of experiences, management really matters almost nothing. The strength of the business itself really has a dynamic of its own that really almost anybody can run it and run it well, relatively.

Now, those businesses are really rare, not that many. You can probably put them in one hand or two hands. And so…again, I come back to the situation, each time is different. You have to really look for each specific company in specific ways and ask all kinds of probing questions and study them over a long period of time in order to really honestly say that you actually understand them.

Understand them enough that you could predict the outcome in 10 years, even given all the up and downs in the macro environment. Are there specific things you learn about managements or companies that you look for in those crises? Li Lu: Yeah, well, so as you said, in my 24 years of managing Himalaya Capital, we have gone through several of those big crises.

Each time when that happens, it was billed as once in a century crisis. It probably was, except it happens on the time frame of every 5 to 10 years. So a financial market boom and bust has been a constant phenomenon since the beginning of the financial market several hundred years ago. And it was driven by human nature, as long human nature remains that way, it will never change. It will always be with us. As a product of evolution, we humans are basically run not necessarily in a very rational way.

Particularly when it comes to money, humans are very funny. They tend to evoke a primal part of human nature. And so particularly as it relates to financial markets, a security market, money, that that human tendency of the extreme instincts become more amplified and more extreme. And how do you deal with such an environment that will be constant? People will always be driven by fear, by euphoria, by this extreme kind of ups and downs. In a sense, have a certain characteristic of antifragile and so that up and down becomes somewhat friendly for us.

In the sense that when our favorite company is on sale discounted by 50, 60, 70 percent, if we have money, will buy more of it. And so to succeed in this game requires a certain temperament and a certain understanding of human nature. Also a certain commonsensical approach. Knowing that your investment return eventually will mirror the actual business return by actual business.

It took years for them to either go up or down. And so you should expect your investment result that come in slowly, gradually over a long period of time. So the short-term phenomena should not really impact you as much, either on the up or on the down. Market that is there to serve you, not instruct you.

Except in the real game of investment, those phenomena, those on the up and down tend to be quite extreme and testing. And so the other thing that will be very testing is that we really do need to understand the business itself. I sometimes almost feel that they exist to really catch human weakness. Bruce Greenwald: Can I actually talk a little bit about a specific example there and maybe get you to talk about an example?

Because one of the things that you talked about was the stability of these companies and their managements in the face of a crisis. So a crisis tells you a lot. And the one company that obviously recently has done extremely well and you could see it is John Deere. Bruce Greenwald: But could you share maybe a historical experience of that so that the students in the audience might have a sense of what to look for in looking for this stability?

Once you achieve a certain notoriety in a certain field that people tend to really copy that. Instead of giving people fish, it is much better to really teach people how to fish. Bruce Greenwald: Ok, so let me do one last question. Do you prefer to be a generalist or a specialist investor and would one work better in the Chinese market than another? But by the time you really get into the companies you really decided to invest, you really better become a true specialist.

And to the point of really know, hopefully better than anybody in the world you can find, including the top management team. And the top management team, because they manage the company, they tend to be deeply personally vested in their own biases and may not be able to look at the business as objectively, rationally as you do. So you want to be a true specialist in the company you chose to really invest.

You want to be a generalist always of business in general, so that your core competence, your circle of competence is constantly evolving and enlarging over time. If I still really know what I knew when I started my first took your class or when you first invested with me, we would not have…anywhere near the results that we both enjoyed, so luckily we continue to expand and we continue to learn.

But on the other hand, it is fascinating to see that how business evolved over the last few decades will continue to evolve in the next few decades. And that really makes me feel that boy I am lucky to choose this field that I get paid to really satisfy my curiosity and to learn all those great people and great enterprises serving society. So I feel happy every day doing what I do. Li Lu: Inaudible turned out exactly as we predicted, Asia indeed became a lot more important, in particularly China in it, has becomes even more important.

As I look at in the next few decades, I would say that the Chinese market, and Asia in general, will become even more important. The set of dynamics that are already set in place, will continue to play out in a robust way, so the Chinese security market in general and Asia economy, that will become increasingly a very, very important, evermore important component of the global market. I mean, the Chinese numbers are obviously very difficult to interpret, at least the official numbers. Over the last 8 to 10 years, China trade has grown by only about 2.

What does that say about Chinese growth? Li Lu: It tells you about the characteristics of the Chinese economy has changed fundamentally. You know, up until 10 years ago, what really propels the Chinese growth…was international trade to a certain extent.

And the other thing that is happening is after the citizens become middle classes, their demand changes from basically just work, saving, into really work and saving and consumption. So roughly around 10 years ago, as you point out, the Chinese economy has slowly evolved into more of a consumer driven economy to the point that interestingly, last year was a watershed year in a sense that the retail sales, the total volume of retail sales for the first time overtaking the United States.

But basically the trend is there. China is emerging to become the most dynamic, fastest growing consumer market in the whole world, and that is likely to continue for many, many more decades to come. And so that really makes China even more attractive to the global economy in terms of people who want to sell to the consumers, to the middle class in China. And the characteristic of the economy would change and would also really provide unique and interesting opportunities for global investors.

