Li Lu on How to Survive a Stock

Li Lu (Trades, Portfolio) is a legendary value investor who is the founder and portfolio manager of Himalaya Capital Management, an investment firm with $2.38 billion in his portfolio of 13F US stocks and over $18 billion dollars of assets under management.

Charlie Munger (Trades, Portfolio) previously called Li a “genius” and credits him with inspiring investment in Chinese electric vehicle maker BYD Co. (SZSE: 002594, Financial), who was one of the Berkshire Hathaways (BRK.A, Financial)(BRK.B, Financial) most successful investments, as it turned a $232m stake into ~$5.6bn (assuming Berkshire kept the stake unchanged until recently; as it’s not a listed position in the United States, the company is not required to disclose minor changes to the position).

In an interview last year with Columbia Business School Professor Greenwald, Li revealed insight into his investment strategy and life philosophy. The original interview lasts over an hour and a half; here are my top eight takeaways.

1. How to handle a stock market crash

Last year, Li said we were living in “unprecedented times” due to Fed liquidity injections, inflation and rising interest rates. He said: “Money tends to promote the primordial part of human nature… Our attitude is that a financial crisis will happen all the time.”

To survive the expected boom and bust cycle that results from people’s approach to money, Li said he “looks for businesses that can weather crises and even thrive. If you weather the ups and downs, your return will be about equal to the companies return on invested capital.”

The quote above helps to keep in mind that in the long term the stock price should correspond to the company’s return on its invested capital, but in the short term it is difficult to see this.

Most people don’t have the temperament to be a great investor because you need to be able to see your portfolio drop 40% and not make irrational decisions out of reflex because of it. As Li said, “We are good at rationalizing but not at being rational.”

2. When to buy stocks

Li has a disciplined value investing strategy and is happy to find a “great company” and then passively wait for the “price to reach our strike zone” before buying. This is very similar to

warren buffet (Businesses, Portfolio)’s style of “waiting for the right pitch”.

“We buy stocks when they’re trading at a discount to their intrinsic value,” Li said. During a crash, Li said he was happy to “buy more when the stock goes down.” .

3. Characteristics of large companies

Asked about his criteria for what constitutes a great company, Li replied:

“A great company has an above-average return on investment…These companies usually attract competitors because everyone wants great returns on investment.”

Return on Invested Capital (ROIC) represents a company’s return on its investments. For example, if a business has five stores and earns a 15% return on each, it knows that by building more stores it can replicate that return. It is a good indicator of a sustainable business model and can be calculated by dividing net operating income after tax by invested capital.

4. Competitive advantages

Li went on to explain that a “great company” not only needs a high return on invested capital, but also the ability to “beat out competitors.” Doing so requires a “sustainable competitive advantage” and a “long streak of growth.”

Buffett’s investment strategy focuses heavily on companies with a competitive edge, or moat. Types of competitive advantages range from network effects to brand recognition, pricing power or even economies of scale.

According to Li, it is very difficult to find these “big companies”.

“They’re really rare…Only a small portion of all businesses fall into this category…If you’re lucky enough to find a long-term picker, own them for a long time.”

5. Excellent management

Investing in companies with excellent management is another key tenet of Li and Buffett’s investment strategies. As Li said, “Management’s ability to allocate capital plays an important role.”

Li gave the example of Berkshire Hathaway as a company with excellent management and an expert capital allocator (referring to Buffett and Munger). He said: “Berkshire started out as a lousy textile company, but Munger and Buffett took that capital and invested in companies with better returns on capital.”

At a previous shareholder meeting, Buffett had mentioned that the worst investment he had ever made was the first “Berkshire Hathaway”, which was a loss-making textile factory. However, as Li points out, Buffett’s genius was to reinvest the profits of this business into other businesses with a better return on capital.

Li also mentioned the importance for investors to have a “business owner mentality” and “intellectual honesty” in order to invest in your skill circle.

6. Li and Munger’s friendship

Asked about his relationship with Buffett’s right-hand man, Li said Munger was “the most influential person in my life.” He was inspired by Munger’s ability to “maintain a rational composure and a common-sense approach to all matters of business and life”.

Li also talked about the importance of having a role model and someone to learn from.

7. Generalist versus Specialist

Li believes that investors should take inspiration from many fields as generalists, but when considering investing, we should aim to be a “specialist”. know more than others to give themselves an advantage.

“We study successful companies and ask whether this success can continue,” Li said.

8. Invest in China

Asked about the prospects for investing in Chinese stocks, Li said he was optimistic about investing in China, saying “the Asian economy will become a more important part of the global economy.”

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