Li Lu Value Investing: Your Essential Guide
This article on Li Lu Value Investing: Your Essential Guide was written by Evan Bleker, founder of Net Net Hunter and author of Benjamin Graham’s Net-Nets, and Phillip Richards, a private investor and Net Net Hunter member living in London. Net net investing was Ben Graham's strategy of choice and even helped Warren Buffett earn the best returns of his career. Get our Essential Net Net Stocks Guide to understand this strategy in detail. Click Here. Article image (Creative Commons) by Rob Oo, edited by Net Net Hunter.
As an investor, Li Lu is one of the world's best-kept secrets, a hugely successful value investor producing very large market-beating returns year after year.
Li Lu's value investment firm, Himalaya Capital Investors, has reportedly produced a 30% compound annual return since inception in 1998, putting this little known investor in the same leagues as the greats, Warren Buffett, Charlie Munger, and Peter Cundill.
A $1000 investment with Himalaya Capital and Mr. Li Lu would have a total return of $321,000 compared to $6600 achieved by the S&P 500 over the same time period. It is no surprise then that Charlie Munger himself has entrusted his own money to Li Lu. But how exactly did Li Lu achieve such amazing returns?
Li Lu: A Superstar Value Investor Bio
Li Lu’s life didn't start as well as it has turned out. Li Lu spent his early life being rotated between adoptive families as his mother and father were sent to labor camps during the Chinese Cultural Revolution. He was born in Tangshan China where he studied Economics at the University of Nanjing before fleeing the country to study at Columbia University.
In his early life, he had no direction and was fighting in the streets as a pastime. It wasn't until his grandmother, one of the first women in her city to attend college, inspired him to start studying and reading that his life trajectory changed. This was a pivotal point in Li Lu’s life and where he started his journey to a fortuitous meeting with a relatively young Mr. Buffett.
Li Lu Escapes to the USA from China
During his time at university in China, he became one of the student leaders at the Tiananmen Square student protests organizing and participating in hunger strikes. Ultimately this led to Lu being chased out of the country and fleeing to America via France.
Mr. Li spoke little English when arriving in America but was welcomed as a hero and provided with scholarships in which he took full advantage, learning English and simultaneously earning three degrees in Economics, Law, and a graduate degree in business, impressive to say the least.
“When I first came to Columbia University, I was dirt poor. I did not choose to come here - I just ended up here because I had nowhere else to go, having just escaped from China after Tiananmen.”- Li Lu, Graham, and Doddsville, 2018, Issue 18.
Soon after graduating and being inspired by Warren Buffett, Li Lu setup Himalaya Capital Management in 1998, embracing the value investment principles of Benjamin Graham, Warren Buffett, and Charles Munger.
Li Lu's First Introduction to Warren Buffett
Li Lu’s first introduction to Warren Buffett was at a guest lecture at Columbia Business School in 1993, where Li Lu almost didn't attend. Li Lu recounted this story in an interview and explained that in his second year of study his friend invited him to a guest lecture of the famous Warren Buffett, knowing Li Lu was seeking ways to make some money.
Li Lu, however, misunderstood and thought his friend said there was a free lunch buffet along with an opportunity to learn how to make some money which was a good enough reason for Li Lu to attend. Thankfully he did and it transformed his life.
To Li Lu’s dismay, there was no free lunch. There was, however, a talk from Mr. Warren Buffett. This talk punched him between the eyes and flicked a switch to his life of value investing and ultimately to a life of learning with a byproduct of wealth.
The lesson here is not to walk away from a free buffet ...or a guest lecture from Warren Buffett!
Li Lu Launches His Value Investing Career
The late 1990s were one of the toughest periods for value investors due to historic stock market valuations. These headwinds did not stop Li from launching an exceptional career.
Unfortunately for Li, he launched his fund as the Asian Financial Crisis (AFC) began to take full effect and suffered a -19% loss in his first year. He would later recount:
“In my view, the biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. Not only is the mere drop in stock prices not risk, but it is an opportunity. Where else do you look for cheap stocks?”
Li’s character, forged partly through his Grandmother’s example and partly through his difficult escape from China, helped him stay the course after a tumultuous start. His stalwartness would soon pay off, as he uncovered what would prove to be one of his best investments ever.
