"The Practice of Value

Investing", by Li Lu
Li Lu of Himalaya Capital spoke in November 2019 to students at Peking
University’s Guanghua School of Management. His speech was titled “The
Practice of Value Investing”, and followed-up from the speech he gave five
years earlier titled, “The Prospects for Value Investing in China”.

I’ve never met Li Lu but through his writings, he’s become one of my
greatest teachers. Stuck at home in self-isolation, I thought I would translate
a transcript of the speech so others can learn from him too.

I’ve tried to keep faithful to the original meaning while editing lightly to
help the flow. Square brackets indicate where I’ve made an indirect
translation or inferred an implied meaning. Big thanks to CG, JN and MC for
their help. Otherwise, all errors are my own.

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THE PRACTICE OF VALUE INVESTING, BY LI LU

NOVEMBER 29TH, 2019

https://xueqiu.com/6026781624/137223946

If you can persevere with anything for five years, you should be able to keep
going; so I’m very happy to be back here in Professor Jiang Guohua’s class
five years after my first visit. First, let me thank Professor Jiang as well as
Himalaya Capital’s Gene Chang, our supporters in the audience and all the
students with an interest in value investing. I had a few regrets after my
first lecture as I focused on the basic theories of value investing. But value
investing is a practical art and I didn’t talk enough about its practice. So this
time, I will talk about the practice of value investing. And because we’re
going to talk about practice, I will also leave ample time afterwards for
Q&A. I will do my best to give you the practical framework I use for
investing and then we can spend time on the questions you’ve encountered
in your practical experience too.

The room seems quite full today. We have a range of attendees, from
students who have just come across value investing to practitioners with
many years of experience, to our academic colleagues. So your questions
should be quite diverse.

I also need to thank Mr. Guo as he was supposed to speak today. Mr. Guo is
one of the original founders of Anhui Conch and deserves our deepest
admiration. I’m very sorry to have taken his slot today. But he will be back
on the 13th and you can all hear him then.

So I wonder how many of you here today were there five years ago when I
last spoke?

1. THE BASIC CONCEPTS AND PRINCIPLES OF VALUE INVESTING

There aren’t too many basic concepts and principles of value investing:

1. Stocks confer part-ownership of a business.

2. The market is a guide.
3. The most important thing in investing is predicting the future but the
future is inherently unpredictable. Investing is therefore about
probability and a margin of safety.
4. Build a circle of competence and stick within it.

Value investing is basically a framework of these thoughts. Their logic is

simple but in reality, they are hard to truly understand. Many people have
some understanding, especially thanks to the attention Buffett has
received. He’s already given us 60 years of successful history and attracted
a phenomenal level of interest. So the question is, when everyone
understands value investing, why do so few people truly practice it? We
estimate that fewer than 5% of investors practice value investing.

Today we will [try to bring theory and practice together, and discuss why
value investing is easier said than done].

First, the key is [that stocks represent part-ownership of a business]. If a

market or a country is willing to protect private property rights, then it
should also be willing to protect the use of private property rights. If these
rights cannot be exercised, then they are not real. And if assets cannot be
freely exchanged, then it is hard to say they are really assets. For example,
cash has property rights. We can spend it whenever we like. And when we
spend it, we can use it to obtain the things we want. As such, the ability to
freely exchange equity and ownership rights is an important indicator of
how a society views the protection of private property rights. The ability to
do this is a social question which relates to all of us because value investing
can only exist if society permits the free exchange of such securities. And
until now, society has given us this permission.

Second, margin of safety. The margin of safety is a methodological

question. Its main difficulty is in the assumption of Mr. Market and the
construction of a circle of competence.

Let’s recall Mr. Market and what Benjamin Graham meant by him. Graham
said that we could imagine the stock market as a somewhat manic and not
too intelligent figure who first thing every morning would come to us calling
out prices. He doesn’t care if you are interested or not and will come
enthusiastically every day to cry his wares. But this guy’s mood is subject to
extreme changes. There will be times when he is optimistic about the future
and so his prices will be high. Then there will be times when he is
pessimistic about the future and so his prices will be low. For the most part
though, you can just ignore him. But when Mr. Market becomes extremely
worked up – either excited or depressed – you can use him to buy and
sell. This was the earliest description of Mr. Market at the time.

Now here’s the problem. When you are at school and hear about value
investing, you think it should be no big deal to put into practice. But as soon
as you get to work, you realise that there are real people on the other side of
every transaction. And that these people are better educated than you, have
more money than you, have more power than you, and have more
experience than you. In other words, they are superior to you in every way
and don’t at all resemble Graham’s Mr. Market. So after a while, after being
continuously scolded by your boss, you will feel that Mr. Market and these
people are all better than you. You will start to have doubts. And this is the
first reason many people go no further.

