Renowned value investor Li Lu recently held a roundtable discussion session with Peking University's Guanghua School of Management and Citic Publishing (the publisher of Li's book), in which he shared his thoughts on topics such as how to research a company and practicing value investing in China. He also answered many questions from the audience. Below are my notes from the Q&A session.
1. What should investors do when the stock of a high quality company is overpriced?
Whether the stock of a business is overvalued or not depend on your judgment over the future growth prospect of the business. You need to come up with an estimate of future growth, then calculate a range of intrinsic value. If the market price offers you a margin of safety, then it's a good investment. This is the general framework you should use. Each investor's level of understanding of a business is different. Therefore, each investor will come up with his own conclusions. No one can make the decision for you.
2. Should investors hold on to a company in light of management team's moral scandal?
It depends on whether and to what extent will the scandal impact the long term competitive advantages of the business. For instance, with consumer businesses, the image of the management team will impact how consumers view the brand. In this case, the scandal will have some negative effects on the brand. But it may not have a longer time impact. It also depends on how competitors react and other external factors. It's not that straightforward. If you can't make a judgment, you probably shouldn't be in the investment business.
3. If an investor currently holds a high quality company is priced at 40 to 60 times earnings and the future growth is estimated to be between 10% and 20%, should one sell the stock? When would you sell a great business?
This is an issue every investor will face during his investment career. Usually I sell a stock on one of three occasions. First, I sell a security if I make a mistake. The second occasion when to sell is when you find something that's better. By better I mean a better risk and return combination. You do that by constantly improving your portfolio's opportunity cost. And the third occasion when to sell is when the valuation swings way too much to the extreme high, or when the market price deviates too much from the intrinsic value. When this happens your opportunity cost becomes cash. Essentially it's all about opportunity cost. But it's not that easy because everyone's opportunity cost is different and everyone's understanding of opportunity cost is different.
Generally speaking, I would require a larger margin of safety when I buy a stock because this way when I'm wrong, I won't lose money. If I'm right I'll make money. But once you've held the business for some time, you start to understand the business from an owner's point of view. You'll find out that the business either gets better or gets worse. And your ability to predict the future prospects of the business also gets better over time. Therefore, you might not need a large discount when holding on to the business. The price at which you are willing to hold on to the business will be higher because you are more confident with your ability to predict the future growth. But when the price swings to the extreme high, you still have to sell because your opportunity becomes cash at some point.
It's an art. When it's at an extreme level the decision is easy to make. But there's a price range in which the decision to sell is relatively harder to make.
4. Traditional value investing has not been effective during the past few years in the ultra low interest environment. What should value investors do in this environment? Should investors lower the valuation standard? How should value investors get a margin of safety when everything is expensive?
We are talking about two questions here. First, what discount rates investors should use under the current interest rates? Secondly, what should value investors do during the period in which the traditional value approach doesn't work effectively?
With regards to the first question, yes we have experienced unprecedented low interest rates recently. We are talking about zero percent interest rates or even negative interest rates. Ultra low interest rates reflect extremely difficult economic conditions. It's not a normal state. Low interest rates mean people are not optimistic about the future. In other words, everyone thinks the future is worse than the present. If this is true, you should use a higher discount rate because if the future is indeed worse, the future growth will be lower and risk is higher. So you need a larger margin of safety, not a lower margin of safety. And secondly, it will take some time for the the negative consequences of low interest rates to take place. It could be inflation or devaluation of the currency. Many things can happen (to force the interest rates higher).
If you use a low discount rate now, you may justify a high valuation of many businesses but you also price in much optimism.
The second question is about ineffectiveness of the value strategy during a certain period of time. If you study the history, it has happened a few times (value underperforms). But this doesn't mean you should judge whether value investing works or not by this standard. It certainly doesn't mean you should lower your standard of margin of safety.
I've been in the market for 26 or 27 years. What I've observed is that authentic value investors have always been the minority. But today, at least in China, I see more and more investors call themselves value investors. But they may not understand the essence of value investing.
As Ben Graham said, in the short term the stock market is a voting machine and in the long term it's a weighing machine. If you are a true value investor, you shouldn't care about the voting results because ultimately intrinsic value is determined by the long term profitability and growth. It has nothing to do with how market participants vote. If you care about how they vote, you are not a value investor. The market is there to serve you, not to guide you.
5. How do you pick what companies to do research on? Is it top down or bottom up?
It doesn't matter whether it's bottom up or top down. What matters is how you measure a business. You are investing in a business. This business competes in an industry with its competitors. This company has its advantages and disadvantages. The industry has its pros and cons. Ultimately your understanding and analysis should focus on the future competitiveness of the business.
The long term prospect of business depends mostly on its competitive positions. If the business earns a high profitability and has a promising growth prospect, it will attract more competitors. If the business earns a lousy return on capital and has a poor future prospect, no one wants to enter the field. You probably don't want to spend any time researching it either.
So if you are interested in a business, you'll find out that you should focus on the long term competitive advantages of this business. What would the business look like in 10 years or longer? Can it sustain its competitive advantages in 10 years? Can it sustainably grow? Will it continuously earn a high return on capital? You'll find out that you will always circle back to the same question – the long term competitiveness of the business.
Read more here:
- Empiricism, Instrumentalism, Critical Rationalism and Value Investing - Part I
- The Agony of Ultra-Low Interest Rates
- A 3-Element Approach to Valuation
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