Li Lu: Value Investing in China, Full Transcript

Li Lu gave a wonderful talk at the 13th Annual Columbia China Business Conference last week. The fireside chat was chock full of great insights into value investing and its application in China.

I felt this talk, more than most, would benefit from being transcribed. And no doubt, the wisdom of Li Lu jumps off the page.

I would like to thank Li Lu, Bruce Greenwald, the Columbia Business School, and the Greater China Society for putting on this talk and making it available to the general public.

For more details about this conference, visit cbs-china.org.

I hope you all enjoy!

(Note: Throughout the transcript I made minor grammatical fixes to improve clarity, but beyond that, transcribed it as accurately as possible.)

Start of Transcript

Bruce Greenwald: I think this is going to be a rare privilege for everybody. I’ve known Li Lu now for more than 20 years, and not only is he a great investor, but he’s a great conversationalist. So why don’t we just start out by talking about how your investment philosophy has changed? Because value investing is, after all, always an evolving field since you began the field, literally, I think I would say, 25 years ago, 20 years ago?

Li Lu: More like 28 now. Time really flies.

Bruce Greenwald: So how has it evolved? So how have you been influenced by people like Charlie Munger?

Li Lu: Well, so before I started, I just want to first of all, thank you and all the organizers of this great conferences. Look at the way the speaker are just really unbelievable. So the quality of the student has dramatically improved since I was a student there. So thank you all for that wonderful work of putting together these great conferences. And it just really gives me such a pleasure to be on the same panel as my professor, Bruce Greenwald. In fact, I got into this field really because of Professor Greenwald’s class. I think, you know, basically you got Buffett to come to speak to the students roughly 28 years ago. And it was really out of that first lecture that we got into this field. So thank you so much. And of course, later, as a business school student, I took all of the courses that Professor Greenwald offered and learned a great deal and made a lot of money, too. So thank you.

So the philosophy is relatively simple. The practice is really hard. So I wouldn’t say the philosophy really evolved all that much for me. Before I got really exposed to value investing through Buffet’s lecture at Bruce Greenwald’s class, I think my whole approach to life was pretty much a set along similar lines. And so there was not much of a jump for me. The idea of buying something at a discount of something that is really worth more is simply intelligent. So (I would assume) that all intelligent investing involves some kind of value investing. And now the difference is, is that your focus on value evolves over time and two different individuals they tend to focus on different areas of that.

For me, when I first started as a value investor, this is now 27, 28 years ago when I bought my first stock. I didn’t really know much about business. I was born and raised in China during the Cultural Revolution. There was not much of a private business or market economy back then, so I had to learn everything new. So at the beginning, obviously look for value primarily on the balance sheet in the classic style of Benjamin Graham, looking for a cigarette-butt, looking for the last puff basically. Looking for a statistically cheap businesses and ignore what the business really is. And that served me well.

Then over time, I evolved into understanding smaller businesses. Because I was just intensively curious about how business run. So much so, actually I evolved to help funding or co-created a dozen or so early-stage startup companies. And that experience has taught me a lot about how business is run, what constitutes bad or mediocre businesses. And so over time I evolved into looking for really good businesses, small maybe, but really good businesses. 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. And so the places where we’re looking for value evolves over time, but the basic philosophy I have pretty much remained the same. But it’s just our core competence expanded over time.

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. It was just a stroke of luck that you can’t even make up in fiction, that I struck a good connection with Charlie Munger and he became an investor in 2003, 2004. And we’ve been partners since then basically. 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. So that’s my version of Tuesday night with Charlie, every week. 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 often the role model is among the eminent dead because it’s safer. So it’s pretty risky to pick a role model that’s still alive. 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. And so mostly it’s really based on his attitude towards life and his ability to keep equanimity in a sense, in the face of ups and downs, successes or setbacks. And I’ve witnessed quite a bit of them over the 17 years or so we’ve been working closely to maintain that rational composure, commonsensical approach to all problems in investment or life. That is extraordinarily hard, and it is a bit against our natural tendencies. And I’ve really watched up close and personal, how Charlie has conducted himself. And it is in that regard that he’s probably the most influential person in my life. 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. Those are the businesses we’re looking for. And they could really come in all industries, in all shapes and forms. But they’re rare. They’re really, really rare to have a business that generates above average returns over a long time on a compounded fashion is, again is really against the natural order of things. It’s really only a small slice of all businesses (that) belong to that category.

