Very Cheap Stocks: How Li Lu Exploits Opportunities
This article on very cheap stocks and how Li Lu exploits opportunities was written by Evan Bleker. Evan is a small investor employing Graham's highest performing value investing strategy, net net stocks. In 2014, Warren Buffett explained that the net nets he bought in the 1960s helped him achieve the highest returns of his career. Evan has been studying Buffett’s early investments since 2010, and stumbled upon 4 rare articles written by Warren Buffett himself that cover his highest conviction picks in the 1950s. Download these original articles in How To Choose Deep Value Stocks Like A Young Warren Buffett for FREE right now. Click Here. Article image (Creative Commons) by Image Genie, edited by Net Net Hunter.
Investing in very cheap stocks that trade below their liquidation value has consistently outperformed the market in the long term. It is one of the oldest investment strategies, with Benjamin Graham writing about it in the 1930s in his investment classic Security Analysis.
Warren Buffett made a name for himself starting in the 1950s with his Buffett Partnerships and returns that were in excess of 40% a year. His preferred strategy during this time was what he called “Cigar Butt Investing”, an investment style he learned from the Dean of Wall Street himself, Benjamin Graham.
As his capital grew and information became more freely available, these opportunities dwindled, forcing Buffett to refine his investment criteria, looking for long-term value, not cigar butts. However, the legacy he left when seeking dirt cheap asset plays helped launch the careers of many tremendous investors, most notably Li Lu, who adopted Buffett’s earlier approach in the 1990s — a period that was notoriously difficult for value investors.
Li Lu would go on to produce outstanding long-term returns during one of the most difficult markets in recent history. Using the same investment strategy of looking for companies trading below their liquidation value that Buffett used during his partnership days and the same strategy Graham had openly discussed decades before, Li proved the timelessness of investing in very cheap stocks.
Very Cheap Stocks: Warren Buffett’s Cigar Butt Approach
Buffett’s best performing approach to stock selection was undoubtedly his 1950s cigar butt strategy. In Berkshire’s 2014 annual letter, Buffett wrote:
“The many dozens of free puffs I obtained in the 1950s made that decade by far the best of my life for both relative and absolute investment performance.”
One of the best examples of a cigar butt was his investment in Western Insurance Securities (Western) in 1953. From the start, Buffett’s preferred approach was obvious: good businesses selling for dirt cheap prices, below liquidation value. Western was just such a company. Trading at $40, a 55% discount to its book value and quoted at less than twice its earnings per share, this is exactly the type of net net Buffett loved to invest in during his partnership days.
He further explained extra factors that expanded his margin of safety and made this stock all the more attractive for investment. Amongst them was that Western was a rapidly growing business, not a declining one, giving Buffett confidence that it could increase its earnings. In a weak year for its industry, Western’s premium earnings were enough to cover its senior charges 10 times over! This gave Western a healthy current account surplus. Finally, Western had a very conservative investment style and never relied on debt to fuel growth. These were all bonuses for this net net.
Within the article, Buffett highlighted Western being a very cheap stock relative to its assets, its stellar management, the company’s conservatism, and additional factors that Buffett in his later career would refer to as a “margin of safety”.
When a master investor tells you how he earned his best returns, it pays to sit up and listen. But Buffett didn’t simply recount the numbers he was able to stack on the scoreboard. In the 1950s, Buffett wrote a series of articles for The Commercial and Financial Chronicle that highlighted exactly how he selected his cigar butts — Western being one of them. In 1951, at the age of 21, he wrote in the same publication about another very cheap stock, one that is still going strong: Government Employees Insurance Co, more commonly known today as GEICO.
Li Lu and Very Cheap Stocks: 1950s Buffett Revisited
The late 1990s were one of the toughest periods for value investors due to historic stock market valuations. These headwinds did not stop one investor from launching an exceptional career. His name was Li Lu and, after stumbling onto Warren Buffett as a student, Li was inspired to pick up the torch as chief of Himalaya Capital Management.
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 stuck by his investing principles despite the terrible first year and has posted an average return of 30% since — this in a decade where the S&P produced a negative return!
Very Cheap Stocks: Hunting for Net Nets Internationally
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 net net 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.
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 to shares. The issue 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, a marketplace and the general uncertainty around Russia during this rocky period meant that these companies were trading for huge discounts. How huge? In the oil sector, where the five-year average price for a barrel of oil was $20, the largest Russian oil companies, with huge oil reserves, were trading for as low as 1 cent on the dollar, some even half a cent. This huge discount equates to these companies trading at 10 cents per barrel of oil!
What made these very cheap stocks particularly attractive to value investors such as Li Lu was 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.
To really drive home the margin of safety that very cheap stocks that are net nets 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!
How Li Guarantees a Margin of Safety
Li Lu continued to look to Buffett for inspiration and incorporated other criteria from the Oracle of Omaha. We saw from the series of articles that Buffett wrote in his youth that he had meticulously researched the insurance business — it is no coincidence that insurance makes up such a huge share of Berkshire. This was his circle of competence, and his research allowed him to spot mispricing in the market on these stocks.
Another quality that Buffett always looked for was stellar management. Even in his Western Insurance article, he made a point to mention of the CEO and his quality management. Even at this young age, Buffett correctly saw how important a factor this was.
In order to post such outstanding returns during the difficult times that Li started investing, he decided to take all the strategies that Buffett had pioneered in his early partnership days and improve on them in his own way.
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.
“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.” — Charlie Munger
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.
While China was just starting its boom decade and was still under-researched and untrusted by most investors, Li saw a huge opportunity. Li’s circle of competence consisted of high-quality, yet very cheap stocks and China, and he combined the two for spectacular results.
Li’s story should remind investors that there are always opportunities in the market; you just need to know where to look. That is why looking for net net stocks internationally is key to high long-term returns, especially if you happen to have an informational edge in a specific country.
The Secret to Long-Term Outperformance
Net net investing may seem risky, but there is an inherent margin of safety attached to investing in such very cheap stocks. As Benjamin Graham himself put it:
“Successful investing is about managing risk, not avoiding it.”
A solid margin of safety manages that risk, as we have seen from the examples above. Investing in high-quality net nets creates the basis of this margin of safety, while sticking to an area of competence and focusing on net nets with stellar management only compounds it.
In today’s market of unrealistic valuations, an investor needs to refine his approach much like Li Lu did. Simply buying low price/equity may not be enough anymore. In order to maximise the odds of outperformance, you need to follow in the footsteps of Benjamin Graham, Warren Buffett and Li Lu, where you not only stand to take on less risk than the market as a whole, but you will also tend to outperform it in the long term.
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