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Grahamites
Grahamites
Articles (398) 

Notes From Li Lu's Roundtable Session - Part I

Li Lu answers questions regarding the current investment environment

September 13, 2020

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.

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About the author:

Grahamites
A global value investor constantly seeking to acquire worldly wisdom. My investment philosophy has been inspired by Warren Buffett, Charlie Munger, Howard Marks, Chuck Akre, Li Lu, Zhang Lei and Peter Lynch.

Rating: 5.0/5 (13 votes)

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Comments

asawhneyy
Asawhneyy - 2 months ago    Report SPAM

What he is investing in? DJCO or

batbeer2
Batbeer2 premium member - 2 months ago

What he is investing in? DJCO or

No, it is the reverse. DJCO's portfolio is based (in part) on his ideas.

jjprojects
Jjprojects premium member - 2 months ago

Thanks for this, he is a great investor and worth listening to.

tmuscat27
Tmuscat27 - 2 months ago    Report SPAM

now you can expand on how to value a stock and on what metric,fcflow,earnings,book value.

every one is short on examples and explanations.

tm

btthus
Btthus - 2 months ago    Report SPAM

Where is part 2?

poolgmac
Poolgmac premium member - 1 month ago
What does Novation Companies OTC NOVC, DX, OCN, COOP & NCT aka NRZ New Residential SNR, NEWM and Drive Shack DS have in common?

Answer Fortress 31.3M NOVC Shares & Barry Igdaloff 36M NOVC Shares (these shares include proven group of investors especially Thomas Akin, Todd Emoff, Howard Amster all DX investors with Igdaloff who is a Board Member of both DX and NOVC). Together these investors successfully restructured Dynex Capital DX 2000-03 from pennies to over 10 per share and today DX pays .13 to .15 MONTHLY Dividend. In addition, Fortress Mr. Wesley Edens restricted Newcastle Inv Corp NCT (Edens 2013-16 Chairman of the Board COB of both Newcastle NCT which is now NRZ, SNR, NEWM and new name for NCT is DS Drive Shack). I believe these investors will restructured Novation Companies Inc OTC NOVC exactly like they restructured these other organization especially DX and NCT which Edens turned at 5 stock 2013 into four separate public companies taking NCT from $5 to $45/aggregate share paying est $4.50 annual dividend at 3 of the 4 MREITs. I believe they will copy this restructuring of NCT at NOVC which holds the exact same attributes.

I believe these investors are working very closely with other NOVC investors Mass Mutual & sub Barings that own 19.3M or 20% of NOVC and former DX COB/CEO Thomas Akin who owns est 5M NOVC shares. Fortress restructured Newcastle Inv Corp and I believe Mr. Wesley Edens and Mr. Barry Igdaloff will restructure NOVC by leveraging powerful and profitable/seasoned collateral assets on most of $3 Billion RMBS, Non-QM NQM mortgage loans.

All discussions are confidential as I hold 18M 16% with handful of other investors. Note since 1/1/2020 est 22.3M NOVC Shares have traded yet last 10K 2019 (released 3/23/20) revealed 114M Common Shares Outstanding Dilute and 713 Shareholders of Record (not including those SR inside street names). This is important as new investors should be able to buy as many shares as they desire up until these powerful investors disclose their true plans to restructure NOVC just like they did at Newcastle Inv Corp NCT and Dynex Capital NYSE DX.

Value Investment Thesis: NOL, MBS experts with Fortress (Peter Briger, Wesley Edens, Co-CEO/COB) 25%, Mass Mutual, Barings 20%, EJF Capital & White Mountains Frank Bazos thanks to me who worked with Board members Barry Igdaloff, Howard Amster and 3 appointees of investors I recruited Chuck Gillman, Jeff Eberwein, Whitney Tilson (Trades, Portfolio) & more own at least 36M or 32%? New investor can buy as many shares as they want, just check the volume.

Executive Summary:

Overview

I believe Fortress Wesley Edens/Peter Briger Co-CEOs, EJF Capital Co-CEOs Manny Friedman, Neal Wilson will spin off from Novation Companies Inc. OTC NOVC 100% owned MREIT Novastar Financial Inc. NFI and use (generate est dividends $2.33/share under tax exempt MREIT structure) collateral assets on most $3B portfolio RMBS, NQM loans (600 WAC). These collateral assets come from the attached Service Rights Transfer Agreement Section 5.04 entitled Cleanup Call Rights to most of $3B portfolio 600 Bpts WAC. These collateral assets can be resecuritize and leverage (10:1) at NIMs close to 500 Bpts creating an annual dividend est $2.33/share all under the tax exempt status per IRC MREIT rules.

Fortress will use NOVC $730M NOLs to positioned 2nd public co as SPAC center around HCS www.healthcare-staffing.com. FVAC is a SPAC Fortress just merged MP Materials.