So if you’re really lucky enough to really find one of those long-term compounders, all you have to do is really to own them for the longest period of time. Now, it helps when you really buy them at the time when they happen to be traded at a discount to their intrinsic value so that if you were wrong about them, you won’t lose money, and if you’re right, you have more returns over time. 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 as I said, there isn’t really a set of things that really made them that way. Every business really build their fortress slightly different, and you just have to really actually be honest with yourself and study them from every possible angle until you’re really convinced that they are actually currently enjoying truly enduring (competitive advantages), and they truly have a long runway ahead of them. 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.

Bruce Greenwald: Ok, can I actually talk a little bit about those businesses, I mean, in limiting competition and I think Charlie Munger is the master of this, we’re really interested in moat’s. That is the barriers to entry into the business because it’s keeping people out. That’s going to limit competition. 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 in automobiles, in the global automobile market, it’s really large. And if you have got 1-2% share, you’re going to be fine. In other markets, like, for example, local distribution of caffeinated soft drinks, you’ve got to get to 20-25% of the market to support the infrastructure that you need to compete. So the first thing is economies of scale.

The second thing I think and again, I’m sort of thinking about Charlie Munger here, is how hard is it to get that market share? Which is all about customer captivity in a contested environment where unique technology will help you with that and so on. So suppose you’ve got to get to 25% share, we know for caffeinated soft drinks that two tenths of a percent share changes hands every year in a contested market. So to get to 25% you’re talking about a 125-year moat.

Do you do a calculation like that for the companies you’re looking at? Do you look at those two elements explicitly?

Li Lu: Well, that and more.

Bruce Greenwald: Ok. So what’s ‘the more’?

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. But the dynamic will change after a certain scale, you mentioned automobiles, that’s an interesting example, you know what happens at different phases of the industry. The consumer side is also important in a sense that if you have quite a bit of consumer addiction to certain products and brand loyalty, obviously that is important and they’re good for a long time until they’re not good. Things do change. New product categories would come along, and brands get tired and old, and not refreshed. The new generations really don’t like to have the same taste as their parents and grandparents. So that’s really the most interesting aspect of businesses is, (the) only constant is the constant change. All great business changes over time. And (there’s) absolutely no business that can really maintain that competitive edge for forever. But some of the businesses can really keep it for a very, very long time. And of course, when it changes it’s really upon the management team to be able to really reallocate capital towards those businesses, (that are) actually now enjoying a robust competitive advantage.

Take example with Berkshire. It started out as a lousy business, losing business of textile in New England. And Warren and Charlie’s skill is that they took the last bit of the cash flow and skillfully invested in some other businesses, really on the right side of the trajectory. 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. And, of course, that the culture of a company in the industry that’s rapidly changing so that you are always a few steps ahead of your competitors, which allows you to always (inaudible) on the edge, that also becomes enduring competitive advantage if that culture endures. 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?

Now, I’ll tell you the thing that when I started investing with you, and I’m honored to say that I made a lot of money doing it, that appealed to me was what you mentioned in your introduction, which is small…markets are necessarily markets where you have to get a big share because one firm can dominate. And that’s not something that most investors look at. So in what other ways do you do things differently from most other value investors and investors?

Li Lu: Well, you’re right. You invested with me or you begin to invest in me. Thank God you’re still with 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. And so we’re not really looking at just big or medium or small. Size is one consideration, but it’s not the most important, certainly not a determining factor is when we’re looking for businesses. 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. Now, they don’t necessarily always grow forever, but they have been growing for a long, long time and likely to continue for some time. 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?

Li Lu: I don’t spend my time studying a hundred people doing that. We spend most of our time studying industries, study specific companies. We’re looking for the ones who are already successful. Try to answer what really make them successful. Can that success be continued? And some of the time we have answers and some of the time we don’t. We just continue to really study them and continue at it, until we have an answer. I think one thing that really that is always important for us is this intellectual honesty, basically knowing what we really don’t know. What we do know and what we don’t. 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. So we really insist on knowing inside and out a particular businesses, to the point we’re able to predict it’s outcome, for example, in the next 10 years. 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. We can’t really predict it forever, but I want to see whether I can predict with a very high degree of confidence, 90% of confidence, that at a minimum what the business will look like in 10 years under all different contingencies. And most of the time by the way, we don’t have an answer and we just keep study and keep at it. Sometimes we study for years and years before we see, ok, we really get it. And then we wait for the price to come to our striking zone, and a lot of the time they don’t. 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.