Let’s turn to circles of competence. What exactly is a circle of

competence? What counts as something you really understand? When the
market is in turmoil and everything you own has lost money while
everything everyone else owns has made money – how do you know you’re
right and they’re wrong? This is why it is not easy to establish a circle of
competence, nor to answer the two questions I just posed.

2. FOUR QUESTIONS ABOUT THE PRACTICE OF INVESTING

The first topic I want to discuss is the difference between investing and
speculating. The second is the meaning of a circle of competence and how it
can be built. The third is an investor’s temperament. Buffett and Munger
will both say that temperament is the most important thing for an
investor. Some of this you are born with and some you learn later. What is
temperament and how can we cultivate it? The fourth is what the average
person can do to protect and grow their wealth if they don’t wish to become
a professional investor. Hopefully these four questions will cover the main
points in the practice of investing. And of course, we will spend the most
time talking about practical issues.

2.1 Investing and Speculating

First, we need to think about what the stock market is. What kind of people
are active in it and how do they behave? Then how do value investors fit
in?

The first modern stock market was established about four hundred years
ago, which isn’t that long ago in a historical context. Five hundred years
ago, the discovery of the New World let Europe enter a 100-200 year period
of high speed growth. This was the dawn of the Colonial age and saw the
emergence of several important companies. The concept of a company was
critical at that time because it allowed fast growing enterprises to raise
capital to fund their growth. Kings and Nobles didn’t have enough money on
their own, so they invited the common people to invest together with
them. This was the birth of the modern company. It let ordinary people
make use of their savings by dividing ownership into small pieces which
could be widely held. But ordinary people didn’t really understand how
these pieces would be priced, nor how the company itself would make
money. Therefore, the idea they came up with at the time was just to buy
and sell [at random].

This design suited the baser instincts of human nature: our greed; our
laziness and our desire to get rich quick. [The human heart is weak]. If
there is a way, we all want to take the shortcut to get to the top. We all want
to use the least effort to get the maximum reward. This is why gambling has
existed throughout human history. The earliest design of the stock market
pandered to these human needs and proved very successful. The most
important companies of the time were the East India Company and West
India Company, especially the former. The money they earned was quickly
re-invested and produced even greater wealth, creating a positive feedback
loop. But more and more people were also attracted to this practice of
haphazardly buying and selling. This created another trade: no longer were
people trying to guess the future results of the East India Company; they
were simply trying to guess the behaviour of other people buying and
selling the stock.

The stock market was a miraculous device with a positive feedback

mechanism: the more people participated in the market, the more
companies would list. And if these companies could ride a wave of long-
term economic growth, they could create more value and more new
products. Their equity would bring wealth to their owners and that wealth
would stimulate consumption. You can imagine all the positive feedback
loops in this system. So even though at the outset the stock market made
use of people’s instinct to gamble, if the economy could continuously
produce such companies, the system could sustain itself going forward.

About 400 years ago, another type of system slowly came into
being: modern capitalism and the market economy. At the same time,
science was also beginning a revolution which would last several hundred
years. The combination of the market economy and the scientific revolution
produced a phenomenon unprecedented in human history which lifted our
entire civilisation to a new level. Compounding is an astonishing concept
which most people do not comprehend. For example, how much will a
company’s earnings grow if it can compound them at 6-7% for 200
years? Most people will never have considered this question because it is
simply something that has never happened before in human history.

Before the modern era, there had never been a system in human history
capable of continuous compounding. But this is exactly what emerged 300
years ago. Stock market returns don’t seem to offer much in the short term
– and yes, much of their performance has come after America’s rise. But 200
years of continuous compounding has produced a return of more than a
million times. Compounding truly is astonishing.

And this kind of compound growth attracted more and more companies to
list. And the companies in turn attracted more and more investors. [All the
means of production were put to work]. This was a phenomenon which had
never been anticipated in the stock market’s original design.

From the beginning, the stock market had two types of people: investors
and speculators. One type forecasted companies’ future performance; the
other forecasted market participants’ short-term behaviour. What was the
difference between these people? What is the biggest difference between
investing and speculating?

The difference in their [approach] wasn’t large but it was in their results. [If
you invest in a company with a proven track record, then your investment
can grow along with its profits]. But if you focus on guessing people’s short-
term behaviour, there can only be one outcome: everyone’s wins and losses
will inevitably cancel each other out. This is a zero-sum game because if you
aggregate the gains and losses of all speculators in the market, they will sum
to zero. This is the biggest difference between investing and speculating: in
the end, the net result of all speculation is zero. Of course, there will be
some people who win for a bit longer; and some [who are taken for suckers]
without any chance to strike it rich. But with enough time, all speculation
ends in a zero-sum result. Therefore, due to their focus on short term
behaviour, speculators have absolutely no influence on economic growth or
a company’s profits. This is the biggest difference between the two groups.