Li Lu’s Russian Oil Investment
From the start, Li adopted sound investment principles that a young Warren Buffett would have loved. Chief among those was the search for very cheap stocks relative to net asset value.
Li’s belief is that the irrationality of the market is always providing opportunities for deep value investors if you know where to look and are willing to do the research. One such example he has talked about is his interest in the 1990s in Russian stocks, specifically oil stocks.
Deep value opportunity is often born in crisis. The USSR had just fallen and the newly born Russia was undergoing capitalist “shock therapy,” quickly privatising the previously government-owned conglomerates. As there was not yet a stock exchange to speak of, regular citizens and workers of these huge state conglomerates received issues, which were convertible into shares. The problem was that regular citizens had no idea what a stock share was, so in their eyes, they had simply received valueless paper.
This combination of lack of liquidity, an absent marketplace, and the general uncertainty around Russia during this rocky period, meant that these companies were trading for huge discounts. How huge? Li Lu explains:
“Forget about earnings, just consider the assets on the balance sheet. At the time, the five-year average for oil prices was about $20 per barrel and on a per-share basis, they were trading for as low as 1 cent on the dollar, sometimes half a cent on the dollar, so about 10 cents to 20 cents per barrel of crude oil. And that's not even counting the earnings from the company! It was ridiculous."
What made these very cheap stocks particularly attractive to value investors such as Li Lu was that this huge discount was not even taking into account the earnings of these companies. At the end of the day, these were still huge companies that held monopolies in the Russian oil and gas sectors, further adding to their moat and margin of safety.
Li Lu invested in Lukoil (LUKOY), a newly formed entity created by the Russian government, who later provided shares to the public. For those investors who saw this opportunity and took action their investment was up tenfold by 1998. The stock was listed over the counter in 1999 for $8, an enormous gain from just a few years earlier.
To really drive home the margin of safety that very cheap stocks provide, we can look at how investors in these oil companies would have done during the AFC when Russia devalued its currency by 90%. Investors who had bought shares in 1993 were still up tenfold on their investment after the severe market decline!
Li Lu Earns Shockingly Good Early investment Returns
Li Lu’s investment returns were so good during college, after hearing Warren Buffett speak and implementing his approach, that he actually made enough money to retire.
How did Li Lu earn such a high return?
The simple answer is a sound investment philosophy - buying dirt cheap but solid companies, a Li Lu twist on Warren Buffett’s classic Cigar Butt approach. The first thing Li Lu looks for when finding investment opportunities is the new low list, searching for very cheap stocks relative to the net asset value.
It is no secret that investing in very cheap stocks that are trading below their liquidation value has outperformed the market over the long term.
This is evidenced both in practice by super investors - Buffett, Cundill, and Schloss, and in the academic research of - Montier, Oppenheimer, Oxman et. el and Vu. The wisdom of this investing style was passed down from Graham, to Buffett and on to Li Lu who wielded the approach masterfully.
Li Lu’s early investment philosophy, like Buffett's during his partnership days, was to buy dirt cheap stocks. This fundamental principle of value investing appealed to Li Lu - buying good securities at a bargain price. In a Graham and Doddsville interview, Lu states this approach was very appealing to him, “If you are wrong you won't lose a lot but if you are right you're going to make a lot.” Monish Pabrai, a self-proclaimed clone of Warren Buffett has a similar approach and outlook - heads I will, tails I don't lose much.
Li Lu holds a strong opinion that the market is irrational and will provide value investors with plenty of opportunities so long as they are willing to put in the work and dig into the research.
Li Lu Invests in Timberland and Makes a Killing
This was evident with another one of Lu’s early investments in Timberland, a shoe manufacturing, and apparel company. The business was trading at what Lu called ‘clean’ book value which consisted mostly of tangible liquid assets, working capital, and 100 million in real estate. At this time, Timberland had no discount to tangible liquid assets but still provided an interesting and eventually profitable investing opportunity.
According to the Wall Street Journal, shares in 1998 were trading at 5x earnings which equated to $28 a share with 11.4 million shares outstanding, this resulted in a market cap of $319 million. The company at this time had current assets of $387 million, the entire company could be bought for less than the company's current assets (note: not net current asset value). Total liabilities stood at $203 million, so while not a net net, the stock had positive net current asset value and was cheap in relation to tangible book.