Li Lu: If they go down 50% to 60% we buy more, so that really gives you a measure of our definition of when we understand them.

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 would you have advice for anybody I’m having now?

Li Lu: Well, we usually don’t study too much about the market except when they are really extreme. And this happens to be one of the more extreme periods of time. It is truly, in many ways, somewhere in unchartered territory. The amount of liquidity that’s been printed, the level of interest rates, and also the slow pace of growth. All of those are quite really remarkable in this period of time. So how do you really deal with them. We don’t necessarily think that history would repeat. 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.

Bruce Greenwald: So you’ve lived through in your 23 years running Himalaya, a number of major financial crises, the Asia crisis in ’97, the tech bust in 2000, the financial crisis in 2008 and actually last year, the covid-19 situation. 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. Now we’re very good at rationalization, but we’re really not very good at being rational…In a sense, we’re governed by some set of hard wired, hard coded instincts. And looking for a zero sum and we’re looking for fast money, and they’re really totally scared when things goes against you. So that’s basic sense of greed and fear, it will always drive the financial market up and down. 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 that’s why the financial market from the very beginning has always been characterized by boom and bust and will remain so. And how do you deal with such an environment that will be constant? One way to deal with that is to anticipate that it’s always on the corner at all times. And that’s basically our attitude, that financial crisis will happen all the time. People will always be driven by fear, by euphoria, by this extreme kind of ups and downs. And so we’re looking for businesses that are capable of living through that and even businesses that could really thrive in that environment. 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. If we don’t have the money, it is the hallmark of a good investor, you can sit through watching your portfolio down by 50% and not being affected at all.

On the other hand, the other side of the coin is that you’re equally unaffected when everybody around you are making fast money, fast and furious, a lot of them. Now you’re really seemingly totally left behind. And that’s really part of the temperament that most people don’t have. And that’s why not everybody can succeed in this game of investment. 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. You know, in real life, real businesses don’t really change by day, by hour, by week, by months. 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. So if you have that basic temperament and basic approaches, what you’re going to find is that most euphoria, as well as the crash, actually can serve you well. And this is really going back to Ben Graham’s basic concept of Mr. 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. And if you really try to pretend you understand and you are really driven by something else other than deep understanding, you’ll be tested. And so that’s the salient nature of the of the financial market. I sometimes almost feel that they exist to really catch human weakness. That if you really don’t understand something that you pretend to, you will be busted at some point. But if you truly understand, you will be able to add when the security will be down 50, 60, 70%.

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.

So if you looked at John Deere in 2000, demand fell by 5% and their profit margins fell to zero. If you look at what happens to them in ’13, ’14, demand falls 35% and their profit margin stays at roughly half of what it was before, which is higher than it had been historically. So clearly, that’s a company that’s changed and in the face of sort of catastrophic external conditions, has gone from doing quite badly to doing much better. Do you have examples of that from the companies you’ve invested in, where you’ve seen them perform through a crisis?

Li Lu: I do in my 27, 28 years of investment, that’s the kind of things you’ll collect. But normally we don’t talk about specific companies.

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?

Li Lu: Well, Bruce, we’ve tried this multiple times in your class. I’m not going to change.

Bruce Greenwald: I know, it’s very familiar to me.

Li Lu: And there is a simple logic, a reason why we don’t do that. Once you achieve a certain notoriety in a certain field that people tend to really copy that. And that’s not the kind of behavior we want to encourage. 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?

Li Lu: Well, in a sense, you always want to be a generalist in terms of a student of businesses that you’re interested…To be good at this game, you have to have the innate intensive curiosity about a business, all kinds of businesses. It doesn’t mean you’re going to really, really get to the bottom of it. Oftentimes you don’t if you’re honest with yourself. 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. And so that’s really the test.

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.