Many people say they use a mixed system and are 80% investors and 20%
speculators. [About 70-80% of investors use such a mixed system]. If they
do it right – even by investing in the index – they will deliver returns in line
with the modern economy’s growth. But the rest will share the same result
as the speculators and their net results will amount to zero. Now that you
know the difference in these two groups’ results, you can choose for
yourself if you wish to be an investor or a speculator. There’s no right or
wrong; only a difference in the impact you will have on society.

Investors will bring all parts of society into a virtuous cycle, helping with
our modernisation – with modern societies being defined as those whose
economies have begun the process of continuous compound growth. I focus
on this issue in my “Sixteen Lectures on Modernisation” to which you can
refer if interested. But the speculative part [of the market] borders on a
casino and cannot be removed. This is simply a part of human nature which
cannot be denied – though we also cannot let it [run rampant]. Any time a
bubble [runs rampant], it causes harm – like 2008’s Global Financial
Crisis. So if we talk about the market and you understand the principle of
zero sum, you can look at these speculators as [the capital market
line]. They might have PhDs; they might be successful for a while; and this
will bring them money and status. But you should know in your bones that
ultimately, all speculation ends in nothing.

If your values are such that you want to contribute to society, then you don’t
need to have so much respect for speculators even if they appear superior to
you in all regards. This is a question of principle. But if you don’t
understand this principle, you will always feel that other people have more
money than you and are doing better than you. Another thing, why can
these kinds of people exist for such a long time? This goes back to one of the
special characteristics of the Asset Management industry. [Asset
Management should offer protection] but because of information
asymmetry, investing and speculation aren’t easy to tell apart. Speculators
have many theories, although those like the K-line are all very low-level
theories. The latest theories now use AI.

I always stress this point to make it clear for most of you. But I’ve never
seen any formal academic works discuss this issue with reference to a zero-
sum game. This really is a fundamental question, so why hasn’t anyone
discussed it? Most either haven’t figured it out or are intentionally avoiding
the topic. Why might that be? In fact, [they receive] an “ignorance tax” – or
we can call it an “information exploitation tax”. The Asset Management
industry exists in large part thanks to this ignorance tax and many people
owe their living to the “information exploitation tax”. If they can quickly
show some profits, they can immediately go out and market
themselves. And if they can let the whole world know, everyone will come
and buy. Then regardless of future results, they can take their 1%
management fee – or even 2%. And why should they care after
that? They’ve already made their money.

Real investors who can deliver returns can earn a bit more [but not
everyone is the same]. It’s hard for anyone to say who’s good and who’s not
without a long period of time. And when these theories get so complicated,
we can’t say immediately whether they’re right or wrong. Therefore, it’s
critical to distinguish speculators from investors. The concept of Mr. Market
is paramount. If you aren’t willing to pay this ignorance tax; if you aren’t
willing to make your living from information exploitation; then you must
stay away from speculation. If you want to contribute to society, then even
if you can’t make it as an investor, you must still stay away from
speculation.

This is why it’s so important to understand this concept and make it

clear. Because if you haven’t figured it out – no matter what you think you
know right now – once you start work, you will be bombarded with other
ideas. You will immediately feel that they are right and what you thought
you knew was wrong – the concept of Mr. Market is a red herring. But
everyone please remember that speculation is a zero-sum game. This is
why speculators do not have long-term track records and do not manage
large sums of money. There are some who do OK in the short-term, though
they mainly rely on [something shady] to make money. For example, if you
conceive of some AI technique, you can probably guess who is buying and
what they’re buying. For example, before MSCI included China A-shares in
its indices, you could build up positions legally in anticipation. [But even if
you made money, it wouldn’t be much]. There is no long-term future in
speculating. Only investors can build long-term track records.

Let me in passing just comment as to why index investing is

acceptable. Index investing is basically the summation of investing and
speculation. Since the net result of speculation is zero, the remainder must
be the results of investing. Isn’t that right, mathematically? Long-term
index investing works therefore but only in some places, namely those that
have entered the modern age and can endogenously produce continuous
compound growth. Moreover, the index must represent all companies in the
economy to capture its overall economic performance.

2.2 Circles of Competence

So if you don’t want to count on information exploitation or to pursue a

zero-sum game, the way forward is to become a proper investor. But how
do you do it? [For this, we’ll delve into a bit of history]. When we invest, we
use fundamental analysis to forecast a company’s future economic
performance. You figure out why and how a company earns money; how
much it will earn in the future; what kind of competition it encounters; and
its competitive positioning. During this process, you will establish your own
circle of competence – the question now at hand.

You might understand this principle and think it sounds pretty good. But
which companies should you look at? Where should you begin? You might
also think you understand something after doing some research. But is it
enough? Do you know enough to buy shares? And at what price should you
buy them? These questions are very specific and faced by everyone in the
industry. Of course, if you’re the seller, you can sell at any price. You just
have to say the price and then justify it later in your spreadsheet. But if
you’re using your own money, the way you do things might not be the same.

