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Stepan Lavrouk
Stepan Lavrouk
Articles (605) 

Advice From Li Lu

The guru discusses his circle of competence and the dangers of shorting stocks

September 21, 2020 | About:

Himalaya Capital founder Li Lu is a value investor to his core, espousing many of the same principles as Berkshire Hathaway's (NYSE:BRK.A)(NYSE:BRK.B) Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio). In a 2013 interview with the Graham and Doddsville newsletter (written and published by students at the Columbia Business School), Li dispensed some important advice for investors.

Defining his circle of competence

Like any investor from the Buffett and Munger school of thought, Li believes you should only deploy capital in areas and asset classes where you have some sort of expertise. But what about his own circle of competence? It has expanded over time:

"I let my own personal interests define my circle of competence. Obviously I know something about China, Asia and America - those are things I am really familiar with. I have also over the years expanded my horizon. I started looking for cheap securities. When you start out, you really have no choice. You don't have enough experience, and you don't want to lose money, so what do you do? You end up buying dirt-cheap securities. But over time, if you are interested in businesses as well as securities you begin to become a student of business… Over time, I really fell in love with strong businesses. I morphed into finding strong businesses as bargain prices."

What's interesting to note here is the implication that buying cheap businesses with a wide margin of safety is actually the best course of action for a novice investor. This would seem to fly in the face of conventional wisdom that newer investors should stick to well-known companies in the large stock indexes.

Himalaya doesn't short stocks

Although he is obviously a very astute investor, Li doesn't short stocks. One reason for this is his desire to be a constructive investor, but another is purely pragmatic - even if you are right on a short thesis, you can still lose all of your money. He gave four reasons for this. First, the upside is capped at 100%, while the downside is unlimited (because a stock can theoretically keep rising forever).

Second, the costs of "borrowing" a stock to short can add up to an amount that makes the whole venture not worth it. Since frauds can be perpetuated for a long time, this makes shorting a dangerous business. Third, Li believes that shorting requires a different mindset to long-only investing, and that trying to be good at both is just distracting. And finally, he pointed out that since the overall trend is for markets to go up over time, it's easy to lose money on the short side just due to rising economic fundamentals.

Disclosure: The author owns no stocks mentioned.

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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