Bruce Greenwald: Ok, so let’s talk about the evolution of markets and in particular at a 2010 panel at Columbia Business School, you mentioned that Asia’s role in the global financial system was becoming increasingly important. Looking back, how has Asia’s role evolved in the last 10 years, and what about China’s role going forward in both the world’s business economy and in the financial?

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.

Bruce Greenwald: Well, all right, so let me give you some data that I don’t think is widely appreciated. I mean, the Chinese numbers are obviously very difficult to interpret, at least the official numbers. And whenever you see that from a company, the data you really want to look at is the data where there’s a reliable counterparty, and the trade data is where there’s reliable counterparty, because every Chinese export has to be an import from another country and every Chinese import has to be an export from another country.

Over the last 8 to 10 years, China trade has grown by only about 2.5% per year. That’s less than 1% faster than US trade. What does that say about Chinese growth? I mean, that’s clearly much slower than the trade growth prior to 2010, 2011, and it’s fluctuated obviously, but if anything, it’s been slowing down. What does that say about China’s future?

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 I would say back in 2010, the net trade, meaning the export/import netted out, was roughly about 9% of GDP. And so China’s economy was heavily dependent on the global market…And they were growing really double-digit growth at the time when the rest of the global economy was growing at much, much less, a fraction of that. And so at a certain point, once you become the largest trading nation, you can’t really grow, the rest of the world wouldn’t be able to keep up. 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. It’s just also human nature.

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. China was the largest retail market in the whole world at a $6 trillion. The US was roughly $5.5 trillion. Now grant it that was a special year in the sense that a global pandemic hit other countries harder than China, it’s (also said) that China did a better job in managing the pandemic. 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. I mean, the thing about retail sales is that it’s selling goods. The thing about the developed economies is that they’re overwhelmingly service economies, they’re not goods economies. And on that dimension, it doesn’t look like China’s doing particularly well. 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?

Li Lu: Well, you’re certainly right that at the current stage, the service sector has yet to become as powerful and dominant as most of the matured and developed economies in the West. And that’s really (inaudible) a new set of opportunities for the decades ahead of them. And that’s, by the way, not that much different than all the other developed economies at a comparable stage in the development of, say, $10,000, $11,000 per capita GDP, which is where China is today.

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. And so that’s why their share of the GDP has gradually began to shrink. 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 so there’s a lot of the development in that regard. And the trading and the investors are still not as mature. And there’s still a mentality of fast trading, high turnovers, which actually render some of the companies, again, go through a faster pace of this boom and bust. Again, that usually provides opportunities for those mature patient investors who truly know what they’re doing. 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. And they’ve begun to open up to the global firms as well in a way that they’ve never done that before. 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. And the fourth and fifth biggest are like wholesale and retail distribution and personal services and then financial services, although in the US it’s a little higher than that. 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. And even if industry, they’re not growing as fast, you can still find interesting companies, values. And I don’t have to…you’re the guru for this field. 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. Some look for value in places that don’t grow at all. In fact, they’re probably declined and therefore they find even bigger markets. 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. They are still growing at multiple times of the matured economy in the West, and there’s still enormous amount of inefficiency in this securities market. 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.S. investors as well.

Bruce Greenwald: Ok, in those terms that as Chinese financial markets are developing. Do you have certain reforms or other things you’d be interested in seeing implemented? You sort of have a top development that you like to see happen in the China financial markets or even in the China economy?

Li Lu: Well in a sense, it’s already happening. That’s what I mean by the Chinese government regulator has been very keen to develop the Chinese security market. For years and years the Chinese security market is not very representative of China’s economy, partially because really the of the IPO rules are based on what they call approval model. 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. But as that process began to play out, we’ll see the financial market become more reflective of the real economy. 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 over time, the financing is best to really do through what they call ‘direct financing’, mostly through market driven dynamics of fixed income, equity, etc. 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. As we’re seeing that dynamic play out over the next decade or so there will be a lot more opportunities and the financial market will become more mature and there will be more institutional players coming into it. And the financial markets will become much, much bigger than what it is today. So those area really all bode well for investors who truly understand what they’re doing in China.

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. I wouldn’t say that…

Bruce Greenwald: No, I’m just thinking in terms of local experts within China (inaudible) local service businesses, that would include, of course, local banks.