The Circle of Competence is the core question for an investor. How can you
build one? It’s different for everyone because everyone’s efforts will be
different. I can share with you how I did it. I entered this industry
completely by accident about 27 years ago. I had just gone to America as an
exchange student and owed a pile of money. I didn’t know anything about
business and worried how I was going to repay my debts. People of my
generation in China in the 1980s had no money whatsoever, so prices in
America just seemed astronomical.

I struggled to think how to earn some money until one day a classmate told
me about a lecture to be given by some guy who had made a lot of
money. The notice said there would also be a free lunch. I went to the
classroom but it looked a lot like this one, not like the tables you’d normally
expect if there was going to be food provided. Where was the lunch
then? My friend told me the speaker’s name was Buffett – ‘buffet’ with an
extra ‘t’. I was still learning English at the time and hadn’t figured it
out. But since this guy had the audacity to call himself ‘Free Lunch’, I
thought he must know something, so decided to stay and listen. And it was
worth it: what he had to say was far more valuable than any free lunch.
In the past, my understanding of the stock market was basically that it was
full of bad guys. But Mr. Free Lunch wasn’t like them at all. He was very
smart and what he said was clever and insightful. I could understand his
principles as soon as I heard them. And I felt like what he was doing was
something I could do too. I don’t know why I suddenly felt this as he was
speaking, as I certainly wasn’t capable of doing anything else at that
stage. Wouldn’t it be alright though if I was good with numbers? The
mathematics, physics and chemistry I’d learned at home in China were good
enough, so I immediately sought out more information to read. And the
more I read, the more I thought I really could do this.

Buffett was strong in theory and in practice. I could understand everything

he wrote in his letters. I started to think of a way to find [potential
investments] with a margin of safety. They had to be cheap, of course. I’ve
already said I didn’t really understand business. I could analyse a balance
sheet as it didn’t need more than primary school arithmetic. I started
reading Value Line which covered several thousand companies. It had all
their basic financial information from the last ten years or so, all arranged
into categories so I could see which areas were the cheapest and what their
PE multiples were. I didn’t really understand PE at that time, nor did I really
understand the companies. Therefore, I focused only on balance sheets,
comparing price to net asset value.

I only looked at a few stocks in the beginning. I didn’t really mind what
business they were in as long as they weren’t losing money. If there was
cash or real estate, I discounted it by half. I believed in Mr. Market, perhaps
because I hadn’t had a proper job at that point, nor had I met any of those
haughty Wall Street folks. So I believed that sometimes the market gets it
wrong. I especially chose a few companies based near New York City and
went to see what they were like and if they were real. Although I didn’t
really understand what they did, they were all trading around book
value. This gave them an adequate margin of safety, so I dared to invest.

I discovered something else: after investing in these companies, I suddenly

became much more interested in them. It was completely the opposite of
what normal theories tell you. If I’d stuck to the classroom instead of going
out to learn for myself, I would never have felt this connection nor felt like
I’d learned enough. But as soon as I’d made my investments, I felt like these
were my companies. I really took Buffett’s teachings to heart.

Note: The transcript of the next three paragraphs is a bit unclear, so I have
edited the text slightly to better match what I understand from other sources
to be Li Lu’s meaning.
The first lesson was that stocks represent partial ownership in a
business. That’s why I felt these were my companies. Every day, I would
head over for a look to see what they did, since I hadn’t really figured it out
yet. For example, the major asset of the first company in which I ever
invested was acquired by a cable company called TCI (Tele-Communications
Inc.). TCI was the largest cable company at the time and it paid a premium
of about 100% [for these assets] over my company’s then market value. TCI
was involved with other, similar companies but I didn’t really know what it
did. It had a lot of licences but its revenue was completely out of proportion
to its market value. So I went to ask and learned that it had spent a lot of
money buying licences over a long period of time. These were recorded at a
very low price on the company’s books but were worth a lot more.

Why they were worth so much, I didn’t know. I thought they might be worth
at least twice as much. In short, TCI had acquired a lot of cable
companies. Since TCI had acquired my company’s main asset, I began to
think TCI was mine too. And so I became very interested in TCI and started
researching it. Cable companies operate in a local market in which you
require a licence to operate. Without a licence, competitors cannot
enter. Customers pay their cable fees one month in advance, so revenues
are good and these companies can be leveraged. Putting it all together,
these are actually quite simple businesses. Using cheap finance, TCI could
buy smaller companies and each time it did, its earnings would increase. It
was just mathematics.

What’s interesting is that a novel product called the cellphone appeared

which suddenly gave these licences a new use. TCI said it had enough
licences to build a national cellphone network and that it could also become
an “Interactive” company. [TCI was ultimately acquired by AT&T, which
sent its President to become CEO of the new entity, AT&T Broadband (now
Comcast)]. TCI had been a relatively unknown company until then but with
this, it became a sensation. The share price rocketed up some 7-8x. It was
pure luck and I was at sixes and sevens, which is to say I thought there was
no longer any margin of safety. I remember that even after I sold, I still
wasn’t sure – even today I’m still not sure – if I understood the
business. The experience taught me a lesson though: if there is enough
margin of safety, you might as well go have a look and learn something.

