For someone who has achieved a great amount of success as an investor, Li Lu is relatively unknown.
Charlie Munger (Trades, Portfolio) thinks so highly of Li that he actually trusts him with his own money. In fact, at one point there was speculation that Munger and Warren Buffett (Trades, Portfolio) would peg him as their eventual successor at Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial).
Li thinks of himself as an old school value investor who aims to take advantage of market gyrations causing mispriced opportunities. In a talk with students at San Francisco State University back in 2012, Li explained how he determines his margin of safety.
Two important criteria
For Li, the margin of safety for any given investment depends on the quality of the asset being purchased. The weaker the business being bought, the wider the margin needs to be.
Oaktree Capital founder Howard Marks (Trades, Portfolio) likes to say that there is no asset so bad that it can’t be a bargain, and while this is mostly true (and value investors should definitely remain open to investing in distressed businesses), you still need to be exceptionally careful when doing so.
A second criterion that Li added was the depth of understanding of the business. In order for a value investment to be a success, the investor needs to have some kind of unique insight into what that set of assets might generate in the future. The more certain you are, the narrower you can allow your margin of safety to be.
Li provided the example of an investment he made in Russia in the early 1990s, when previously state-owned oil and gas companies were being sold in the open market for prices as low as half of one cent on the dollar. Although he didn’t have very deep knowledge of Russia, Li felt that these prices were simply too good to pass up:
“I know very little about Russia, and had every reason to be suspicious of the investment, so I wanted a margin of safety of 99%, and got extremely uncomfortable when that went to 80% [when prices for Russian oil companies began trading up to 10 cents on the dollar, according to Li’s estimated]... Each situation is different, but in general I have to understand the external forces, the management, the general business practices. Generally I think a 70-80% margin is pretty good”.
Li acknowledged that these are very wide margins. However, he also noted his belief that it is better to invest infrequently and well, rather than frequently and inefficiently. In other words, you don’t have to swing often, but when you do, you should swing for the fences.
Disclosure: The author owns no stocks mentioned.
Read more here:
- The Value Investor's Handbook: An Introduction to Enterprise Value
- Buffett and Munger Explain Their See's Candy Investment
- Mohnish Pabrai: Don't Think Too Much
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