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. Whether they’re a town, or villages, or the cities, etc. 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.

Bruce Greenwald: Ok, so why don’t we talk more broadly about new trends in value investing? So among them many popular and rising technological fields such as 5G, Bitcoin, AI, has any of that attracted your interest as a value investor and why?

Li Lu: Well, as I said, if you’re an investor, you really want to find out what really influenced the change of your companies. The one big forces that are really quite prominent is the fast acceleration of technological changes. And of course, you need to be well aware of those mega technological trend. This current wave that started 40, 50 years since the invention of the semiconductor, particularly the integrated circuit, that really ultimately led to personal computer and computational proliferation, the computation power to ordinary citizens. And from there, there’s also the evolution of communication technologies and then the invention of the internet somewhere 25, 30 years ago. From there, the mobile internet.

So the intersections of computing as well as the omnipresent and instantaneous communication really led to this new phenomena of artificial intelligence and the data economy as a result of it. And so this wave of technological change over the last 40 years has fundamentally altered the business landscape of all kinds, basically. And so whatever kind of investor you are, we do need to be aware of these huge changes. And how do you deal with that in a sense? Well you’re investing in businesses that are either well insulated from those technological change or in companies whose management team is quite capable of adapting to those technological changes better than their competitors. Or in companies that are leading those changes or enabling changes so that those changes are really on your side. And so, now do you have to be a true expert to the point of an engineer? I don’t think you do, but you do need to be broadly aware of all of us have big technology changes. Now, if you happen to be a venture capitalist in those fields then of course you do, but if you’re a generalist and study all the businesses, you need to be aware of those trends. How does it really impact in the industry, in the companies that you’re invested in? So we are still really in the middle of that gigantic wave that started with the invention of the semiconductor.

Bruce Greenwald: By the way, do you know when the transistor was invented?

Li Lu: Well, that’s a longer I know that.

Bruce Greenwald: That was 1942.

Li Lu: Yes, yes, yes.

Bruce Greenwald: And the first (integrated circuit) was 1961.

Li Lu: Yes, yes. You’re referring to the time (technology) really gets integrated into industry. So that really started this whole revolution that we’re actually still in the middle of it. And the current wave of neural network based artificial intelligence is just kind of the recent iteration. And the data economy that as a result of it is the newest adaptation by industries in response to that new technology. We’re going to see more of it as time evolves from here.

Bruce Greenwald: Do you see opportunities to invest in new technologies? Do you have an example, maybe in your past where you did invest successfully in a new technology?

Li Lu: We have, in a sense, back in the days I was trying to learn about businesses, I invested in a number of startups. And so I am fascinated about the technologies. And today we have somewhat smaller exposure to that. But it is fascinating. It’s not really that (I’m) not interested in technology. It’s just that it’s not that easy to predict their impact because of the pace of change. It does require a different aptitude, different domain expertise, etc. The other things is we chose to have other set of easier opportunities. We just happened to be lucky.

Bruce Greenwald: All right. So let’s talk about a specific example. A lot of smart people believe that renewable energy is the next big revolution. And you’ve done a lot of work on battery technology and BYD. So is that something that you think about beyond batteries? What’s your outlook for the electrical vehicle industry say in the next five years, or is it overheated now? Where is Tesla going?

Li Lu: So the car industry is simultaneously kind of being impacted by you know, four or five big megatrends. Electrification, ride sharing, autonomous driving, and the intelligent design. All of those really going into the industry simultaneously. And so that really attracted more entrants and that really heated the competition. Also, against the broad background of climate change, the carbon neutral revolution in the sense. So as a result of the industry that really has last for 100 years is really being turned upside down. On the other side, it is a gigantic industry. So other than housing, that’s probably one of the biggest industry. So the prize is also in the end. In the process though, the competition is going to become very, very intense. Still it does still have that characteristic of being a scale economy, as we talked about it in the beginning of our dialogue. So the survivors or the winners do need to have a certain scale in order to be able to win in the end. So it is still early to predict who will be the ultimate winner, but it is not early at all to predict those mega trends are here to stay.