I realised later that we change after buying a stock. To say that a stock is
partial-ownership in a business is a psychological concept. I hadn’t
understood this before but got it once I had made my investment. It’s no use
being an armchair general and talking in theories. But as soon as I had
bought shares; as soon as I had become an owner, I realised I cared about
everything. For example, I remember there was a security guard at that
company who didn’t let me in once. So I spent an hour talking with him
about how guards like him were hired. I truly saw myself as an owner. I
was very interested and it really helped my understanding. Because of this
experience, I began researching Cable and then [Telegram], which was also
very interesting. I realised later that I often share this example because it
was my first experience and I still remember it vividly. There were similar
companies later [and I started understanding them one by one]. [The
condition was just that there should be a margin of safety]. After I had
invested, these other companies began vigorously expanding their
businesses. And this told me that their value wasn’t on their balance sheet,
per se; it was in their earnings power – their ability to make profits.

I didn’t really understand big companies, so I found some small ones. When
they were based near New York, I could go and check up on them. There
was no problem just to chat with the guards at the entrance because after
all, they were hired by my company, right? I realised that [this made me
kind of special].

I discovered I was also interested in companies competing within the same

industry. There were two gas stations at an intersection near my home. I
saw that cars would always stop at one of the two, regardless of which
direction they were heading. Prices at the two gas stations were about the
same and of course, their product was identical because they were both
made to the same standard. I thought this was very strange. And since
these companies were in my neighbourhood, I felt I had to go have a look
and figure out what was going on.

The gas station which attracted all the customers was run by a family of
Indian immigrants, who all lived there too. Whenever customers came, the
whole family would be there to serve them. Someone would come out and
offer a glass of water. Whether you wanted it or not, they would always
offer it to you first and then have a chat. If the kids were home from school,
they would come out and help you tidy up. The other gas station was run by
a typical [American]. The gas station didn’t belong to him as he was just an
employee. He didn’t care what was going on outside. He would just stay
inside and never come out. He wasn’t a bad person; he just did his job. And
because of this difference in attitude, I realised traffic at one gas station was
at least three times higher than the other.

I began to understand the importance of ‘owners’ talent’ in how a company

makes money. Why should one earn more than the others? These two gas
stations were just classic because they were identical in virtually every
way. However, thanks to a small difference in their service, one had almost
three times as much traffic as the other. For [the Indian family], this was
their livelihood. If they didn’t win customers’ business, their kids wouldn’t
be able to go to school. At the other, the employee would be fine regardless
because all he did was collect a salary. So from this point on, I began paying
attention to a company’s management, its competitive advantage and which
of those advantages were sustainable. Later, we began selecting 1 or 2 small
companies which had especially strong competitive advantages.

When we just started our business, the Asian Financial Crisis broke out. Oil
also fell to less than USD10 a barrel. We discovered that we could invest in
some of South Korea’s exceptional industries via their preference shares,
allowing us to invest at prices of just one to two times earnings. When we
got to Russia, the price of oil had fallen from USD25 to USD8 a barrel. We
could invest in the largest oil company there based on its reserves and pay
just three to five cents on the dollar. I felt like there was no risk with these
investments, so we bought both. I use these examples to illustrate that
when you are building your circle of competence, you only need to
understand your margin of safety. You don’t need to understand everything
else. This is the first point.

The second point is that when you start looking at things from an owners’
point of view, your understanding of business will be completely
different. And the best is if you don’t even think like an investor but instead
like a business owner – although this is hard psychologically. Why do we
treasure our own things even if they aren’t the best? It’s just human nature
once something becomes ours. Your own kids are always the best, kind of
thing. Human nature has its swings. Once you see yourself as an owner, you
will find ample motivation to learn.

When analysts join our company, the first thing we do is to send them to
study some companies. We ask them to assume an uncle they’ve never met
before has passed away and left them the business. What should they
do? They suddenly inherit this asset but have no idea what it is. You must
call a board meeting and participate in the discussion. This is the mental
model we ask them to use when they conduct their research.

What we do today is exactly the same. We research and discuss every

company as if we owned 100%. The first thing you need to do is go to the
company. If you bump into the security guards, have a chat with them. How
are our security operations doing? Are they up to scratch? How are our HR
policies? [These are the kinds of questions you need to think of.]