In addition, Timberland had steadily been paying down debt from 1996 improving its debt to capital ratio from a high of 53.4% in 1996 down to 27.3% in 1998. The company was also family-owned and controlled with the company buying back shares when statistically cheap, a good sign for fellow investors and elements that are included in the Net Net Hunter Scorecard.
Like many value investments, the company was out of favor with the market in this instance as a result of numerous lawsuits. However, within just two years the stock went up 700%, propelled by earnings growth of 30% a year. Li Lu had 20% of his portfolio in the stock and achieved a great return with relatively little risk.
This again highlights Li Lu’s approach to investing as well as further demonstrates several of the key concepts of value investing - markets can be extraordinarily inefficient and provide the informed investor with opportunities to profit significantly in such circumstances.
“In my view, the biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. Not only is the mere drop in stock prices, not risk, but it is an opportunity. Where else do you look for cheap stocks?”- Li Lu
It is not surprising then that Li Lu quipped that he was able to retire after college!
Charlie Munger Takes Li Lu Under His Wing
Charlie Munger has previously stated that he likes to partner with people and individuals who can be dropped into a completely new country or environment without any resources and still end up making a fortune.
After you start to understand Li Lu’s Investor background, it is clear to see exactly why Charlie Munger chose him to manage his money, this ability to thrive in a foreign environment, his outstanding results, temperament, discipline, and outlook. Buffett and Charlie Munger always invested in businesses they knew and understood, which translated to them avoiding much of the pain of the dot-com bubble bursting, as they did not want anything to do with the new tech darlings and their sky-high valuations. Li also stuck by his circle of competence, but instead of thinking of industry, he expanded it to include geography.
Much like Buffett decades earlier, Li saw the lack of deep value opportunities in American stocks and knew he had to look elsewhere. Luckily, Li was born in China, spoke the language fluently, and understood the culture.
In 2017, Munger revealed just how valuable Lu has proven for the Munger family.
"I’ve read Barron’s for 50 years. In 50 years I found one investment opportunity in Barron’s, out of which I made about $80 million. For almost no risk. I took the $80 million and gave it to Li Lu, who turned it into $400 million or $500 million. So I have made $400 million or $500 million out of reading Barron’s for 50 years and following one idea…I didn’t have a lot of ideas. I didn’t find them that easily, but I did pounce on one."- Charlie Munger, 2017, Daily Journal Shareholder Meeting
Charlie and Lu met through mutual friends and hit it off, talking about business, life, and investing. It was Li Lu who first introduced Charlie Munger to BYD, a Chinese battery producer and automaker. The Wall Street Journal reported in 2010 that since the initial $230 million Berkshire investment in BYD in 2008, Berkshire’s position has surged more than six-fold, generating profits of approximately $1.2 billion. Mr. Li’s own $40 million investment in BYD was worth around $400 million, not a bad return for a two-year investment.
Over time their relationship evolved into a mentor, mentee partnership, and even friendship. As occurred with Warren Buffett, Charlie helped to introduce the idea of buying a wonderful company at a fair price, a necessity with managing large sums (anything over $10-15 million) of money. A disadvantage of large investment funds, they don't get to benefit from the significant returns of net nets. Munger explained,
“He’s partly a Chinese Warren Buffett. That really helps, partly he’s fishing in China. Not in this over-searched, over-populated, highly competitive American market.”
Now, if you don't personally have any mutual friends with Charlie, both he and Warren have been generous with their time and you can learn to replicate their strategies through their writing, interviews, and the yearly Berkshire Hathaway Annual Meeting. A great resource when you have $10-15 million to invest. On the other hand, if you are managing $1 million or so, and you would like to build wealth like Li Lu, net nets are the way to go!
Himalaya Capital Proves a Major Winner
Himalaya Capital was founded by Mr. Li Lu in late 1997. Only one fund is managed by Himalaya Capital Investors, which Mr. Li Lu has been running continuously since its inception on January 1st, 1998. Himalaya Capital embraces the value investment principles of Benjamin Graham, Warren Buffett, and Charlie Munger, and today primarily focus is on publicly traded companies in Asia, with an emphasis on China.