So five years there will be far more electric cars sold. We have seen the European countries began to declare a deadline to stop basically gasoline powered cars. China is following that up, I think, in due course. And we are going to see those megatrends here to stay. And five years from now, that trend will become even more prominent than what it is today. But it is very difficult to predict the ultimate winner…and it continues to attract new entrants at this point. But I do think that the ones that really possess unique technology, have the scale, and have the right strategic focus ultimately will do well.

Bruce Greenwald: Do you have a sense of which companies will do well?

Li Lu: Well I bet once. So I let my money speaker for itself. But we’re not going to be the only ones, there will be a few. It is a gigantic industry.

Bruce Greenwald: Ok, so in terms of value investing education, you actually played a big role in promoting and advocating value investing from the books to actually you underwrote this class that we talked about where I went to Peking University and I think it still survives. What’s your vision for the kind of education that a new investor should embrace and where that education might be available?

Li Lu: Well, first of all, thank you Bruce for coming to teach at the Peking University value investing classes that my colleague Jing Chang and I started six years ago. And now it’s six year and it’s still running and running very well. And you have played an important role to that. And I think our original inspiration for that class was really based on pretty much your class and your class was pretty much inspired and a continuation of Ben Graham’s class…Graham and Dodd, which had, among others, Warren Buffett as a student. And I’m your student. (There’ll) be many more much brighter investors coming after us. And that’s a good thing. So we’re trying to really do our part to pass on both the philosophy, the thinking, and the practical art of investing to the next generation, in a sense. So in terms of the younger students when you start today. So I think a few things will be important. When I talk to young students and people who started out trying to get into the field, I say several things that are important.

‘A’ to always adopt an owners mentality. And so I like to really ask a student or analyst at our firm basically to imagine that all of a sudden that one of your unknown uncles died and handed over 100% ownership of the company to you. And that’s the business you were going to study. So any company, think starting point that way. And once you really kind of think you own 100 percent of it, your mentality is totally different. So you never know that business existed, now you own 100%. You have no idea how to run it. You don’t know the people who run it. What do you do? You want to know everything, everything you can possibly get your hands on.

And a lot of the things you know, you don’t really understand. You just know the facts. You don’t understand it. But that’s OK. You’re going to continue to learn until you get a handle of it. And even if then because of the constant change, you’re going to continue to evolve your knowledge of it. Now, if you adopt that mentality, study any businesses, you have really started the process of becoming a real value investor. So that’s the first thing.

The second thing is you really want to maintain intellectual honesty. And that is very, very important. You have to be really honest about what you know, what you assume…what you pretend…subconsciously…and what you don’t know. How do you know that? One of the things that Charlie has talked about that I think makes the most sense is, (he’s) said that “I’m never entitled to have a view until I can find the smartest people on the planet who took the other side of that view and I can argue better the opposition than he does. When I can do that, I would be entitled to have a view.” The same thing applies to investing in a sense. That intellectual honesty is a good life philosophy to begin with. It is critical. It is vital when it comes to investment. Because, as I said, the security market almost exists to really find your weaknesses, your dishonesty, your pretension, your mushy knowledges. And if you do not really possess that fundamental attitude of intellectual honesty, you’ll get destroyed at some point during your career by the financial market. It was almost designed that way to catch you.

Bruce Greenwald: Can I say something about that? Because it is better than designed that way. Every time you buy a security thinking it’s going to do well, somebody else is selling you that security, thinking it’s going to do badly, and vice versa. And one of you is always wrong. So you better be sure that you’re the one that’s on the right side of that transaction.

Li Lu: Well, there is some zero-sum aspect, but not always.

Bruce Greenwald: Oh no! It’s 100% zero sum. The average return to all investors in any asset class and therefore in all those asset classes is the average return to all those assets.

Li Lu: Hey Bruce, I take a slightly different view. But I’m never going to argue against my professor, so let’s just agree to disagree on that point.

Bruce Greenwald: Ok. That’s fair. Keep going.

Li Lu: That is a fair point. Fair point. And another thing I want to say is that you want to really devote as much time as possible to study of the history of  businesses and the history of great businessmen in the past. The more you study more companies, the better you are when it comes to judgment on good opportunities and the judgment about the fundamental characteristic of the company you’re interested in. And so I say all three things are important. To start with the 100% owner mentality, to continue to train yourself, to have a high degree of intellectual honesty. And lastly, to be a very thorough student of the history of the businesses. All three things are really going to be very helpful if you are beginning to get into the field of investment or really want to improve your game. So that’s my advice to your students.