The third point is that knowledge is indeed cumulative but you must always
maintain intellectual honesty. It’s very hard to be objective because we are
emotional creatures. We are willing to give people the benefit of the doubt
when it’s in our own interest, often leading to overconfidence. We always
predict events will be good for us. But objectively, that’s not how the world
works (even if this possibility cannot be strictly ruled out). In short,
intellectual honesty is vital. Knowledge is accumulated bit by bit. When you
have the right approach and are doing the right things, you will see that
your knowledge accumulates in the same way the economy grows. It’s a
process of compounding. If I hadn’t [made those investments I described
earlier], I might not have understood other investments as well when I came
across them later. It was very helpful to have that knowledge already. All
these experiences will corroborate and reinforce each other so that you
gradually develop a grasp of some topics.

The last thing is that you should let your passion be your guide. Don’t listen
to what others think of you. They have nothing to do with you. You only
need to manage your own affairs well. If you see an opportunity, go look
into it. If you are interested in something, these kinds of opportunities will
continue to increase your knowledge. So don’t be worried. The result
though is that everyone will have a different circle of competence. What you
want to invest in is an attitude because it will require a lot of time to build
up your understanding of something. It’s the same for every stock. The
ability you develop will help you to make accurate forecasts in a small
number of things inside your realm of ability. For example, Mr. Dong
Guangyang has a connection to alcohol and doesn’t spend time on anything
else. Accept that your circle of competence will be small and don’t worry
about everything else. Making money doesn’t depend on how much you
know; it depends on whether what you know is right or wrong. If what you
know is right, you will not lose money.

These are just some personal experiences. Each of us can go out and build
our own circle of competence. However, overcoming our innate nature and
psychological biases is another very important question in practice. If you
begin practicing investing, these issues will all surface. Today we will go
through them first and then we can come back later to talk about any
questions you might have.

3. A VALUE INVESTOR’S TEMPERAMENT

I’d like to pose a question: what kind of person suits being a value
investor? Does value investing require any special attributes? Buffett and
Munger always say that what makes a value investor successful isn’t IQ nor
his experience; it’s his temperament. What does this mean? With all my
years of experience, I also think that some people are suitable, and some
aren’t. So what kind of people are suitable then?
3.1 It’s the Inner Scorecard that counts

[The right person] will use his own yardstick and not others’. For example,
some people find happiness in how others see them. If other people don’t
like your handbag, then you might feel it was a waste to buy it. For some
people though, it’s enough to like the handbag yourself regardless of how
much you paid for it. These two types of people are not the same. People
who invest must be independent. That is to say, they must use their own
yardstick and not pay attention to other people’s evaluation. This is a
personality trait and some people are just born with it. This is very
important to investors because there will be temptations at every
moment. And if you think you don’t have any, there will always be the
temptation to feel jealous of other people, like those who just made a lot of
money. I won’t go into this any further as I’m sure you all get it now.

3.2 Stay objective and rational; dispel emotions

If a person can be objective, emotions will have a smaller influence over

him. We want to see how someone acts. There are some people who make a
pursuit of being objective and rational, holding these up as moral
principles. These are the kinds of people who suit investing. [However,
because investing is about objectively analysing all sorts of issues,
evaluating these traits over the long term is very hard]. If you go beyond
the balance sheet to evaluate a company’s earnings power, it is no mean feat
to evaluate the company’s competitive advantage and ability to maintain its
profits over the next ten years. You must maintain an extremely objective
stance and be willing to learn continuously. This is another important
personality trait.

3.3 Extreme patience combined with extreme decisiveness

This attribute is relatively special because it is contradictory: [an investor]

must match extreme patience with extreme decisiveness. If there are no
opportunities, he must be able to wait for years without doing anything. But
once there is an opportunity, he must be able to act without hesitation. I’ve
known Munger for 16, 17 years. We dine together once each week and have
talked many times. He subscribes to Barron’s magazine, a weekly periodical
from the Wall Street Journal. He’s read this magazine for forty or fifty years
for the purpose of finding investment ideas. And can anyone guess how
many ideas he’s found in that time? One. He’s found just one
idea. Moreover, he didn’t know that it would take thirty years to find this
one idea.
Ten years after discovering this first idea, he has still not found another. But
he’s kept on reading the magazine. I’ve known him for so many years and I
know he will read each issue every weekend. To have such patience is a
unique attribute; to be able to do nothing and then suddenly to dare to put
all your money into an idea when you find one. We won’t go into details but
this investment was a multi-bagger for him. In sum, this is an exceptional
temperament. You must have extreme patience. When there are no
opportunities, you must prepare diligently. And then when an opportunity
comes, you must take strong action. This is an excellent quality to have.

3.4 An extreme interest in Business

What really motivates you? Many people don’t know what motivates them
to take such a strong interest in business. Munger has a very strong interest
in business. He just naturally mulls over how and why a business is making
money; what competition will look like in the future; whether the business
will still be able to earn money in the future. He’s always just wanted to
understand these things. This interest drives his reading. When there
aren’t any opportunities, he’s not worried. But when there are ideas, he
bites quickly.