Himalaya Capital’s aim is to achieve superior returns by being long-term owners of high-quality companies with substantial "economic moat," great growth potential, and run by trustworthy people. A lot has changed since Lu’s Timberland days.
Since inception Himalaya Capital Management has achieved a 30% annualized compound return and ballooned its portfolio from Li Lu’s initially borrowed $300,000 to over $9 billion. The fund runs a concentrated portfolio of currently only 4 companies, albeit this may only be the American holdings disclosed in Himalaya Captial’s 13F filing. Nonetheless, Li Lu likes to back up the truck when an opportunity arises.
Mr. Li once recounted that he even took a valuable lesson from watching the Soccer World Cup. “You may very well work extremely hard and seldom score, but occasionally - very occasionally - you get one or two great chances and you make decisive strikes that really matter.” Li Lu certainly concentrates on his best opportunities.
And, as Warren Buffett says:
"When it's raining gold, reach for a bucket, not a thimble.”- Warren Buffett, Berkshire Hathaway Annual Letter, 2009.
Himalaya Capital like Li Lu is constantly evolving, learning, and trying to develop -- a practice that individuals should take up as well. Himalaya’s origins were in buying very cheap stocks and traditional value investing, however as assets under management grew, Li Lu’s approach shifted towards wonderful companies at fair prices, again following in the footsteps of Warren Buffett.
However, it was not always plain sailing for Himalaya Capital, in the first year of operation the fund was down 19% and the Asian Financial Crisis had just begun. Evidently Li Lu persisted and has become one of the world’s best investors with Himalaya Capital becoming a major winner.
What Deep Value Investors Should Take Away from Li Lu
As those who have already requested free net net stock picks know, Graham’s original net net strategy has produced incredible returns since at least the 1930’s. Early in his career, before Himalaya Capital Management became a significant investment fund, Li Lu adopted a very cheap stock strategy. The results with Li Lu’s investor returns are a testament to the success of this strategy, however, the individual small investor can achieve similar if not better results over the long term and emulate Li Lu’s success.
For those who are or are contemplating a deep value investment style, lessons should be taken from those who have successfully implemented this market-beating philosophy.
Li Lu implements both a quantitative and qualitative process, a young Buffett/Graham value investing approach followed with a modern Buffett wonderful companies quality business style. Li Lu provides further evidence of how successful value investing can be and provides several key takeaways:
- Understand yourself - A value investor needs to be comfortable being in the minority. You will have to adopt the position that you are right because of your reason and evidence, not because others agree with you.
- Small and Concentrated - The small-cap advantage has shown that small-cap companies have outperformed larger caps over the long term. In part, the lack of coverage leads to outperformance. As was the case with Timberland and Li Lu, no analysts were covering the company yet it performed amazingly. Li Lu runs a concentrated portfolio at Himalaya Capital Management and only invests in his best ideas.
- Think Differently from the Market and Long-term - To achieve outperformance, individuals have to think differently which includes looking at the beat-up, downtrodden and unloved companies. Li Lu still prefers the quality variety of the downtrodden but a contrarian outlook is helpful in these instances. The key to success for the small investor is locating the parts of the market where investors are selling for reasons other than a fundamental assessment of value. “The single greatest edge an investor can have is a long-term orientation.” – Seth Klarman.
- Demand a Margin of Safety - Price is what you pay and value is what you get. Buying companies for less than liquidation value provides a huge margin of safety as too does buying wonderful companies at fair prices. Again Seth Klarman provides a great definition: “A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.”
- Be patient but decisive - Warren Buffett often says "be fearful when others are greedy and to be greedy only when others are fearful." This is certainly the approach Li Lu takes when it comes to investing and has been proven true over the years with the examples given above.
As an investor, Li Lu’s approach is simple but it is not easy - find undervalued securities and back up the truck. Much like Buffett, his investment approach had to develop and evolve over time but he started out buying very cheap stocks and outperforming the market building his wealth along the way.
Is Li Lu the world's best investor? Possibly. Few can argue that he has not led an extraordinary life, created extraordinary returns for his investors, and is worthy of study. The best place to start on the journey of becoming a Li Lu investor is to invest in yourself and start your education today.
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