Bruce Greenwald: Good advice. I’m not going to argue with that. When you look back over your own career. Are there things that, whether at Columbia Business School or in your career since then, you would have done differently that would have helped you get to where you are today sort of more quickly and more easily?

Li Lu: Yeah, well looking back I feel I’m extraordinarily lucky and I feel nothing but gratitude. I feel lucky to accidentally step into Buffett’s lecture at your class, basically. The first time he came. I feel extraordinarily lucky that I got into the business and to strike a relationship with Charlie Munger. I feel extraordinarily fortunate to live in a period of time when both the United States and China are going through a fundamental economic growth and providing enormous amount of opportunity and that I happen to really know both markets well. And so looking back at my career, nothing I regret. I feel nothing but really gratitude. But in terms on the transition from U.S. to China. I think a lot of people, myself included, went through a period of time to really try to understand the nature of the Chinese economy and the nature of the Chinese market, the nature of the Chinese company…investment in Chinese companies.

So one of the key learnings that I have, and it is not that obvious, is the role that the Chinese government played in that whole equation. If you have been successful investor in the United States, for example, or in the developed market, you tend to come with a set of assumptions about the role of the government and the role of the market participants. And when you really look into the Chinese market, that assumptions, you will see a lot of challenges.

And so you might really, from time to time, arrive to views that are inconsistent with your own experiences, partially because historically the Chinese government and the U.S. Government, Western governments, perform very different roles. And that’s one of the key aspect of really investing in China that really requires much deeper understanding and also a systematic comparison to get rid of those biases. And that’s why that you could really get rid of this typical global investor (inaudible) fear or enthusiasm or basically pessimistic kind of ‘coming collapse of a China’ type of mentality when things are not going to at all. And so that is the education of most of the international investors, particularly when it comes to China that they have to go through. And that is important. But bearing in mind the other aspect to understand to the Chinese economy is that the nature of the modern economy is its ability to generate sustained, compounded economic growth, something that is only recently emerged as the human phenomena. And this is where we talk about the zero-sum versus win-win type of mentality.

Now for the longest period of time that almost all natural or human affairs are characterized by cycles in the sense that everything goes up cycles. You know, we’re born and then we grow old, and we die, or the trees it goes up and they die. So entropy basically, is always increased. Energy goes from hot to cold things. From order to disorder. Great businesses eventually loses its edge. So that is the nature of things. And economy goes from boom and bust.

But something unique happened over several hundred years ago with the beginning of the Industrial Revolution. We began to see this phenomenon of continued, sustained, compounded economic growth. And that is really when value investing become very important. And that’s why you begin to have a phenomenal record such as the one produced by Warren Buffett and now by a few other people as well. The basic logic behind that, as I said, over the long term, your investment returns are likely to approximate the actual business returns of the company you’ve invested in. And so the fact that you were capable of generating that long term results is a reflection of a changing nature of the economy. What really drives that phenomenon is something that is utterly fascinating. I literally spent 30, 40 years thinking about that. Until I think I come to a certain knowledge, I wouldn’t say really know it all, but I think what really produced in that phenomena is, is a combination of free market enterprise, way of organizing social economic affairs. And combine that one with the invention of modern science and technology, a combination of those two produced a modern form of economy. And it’s a paradigm shift.

So what has happened in China is that roughly around 40 years ago, China has really stumbled finally into that magic formula of free market economy. Now, with Chinese characteristic, of course, along with modern science and technology. And any economy that has really strike that magic formula, begins to produce the phenomenon of compounding economic performance. Now that has to be combined with the stability of overall political environment to allow the market force that a new economy to really release that power. And that is when a sustained investment record can be possible in China. It’s not always there, it’s not always possible. And often it was a zero sum. But I think from that period on, that a sustained win-win type of a compounded investment return becomes possible. And notice that I didn’t really include the political component of it. Most of the Western observers believe that political democracy has to be part of the equation, except they forgot that political democracy wasn’t there when that phenomenon began to take place in the West. In fact, the political democracy happened later, almost as a result, but not because of it. Anyways, so that is another layer of understanding the phenomena of investment opportunities in China that could be interesting.