The combination of these qualities isn’t very natural. However, when they
are combined, they make for an exceptional investor. Some are innate and
some are learned. An interest in business is something you can cultivate
gradually. But I don’t think extreme patience and extreme decisiveness can
be taught. Without some reward, most people would have given up reading
Barron’s after thirty years. I’m close to Munger so I’ve observed him
clearly. And he really is like this.

Independence is also hard to come by because most people will be

susceptible to other’s influence. Most people will care deeply about what
others think, and hold others’ attention and opinion as their standard. If
you are like this, it will be hard to endure.

The combination of these attributes is far more important than IQ. IQ and
academic achievements don’t matter that much. If they were, then Isaac
Newton would have been a stock market genius. But as everyone knows, he
almost went bankrupt speculating in the South Sea Bubble. He bought in
right at the peak and invested his entire savings, with the result that his
family almost became destitute. This happened to Newton and it happened
to Mozart. Do you really think you’re smarter than them?

But you don’t need an IQ that high, nor to be a genius. I studied Physics and
always wanted to win a Nobel Prize. But when I entered the Physics
Department [at University], I realised that everyone there was smarter than
me. I didn’t pursue the subject, although some classmates did and are now
doing relatively well. This profession doesn’t demand you to be especially
smart, nor to have a high IQ or the best academic credentials. Nor does it
require any outstanding prior experience. None of these things are of much
use. This might make you happy to hear if you don’t have any of
them. Because I’ve seen too many people who possess them be seduced into
speculation.

You must persevere. You don’t need to be a graduate or have an MBA but
you do need a strong interest in business. I think in a way it’s like playing
golf. There is absolutely no relation between this hole and the last
one. Every hole is independent. You might have got a hole in one on the last
hole but how about the next one? You must keep your cool and not get too
excited otherwise you won’t get it in. The temperament you need for golf is
like what you need for investing. Meditation can help you see your blind
spots more clearly. For example, it can help you to develop patience. Some
of this is innate and some can be learned. Another thing is that if you don’t
do something for a while, you will forget how to do it. Once you’re out of the
business world, your [acumen] will slowly disappear.

Some people say they just don’t have this temperament. My suggestion is
not to force yourself to do something to which you’re not suited. You can
find someone to help you instead. You don’t have to become a professional
investor. You can always find something else to which you’re suited and in
which you’re interested. Like Professor X who flies around the world. It
seems exhausting but he’s never tired of it. You must be like this; everyone
must be like this. Or look at Mr. Yao, who spent more than a decade
developing his retirement home business. Most people wouldn’t persist if it
took that long for things to work out. But he was very content while he was
doing it and never worried what others might think. You need to find your
“game” and this game should be one in which you can learn and get better.

4. HOW CAN THE AVERAGE INVESTOR PROTECT AND GROW HIS

WEALTH?

4.1 The Four Ways to Protect and Grow your Wealth

I’m going to talk about the average investor now because many people won’t
want to become a professional investor or won’t have the opportunity. How
can you protect your wealth then and gradually increase it?
First, I think cash can be a good fundamental investment decision. When
you don’t have any other ideas, cash can be a good choice. At the least, it’s
better than throwing money around speculating.

Second, there is a place for index investing if a stock market can reflect an
economy’s overall condition. If the economy grows at 2-3% in real terms
and we add 2% inflation, then we’ll get 4-5% nominal growth. Corporate
profits should grow slightly faster than this too. So if you get 6-7% growth,
this will deliver a pretty good result over your lifetime. You don’t need to
worry about what returns everyone else is getting, however great they tell
you they’re doing. As soon as you hear it, you’ll know they’re speculating
and aren’t worth listening to. You need something reliable. So what’s
reliable? It must be sustainable. And if it’s not, then index investing does a
pretty good job of reflecting the economy’s aggregate performance, so isn’t a
bad choice. Of course, if you can find an exceptional investor that will be
better. But finding exceptional investors isn’t easy.

Actually, I’d like to organise a congress for asset managers in China where
we’d all volunteer to record our returns. Investors are now calling their
funds “products” and I really don’t understand it. It’s like they’re in a
factory, just pumping them out. And if you don’t have one or two hundred
products, then you aren’t a successful investor. In the end however, you
can’t tell what their results are. In contrast, we’ve only ever had one fund in
23 years and no change. All the money has been in this one fund, which I
think looks a bit better. If you can find this kind of genuine value investor, it
will be a good choice. When you must choose, make sure first that the
person isn’t a speculator. Do this carefully. Then make sure he has the right
temperament.

Third, investors must have a deep understanding of their profession and a

long track record. Within the scope of his circle of competence, an area
without as much competition will produce better returns.

Fourth, this person shouldn’t be too old so that we will have a long runway
in the future during which our money can compound.

If you can find someone who meets all these conditions, count yourself very
lucky.

