In my previous articles, I shared my notes on a few topics discussed by Li Lu in his recent interview with Barron’s China. Most of the topics covered in my previous articles were big picture questions, but Li also offered more specific advice on what a value investor should do during the current crisis.
Consider all risks
When asked about how investors should react to black swan events such as the Covid-19 crisis, Li said that all kinds of risks should be considered in the margin of safety analysis, even the extreme events such as a pandemic, a plague, or a severe economic recession. Investors should be able to assess what the fundamentals of the business would look like in extreme environments. If the principle capital can be preserved under the most extreme scenario, there’s sufficient margin of safety. The possibility of a pandemic should be included in the risk analysis prior to the occurrence of Covid-19, not afterward.
The difference between buying and holding
To many investors, the difference between buying and holding is not clear cut. Here, Li made a fantastic point on the difference between buying a security and holding on to it:
“All investors will face this problem (of whether to buy or to hold). In fact, at any time, you should consider whether the company's future growth and its value still match. When you buy and hold, you think differently. You need a larger margin of safety when buying. But once you have bought the company, your understanding of the company will become more and more profound, and at this time you may have accumulated a lot of unrealized gains. The calculation of value versus price has changed. In addition, your ability to predict the future of the business will also change after buying. Therefore, at this time (when you hold), you can accept a broader range of values for this business. The margin of safety (of holding) comes from a deeper understanding of the company, especially the certainty of future growth.”
Margin of safety and low interest rates
When asked about the impact of the current ultra- low interest rates around the world, Li said that the low interest rates certainly have an impact, but how big the impact is depends on whether this phenomenon can be sustained. He then added that ultra-low interest rates in major countries are rare in history. He is skeptical to the view that this new interest rate level can be used as justification for sustained high valuation levels.
Li believes that in the long run, if interest rates remain this low, there will be some negative consequences such as inflation and the potential damage to investors' confidence in the U.S. dollar. Therefore, Li thinks that if investors use the current interest rate as the "discount rate" in the investment model to value the company, they obviously do not think about the margin of safety very clearly.
First, the current low interest rate levels could be a very short-term and special abnormal phenomenon. Second, low interest rates are not a sign that the economy is getting better. In fact, theyr'e a sign that the economy is under extremely difficult conditions. So at this time, you should ask for a larger margin of safety, not a smaller one, as has been the trend in markets recently.
Why Buffett sold the airline stocks
When asked about his opinion on why Buffett sold all Berkshire’s holdings in the airlines, Li said although he hadn’t discussed it with Buffett directly, he understood why Buffett sold them. First of all, the U.S. aviation industry is indeed on the verge of bankruptcy. Even now, we can't judge exactly how long the pandemic will last. As long as the pandemic exists, the airlines will face loss pressure. No matter how excellent the airline’s operation is, it is impossible to bear a long-term loss without going bankrupt. There is the possibility that the U.S. government may bail out one or more of these airlines if they become insolvent, but that is certainly no guarantee that the equity of airline investors will not wiped out.
Li added that if you really understand Berkshire Hathaway, you’ll find out that Berkshire’s equity investment has become less important to its business value.
Read more here:
- Notes From Li Lu's Recent Interview - Part II
- Notes From Li Lu's Recent Interview - Part I
- Amazon- Still Day 1?
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