Bruce Greenwald: Let me just talk a little bit about that. And as I say, the export data, you could understand that would slowdown, but the fact that the import data has slowed down just as much or more tells you something about the nature of domestic growth in China. What about the challenges in the service sector in China? But if you look at the underlying dynamics of the various different businesses, different performance, both consumption, retailers and the services are basically the ones that are growing the fastest.

And overall, trade internationally is still growing at a robust rate, but not nearly as much as the domestic side of the economy. So domestic consumption becomes far more important, both goods and the services, as you point out. So that just tells you that a different stage of the economy where it is today. Bruce Greenwald: So where do you see the unique challenges and opportunities in sort of finding value investment opportunities in China?

Li Lu: Well, China remains, I think, one of the best market, if you were a value investor. In a sense, the market is still somewhat underdeveloped. The market today is not as representative as the real economy the way, for example, the United States is. And the trading and the investors are still not as mature. And also, as you said, in the service sector of the economy when it comes to financial services, is still yet to be developed.

And China was really right at this stage in the financial services industry, actually is about to take off in a big way for many reasons. And it just so happens that the Chinese government is quite keen in making macroeconomic policies quite conducive for the development of the financial services industry.

So all those confluence of factors really make the market that much more attractive today than it was before. Bruce Greenwald: Yeah, can I say something about that? Financial services is probably the fifth and sixth largest service sector.

The biggest is housing by far. The second biggest is medical care. The third biggest is education. What about those sectors in China. Li Lu: That sector is also growing… Bruce Greenwald: Right, but do you see opportunities in housing… Li Lu: Virtually every industry are going through robust growing stage, some more than the others.

So different people tend to focus on different aspects of the industries and different aspects of the growth profile, some looking at value and high growth companies, some looking for values at moderate growth companies. And so if you are a true good investor in that sense, you can find value everywhere. But you will probably be more capable of finding values in dynamically growing economies such as China. So that combination of those two really make it enticing.

On top of that one, a whole series of government reform will make those inefficiencies gradually be more efficient. And so that transition offers even more interesting opportunities. So this is a good time for global investors and certainly for U. Bruce Greenwald: Ok, in those terms that as Chinese financial markets are developing.

You sort of have a top development that you like to see happen in the China financial markets or even in the China economy? You have to go through…layers of approval process in order to be listed. And so the ones who are listed are the ones who really approved by government, for whatever reason, often not really market driven. Compare with other markets such as the United States, that it is registration based.

And so it is market driven. As a result…the security markets here are quite representative of the true economy. And as the Chinese economy moving from an export import driven economy into more of consumer demand economy, the entrepreneurial companies with market driven dynamics are increasingly playing a larger role. And therefore the financial markets have to reflect the changing dynamics and the Chinese government is determined to reform this IPO process from one of approval process model into one that is much like the United States of registration-based model.

And so we are probably still early in that process. And the other big changes that is happening is that most of the financing are done through the banking sectors up to the point, 80 plus percent. And so we see the overall financing model, the Chinese economy, from one that is more indirect, into more direct. And so thus is the reason for opening up this financial service industry, both for domestic players and global players.

And the financial markets will become much, much bigger than what it is today. Bruce Greenwald: Now, let me ask another question in that connection. I mean, the thing about a service economy is that services are overwhelmingly locally produced and consumed.

There are very few global universities, for example, there are very few global high schools, very few global hospitals. That means that typically if you look at developed economies like the United States with big service sectors, the firms which tend to be local, the service firms that tend to be local, tend to be locally financed.

So I assume you know that local banks in the United States are much more profitable than the big global banks. Do you see a comparable trend developing in China that you can take advantage of? Li Lu: Some yes and some no. Li Lu: Yeah, well, they tend to really know their local area. But the Chinese regulation in banking is slightly different. So there are only roughly about 15 banks that really have the mandate of being able to take deposit on a national basis.

And all the rest of the financial institutions are able to really take deposits in a very, very small, well-defined local region. And so it is a heavily, heavily regulated business. And so that really gives them almost an oligopoly type of a status in terms of taking deposit, which is very important and of course, in terms of the source of capital. So that dynamic is a slightly different than the United States, for example. That the license ability to really be able to open a bank is much, much more relaxed in the United States than in China.

As a result, basically the dynamics of the larger national versus local or regional banks and other financial institutions, are more driven by basically the business dynamics and market dynamics. And this is very different than in China.

It is driven first and foremost by the regulation regime. And so, that makes the comparison of the banks really quite different in China than the United States. Bruce Greenwald: So somebody investing in banks in China have to be an expert in Chinese regulation? Li Lu: Absolutely. Bruce Greenwald: A specialist? Li Lu: Yes. Inaudible if you invest anything, I recommend you better become the most knowledgeable specialist on the planet before you really invest and hold it through the ups and downs and the thick and thins.

And if you do understand them and they are good, it is far more profitable to hold over the long period of time.

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