4.2 Faith in Compounding and Value Investing

The biggest taboo for investors is to be like Newton and be seduced by the
market: to buy at the market’s hottest peak and to sell at its most
depressed. If you don’t participate in speculation and stick strictly to
investing in what you understand, then you won’t lose money. If you’re
determined to invest for yourself, then that’s fine. But since personal
investors have limited time, your portfolio must be concentrated in the few
ideas you really understand. Don’t be afraid of concentration though
because you’ve got the time, energy, experience in your chosen areas and
the long-term time horizon. The worst thing you can do is to pay the
“information exploitation tax”. Ordinarily, the management fees on the
funds you might see work only for the managers. This is their “information
exploitation tax”. It’s great for them but not for you, so it’s important to
understand the basic principles. With compound interest and the right
approach, your wealth will grow gradually and in time become quite
sizeable.

Most people don’t believe in compound interest because it’s so rare in our
lives. For example, our own wisdom has the highest chance of
compounding. But due to the way most people study, their knowledge will
age and never accumulate. Therefore, they won’t see even the most basic
compounding. The average person will almost never see this kind of
compounding. They don’t think about it either because it’s so hard to
conceive. But if you’re interested in investing, you must already be different
from other people. You will understand the power of compound interest,
Einstein’s so-called ‘Eighth Wonder of the World’. The more you
understand the power of compound interest, the more you will understand
how hard it is to obtain. So when you find an opportunity offering
compound interest, it won’t seem so [intimidating]. The best and most
important thing is to have a long enough time over which to compound. Our
suggestion to the average person is to only do things you understand and to
stay away from everything else.

Finally, I’d like to discuss whether value investing is a kind of faith. In fact,
it is a question of morals: you are unwilling to exploit others; you won’t
participate in zero-sum games; you will look for win-win situations; you
want to make money in a way that benefits society; you will be someone
who abides by these ethics.

[We’ve all seen lots of people at the casino who keep coming back but just
look depressed. It seems pointless for them to go but they’ve become
[addicts]. In the end, they’ll lose everything. If you tell yourself it’s OK to go
to the casino because it’s just for fun, that’s one thing. But if your values say
otherwise, you need to keep your distance from unacceptable things like
this].

Don’t do things you don’t understand. And remember that understanding

something means being able to make accurate forecasts over a long period
of time with a high degree of confidence. Accepting this definition is akin to
a moral principle or value. [If this is a faith, then you must go and obtain
verification, after which you can experience the test of despair]. Your
feelings will be all over the place, at least at the beginning.

But over time, these values will become a part of your life and you will
[reach nirvana]. Your interests will be related to business, and from these
you will gradually build up your circle of competence. Within your circle of
competence, you will move skilfully and easily, setting you apart from
others. I’ve realised that successful investors all live far from financial
centres. For example, Buffett lives in Omaha and I live in Seattle. Places like
Beijing, Shanghai, New York City or Hong Kong are not necessarily the
best. All those highfalutin’ people are just noise.

Why is it called noise? Because it ultimately produces next to nothing. If

you remember anything from what we’ve discussed today, it should be the
idea of a zero-sum game. Although it’s not often mentioned because so
many people in this industry make their living from the “information tax”,
this is a simple mathematical concept: the net result of all speculation is
zero. Just remember that next time you encounter some highfalutin’
statement, you can treat it as Mr. Market. Benjamin Graham’s description of
Mr. Market still holds water.

Finally, I want to say that the whole process of investing is especially

interesting. At the time I started investing, it was a way to make ends
meet. Then I discovered there’s much about it that’s special. It forces you to
learn continuously. You will clearly feel your knowledge, practical
experience and judgement compounding. You won’t just feel your assets
and returns compounding, already a phenomenon which doesn’t occur in
real life. If you can feel your ability, wisdom and experience growing in a
compounding way, then it is especially meaningful.

When I was younger, I always wondered what is the meaning of life, either
for ourselves or for society. Later I realised that [knowledge] is the meaning
of life because it can change both our own lives as well as society.

There is an important difference between the world of people and the real
world we observe. Entropy increases in the real world we observe as
energy flows from high to low, and the big devours the small. Once this kind
of world reaches a certain stage, it will die. But people are different. Our
world can be turned into one in which entropy decreases. People can go
from ignorance to possessing great skill. Through self-cultivation, they can
become virtuous and succeed together with society. What we’ve learned
can today create extraordinary things that had previously never before been
imagined in China. Since man’s arrival, the earth has changed. And now we
can even leave the earth to go into space. We can change our
environment. Everything is now possible.

I’ve talked about my first investment when they were doing cellphones –
wireless telephones. I never really figured out what it was. Now 26 years
later, which of us can leave his mobile phone behind? The world is
undergoing great change. The internet is changing us profoundly. From my
personal experience, investing is a wonderful thing because it has allowed
me to experience a process which reduces entropy. Studying investing –
particularly the true path of value investing – has been a process which
reduces entropy. During this process, you can help the world to create new
things. In fact, you can do a lot and help not just yourself but also others.
Gurus, Investing15 April 2020