Why do I believe this because Fortress Mr. Wesley Edens controls NOVC with past co investors Barry Igdaloff. Fortress and EJF Capital do this via CDOs that hold all of NOVC Sr Debt. Note documents show Fortress and EJF Capital have hidden behind these CDOs and paid little to almost nothing for CDO Service Rights that own all of NOVC Sr Debt. This thesis is based on Fortress executing the exact same restricting at Newcastle Inv Group NCT see slide 4 of Mr. Edens own Dec 2016 presentation to shareholders after the fact. By waiting they enabled investors in the know to buy NOVC at pennies or take half their positions at pennies. This is exactly what I believe they are doing at NOVC as explained by the PowerPoint deck below link. Fortress, Barry Igdaloff and their co-investors especially Thomas Akin (ex-COB of DX) and Mass Mutual and sub Barings own at least 86.6M or 75% of NOVC. I have a shareholder count of half dozen investors that hold 18M or 16%. In total this is 105M of 114M commons shares outstanding dilute (includes 22.3M Ten Year Warrants given EJF Capital and Fortress at One Penny Strike).

http://ir.driveshack.com/Cache/IRCache/a1b2ee64-5797-45c5-953a-7aed241fbd80.PDF?O=PDF&T=&Y=&D=&FID=a1b2ee64-5797-45c5-953a-7aed241fbd80&iid=4040318

Just like Wesley Edens achieved at Newcastle Inv Group NCT now called Drive Shack, DS, New Residential NRZ, New Senior SNR, New Media, NEWM they will turn NOVC from penny stock into 2 separate public companies (both either tax exempt per IRC rules or operating with 730M NOL) trading aggregate $28/share 1 paying an attractive dividend, both tax exempt or tax favored with $730M NOL. Fortress owns 28% of Novation Companies, Inc. OTC: NOVC with their Sr Debt partners EJF Capital C0-CEOs Manny Friedman, Neal Wilson along with blue chip investor Mass Mutual & sub Barings also own 19.3M 20% and Barry Igdaloff (Board Member today at both DX & NOVC ) and known other close investors to Igdaloff that own at least 36M 32% of NOVC Shares.

It is appropriate to note DX Investors lead by Barry Igdaloff restructured Dynex Capital NYSE DX 2000-03 from pennies to over 10 per share with the help of Wesley Edens who at the time was COB of both Fortress and CMO Capstead Mortgage which owned DX.

It is important to understand the experience and relationships of these NOVC Co-Investors because new investors can predict the future with greater reliability once they understand what they have done their history is a certain forecaster of how they will behave. New investors should want to align this investment thesis with the experience of Fortress, EJF Capital, Barry Igdaloff, Thomas Akin & Mass Mutual & Sub Barings, (Fortress Co-CEOs Peter Briger x Goldman Sachs & Wesley Edens x Blackrock, Manny Friedman, Neal Wilson Co-CEOs at www.EJFcap.com also co-founded FBR Friedman, Billings & Ramsey, D.C. + Thomas Finke, Chief Investment Officer, Mass Mutual & Barings.) Make a lot risk a little.

Two documents support this thesis which splits a penny stock into two public companies: both tax favored one tax exempt MREIT paying dividends + positions remaining corporation as SPAC/Blank Check Corporation with $728M NOL & Healthcare business, exactly like Fortress accomplished at other reorganizations, DX, CMO, OMF, NST/COOP, NCT/DS.

1. Service Rights Transfer Agreement sec 5.04 attached to Q3 2007 10Q.

2. Link below to NCT/DS reorganization plan executed by Wesley Edens, Chairman of the Board at both Fortress and Newcastle NCT now called Drive Shack, DS. Fortress owns 31M NOVC shares 28% with Sr Debt partners. Mass Mutual & sub Barings own 19.3M shares 20%. NOVC has the exact same attributes as NCT now called DS, DX, NST now called COOP, CMO, OMF, all reorganized by Wesley Edens, COB of Fortress.

http://ir.driveshack.com/Cache/IRCache/a1b2ee64-5797-45c5-953a-7aed241fbd80.PDF?O=PDF&T=&Y=&D=&FID=a1b2ee64-5797-45c5-953a-7aed241fbd80&iid=4040318

I believe these experienced investors many with history investing together, will turn a penny stock Novation Companies, Inc. OTC NOVC into two separate tax exempt/favored companies worth over $2-3B market cap $28/NOVC share in aggregate & paying est 2.33 per share annual dividend. They have executed the exact same plan before at DX and DS aka NCT.

Barings & parent Mass Mutual (Blue Chip Investor with Trillions in AUM) hold 19.3M shares 20% of Novation Companies, Inc. OTC NOVC + Fortress 28% (manages $40B AUM & lead by Co-CEOs Peter Briger ex Goldman Sachs & Wes Edens, ex Blackrock) & EJF Capital (manages $10B AUM) hold 31M shares of Novation Companies, Inc. OTC NOVC (9M+22.250M Warrants) & control all Sr Debt via CDOs they hold. Sr Debt has fair market value FMV of onlky $17M per recent 10Q Q2. Investors Thomas Akin/Talkot Capital & Barry Igdaloff (go way back with Fortress as both sat on Board at Dynex Capital NYSE: DX) they hold 36M shares 32% of NOVC, the max allowed by Poison Pill (protects $728M NOLs from IRC sec 382). These investors own at least 75% of Novation Companies, Inc. OTC NOVC 86M of 114M CSOS per 10K.

