THE PRACTICE OF VALUE INVESTING, BY LI LU - NOVEMBER 29TH, 2019

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” .

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.

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 skillfully 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.