Bruce Greenwald: Ok, so what about, let’s just talk briefly in these last eight or so minutes about your personal interest. So you’ve devoted efforts to improving equality and welfare for Asian-Americans. And given the recent elevated attention on this community, what are you doing and planning to do or you think ought to be done for that community?

Li Lu: Well, I was really, like many people around the Asian-American community in America, just utterly dismayed, heartbroken over the last year and a half. Particularly since the later years of the Trump administration, it got worsened because of the pandemic, this new wave of anti-Asian hate crimes. And by all statistics that instance of racial discrimination against Asian-Americans has dramatically increased over the last year and a half. For a variety of different reasons. The pandemic, the Trump policies, the U.S./China tension, and the systematic historical root. Suffice to say that many people in Asian-American community are living in fears, literally physical fears today after being here for so many years, of being such an important part of the American experiment. Particularly to the Chinese American community. After 150 years, it feels like the Chinese Exclusion Act has come back again. And so I have been thinking long and hard at what can we do to change the paradigm? Now I had a different experiences when I came to America. I had a wonderful, wonderful experiences. America embraced me with open, warm heart. And I have gotten an enormous amount of opportunities like Columbia University and all the great people I met along the way. And the opportunity I was given to be successful way beyond my wildest dreams when I first came here as an immigrant. Not a penny and nobody to speak the language, to be where I am today.

And so one thing that I always believed about America is this. I think America is not defined by geography. It is not defined by race. It is not defined by a culture. Not defined by religion. America is defined by a set of ideas and ideals. Anyone, no matter your race, religion, culture, background, if you sign up to that set of ideas, ideals, can be America. I was one of those who believe in those ideas and ideals that became a successful American. And I want that experiment to really continue. And obviously, when you look at history, it was never a perfect experiment. In that it was often marked by the (inaudible), and sometimes actually outright cruel, malicious, if you think about it, experiences with the African Americans and all the other minorities. But I think America remains the only country on Earth, so inspired and such constructed. And for that experiment to continue, it calls constantly to our better angels inside each one of us. And to really restrict the worst instincts of all of us. And throughout a different period of time, people need to rise up to counter those worst instinct and fight them and face them down.

And this is one of those periods again. So I think the entire community of Asian-Americans have to come together. The entire American community need to really come together to really fight this wave of Anti-Asian discrimination. So along with a number of wonderful colleagues, we are cofounding a new national organization whose mission is to serve Asian-Americans in their pursuit of belonging and prosperity. Free from discrimination, slander or violence. And one of the things that our (inaudible) needs is, an enormous amount of funding. The statistics tell us that only 0.2% of all philanthropy in America goes to Asian-American causes. And we want to fundamentally change that. And hopefully with this new organization, new group of people, we really want to fundamentally change that picture.

And the other thing is that with the global economy, the center of the global economy shifting from the Atlantic Ocean to the Pacific Ocean, Asian American, 20 million strong are going to play an increasingly important role to position America as the new Pacific economic power. And that group of people more than other ones, if fully integrated as the very fabric of American society, could help lead America to better integrated with the better economic ties in Asia.

Bruce Greenwald: Ok Li Lu. That’s terrific. It’s a great note to end on. Unfortunately, we have two minutes left. Thank you very much for this really encyclopedic and enlightening talk. I think I have to turn it back over, however, to the M.C. For the last two minutes.

Li Lu: Ok. Thank you for really having that class 28 years ago, without that class I wouldn’t know what I’m doing today, so thank you.

End of Transcript

Thank you for reading. I hope you all thoroughly enjoyed the transcript. If you found any errors, kindly let me know and I will fix them. Furthermore, if you’d like to be informed of future posts, transcripts, or events, please subscribe.

Sincerely,

Richard Lewis, CFA
White Stork Asset Management LLC
Partner, Investments

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10 Comments

  1. Thank you Richard for all that you do via the website. So happy that I’ve stumbled on this corner of wisdom – I’ve been an admirer of Warren and Charlie, and by extension, Li Lu – and it’s just not easy to get my hands on the latter’s materials without speaking Mandarin! Thank you.

  2. Wonderful work, thanks Richard. Saved me over an hour of capturing key points. Early on “imminent dead” was mentioned. Should be corrected to “eminent”.

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