I have a shareholder count of less than 6 investors that hold and do not trade 18M NOVC Common Shares. It adds up to 87M+18M = 105M of 114M common shares outstanding dilute (which means SDH Fortress 22.250M Ten Yr Warrants at 1 penny strike are included). NOVC 2019 10K certified by Top 100 CPA firm Boulay Group shows 713 Shareholders of Record SR (not including SR inside street names). Days ago 1.9M shares traded yet only 10M shares are available to be held by the remaining 713 SR + inside street names and millions trade in a single day. Very odd indeed.

NOVC has good reason to copy Fortress’ reorganization blueprint at Newcastle NCT which changed its name and symbol to Drive Shack DS. The link below defines this reorganization plan at Newcastle NCT before changing its name DS. Wesley Edens spun out NCT 3 tax exempt MREITs: NRZ, SNR, NEWM/GCI. Fortress will make billions off NOVC common equity which leads me to believe the Sr Debt also owned by Fortress $17M FMV will be retired at discount.

http://ir.driveshack.com/Cache/IRCache/a1b2ee64-5797-45c5-953a-7aed241fbd80.PDF?O=PDF&T=&Y=&D=&FID=a1b2ee64-5797-45c5-953a-7aed241fbd80&iid=4040318

I believe NCT/DS reorganization blueprint will be copied by these same investors at NOVC, by spinning out as tax exempt new issue NOVC’s prior MREIT business Novastar Financial Inc. NFI structured as tax exempt NEW MREIT just like Fortress did at NCT prior to name change to Drive Shack DS – READ NCT deck above link - specifically blueprint overview on slide 4 & 5. NOVC aka Fortress will trigger cleanup call rights on most $3B collateral assets (see Bond Remittance Reports on NOVC web site www.novationcompanies.com and leverage into a dividend like Thomas Akin ex COB did at Dynex Capital and IMH. Akin sat on DX Board with Barry Igdaloff now with his HF Talkot Capital is one of the largest shareholders in NOVC.

Fortress is an expert in SPACs, NOLs, MREIT, MBS & I believe will position the remaining co NOVC as SPAC/Blank Check Corporation, with tax favored $728 NOL. Fortress’ CEO Wesley Edens was also COB of NCT/DS. NOVC owns 100% of www.healthcare-staffing.com $64M healthcare business with high moat, solid credit customers and room to expand 10-fold.

New MREIT will be tax exempt per IRC and generate an annual dividend estimate of $1-$2.33/per share (10% yield = 23/share pps) & SPAC $4-5 like DS estimate $28/one NOVC share today plus pay an annual dividend (see attached Service Rights Transfer Agreement sec 5.04 that allows NOVC aka NFI to call back very profitable/season collateral assets on most of $3B Non-QM/NQM RMBS portfolio. Fortress could cash est billion on just their 31.3M NOVC common shares. Fortress/EJF Capital have little cash invested in NOVC Sr Debt. Fortress would also collect annual dividend est $73M annual.

I believe to accomplish this reorganization Mass Mutual & Barings has an understanding with these investors. That understand is twofold:

1. Retire the Sr Debt at discount

2. Participate in private placement called Preferred Stock Series F which is defined in NOVC Form 14A Proxy 2018 Rights Offering pages 11-15, Preferred Series F. This document prices one NOVC common NOVC at $2.33/share (Mass Mutual cost basis) and provides for as much as 500M common equivalents. This would raise additional capital $1.165B cash providing for the retirement of Sr Debt at a discount, acquisitions to grow SPAC, HCS www.healthcare-staffing.com and monetize $728M NOLs (5 times NCT/DS NOLs $160M see slide 11). This will also provide cash to trigger the Cleanup Call Rights CCR per Service Rights Transfer Agreement section 5.04 and generate a tax exempt MREIT and annual dividend $1-2.33/share depending on leverage deployed. Once NOVC spins off the MREIT I expect NOVC shareholders will obtain 1:1 shares in New MREIT. I believe the PS Ser F is already pre-agreed to by these investors and represents the true reorganization plan at Novation Companies, OTC NOVC. Book value per share goes from negative to estimated $1.85/one common share. Investors in PS Ser F would make more than 10 times their $2.33 investment for financial engineering they already have done many times. NOVC formally exited Ch 11 4/19/19.

These investors have done it before especially at Newcastle NCT aka Drive Shack DS (e.g. Fortress collects 1.5% x equity at NRZ and collects dividends on 2.4M NRZ shares + 6.5M NRZ options DER), Dynex Capital NYSE DX (Thomas Akin was COB of DX & just left Board of IMH and Barry Igdaloff is a Board Member at DX & NOVC). Fortress has successfully reorganized companies like One Main OMF (selling Fortress 40% OMF to APO Apollo for $1.4B) and Nationstar NST (selling Fortress 68% NST to Mr. Cooper COOP for $3.8B, KKR owns 17% of COOP aka Washington Mutual WAMU).

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