Phase IV B – Studying the History and the Ecosystem
The biggest frustration I had in 2015 and 2016 as a professional investor was the negative surprises, which often led to dramatic stock price decline. Said differently, it’s the risks that I was not aware of. The other frustration was sometimes when I read the sellside reports or read earnings calls or conference transcripts, I had trouble understanding an important term whether it’s industry related or company-specific. I’ve written a few examples of such situations and discussed what I missed on DaVita (DVA, Financial), Discovery Communication (DISCK, Financial) and Colfax (CFX, Financial). It sucks to be so obviously ignorant, so after a few times I was determined to tackle that issue.
I’ve quoted Mr. Li Lu many times in my articles and it’s not by accident. The most important lesson I learned from him is on the subject of how to build a circle of competency. For reference purposes, below are his words that shaped my current research philosophy:
“So how do you really understand and gain that great insight? Pick one business. Any business. And truly understand it. I tell my interns to work through this exercise – imagine a distant relative passes away and you find out that you have inherited 100% of a business they owned. What are you going to do about it? That is the mentality to take when looking at any business. I strongly encourage you to start and understand 1 business, inside out. That is better than any training possible. It does not have to be a great business; it could be any business. You need to be able to get a feel for how you would do as a 100% owner. If you can do that, you will have a tremendous leg up against the competition. Most people don’t take that first concept correctly, and it is quite sad. People view it as a piece of paper and just trade because it is easy to trade. But if it was a business you inherited, you would not be trading. You would really seek out knowledge on how it should be run, how it works. If you start with that, you will eventually know how much that business is worth.
A certain industry might have characteristics that make it different than others. In certain industries you might have better prospects than others. Find the best of the players in the industry and the worst players. And see how they perform over time. And if the worst players perform reasonably well relative to the great players — that tells you something about the characteristics about the industry. That is not always the case but it is often the case. Certain industries are better than others.
So if you can understand a business inside out you can then eventually extend that to understanding an industry. If you can get that insight, it is enormously beneficial. If you can then concentrate that on a business with superior economics in an industry with superior economics with good management and you get them at the right price — the chances are that you can stay for a very long time.
The essence of investing is to predict the future. Understanding an industry and a company requires judgment of what the business fundamentals will be in 5 or 10 years. It’s not an easy thing to do. When we invest a company, we have to at least understand in the next 10 years what the fundamentals of the business will look like? How would the business’s fundamentals be affected in a downturn? Otherwise, how can we estimate the downside of the investment? We have to make a good guess of the business’ cash flow for the next 15-20 years if we were to do a DCF calculation. But even if you were the founder of the business, do you really know what the cash flow will be for next year? You can’t say with absolute confidence that you can predict the future business development for the next 10 years. Very few people can do that. There are too many uncertainties. For most industries and companies, it’s impossible to see 10 years out. But there are some industries and companies that are predictable. If you spend enough time doing the research, gaining experiences in the industry, you will find out that you really can tell how the business will behave in the next 10 years during normal times, good times and bad times. It requires years of diligence, research and relentless learning. When you can make this judgment (10 years outlook), you are starting to build your circle of competency. Your circle will be extremely narrow starting out and it requires a very long time to build it. That’s why value investing is a long journey and very few people can make it to the end. It requires a huge amount of commitment but you may still be much ignorant even if you spend much time for many years.
If you can’t tell the edge of your circle of competency and if you step outside of your circle, you will be destroyed by the market at some point.”
I know, it’s a long quote. But it’s worth reading every word. For me, Li Lu’s wisdom provided an answer to the question I had earlier – how can I avoid negative surprises? And the answer is - I have to know the business inside out by building a circle of competency. It sounds simple, but it's extremely difficult.
To this day, I honestly still can’t claim that I know one business inside out. But I think I know a little bit better how to build a circle of competency: You have to study the whole ecosystem, not just the company and its competitors. You have to go out and study the upstream and downstream partners. In some case you have to understand how the government thinks (regulation). And if possible you also have to understand how the business is positioned from a national competitiveness point of view.
In December last year, I wrote an article on my journey of building a circle of competency in the pharmaceutical industry. After more than two years, I still can’t claim that I’ve built that circle yet. The health care ecosystem is quite large and complicated. In order to build the circle, I have to understand how MCOs, PBMs, distributors, hospitals and even health care IT businesses work. And my to research list is frustratingly long.
Again it’s extremely difficult to practice what Li Lu’s preaches because it takes so much work. So is Zhang Lei’s approach. I think Li Lu’s approach and Zhang Lei’s approach are more similar than they are different – they all boil down to gain an ultra-deep understanding of the business they invest in. I’d go so far to argue that they start from a much higher level than 99% of the value investors. Their mind-blowing returns speak for the effectiveness of their approaches.
Final thoughts
As you can tell, I went from an infant seven years ago to a baby today in terms of figuring out how to do real deep fundamental research. Perhaps every value investor goes through the same phases but some stop at some point and some continue to evolve after some bottleneck. I have been stuck for a while but Li Lu and Zhang Lei provided me with some hope.
To be clear, I’m not suggesting that everyone should take on Hillhouse or Himalaya’s approach. I happened to have both U.S. and China experience, so Li Lu and Zhang Lei’s approach naturally attracted me. You have to find the research approach that makes the most sense for you, based on your personality type, experiences and specific personal conditions, (such as work and family). The most important lesson is that there’s always something we can improve for our research process. And the most important thing is to keep learning and improving.
