In 2014, Himalaya Capital and Peking University's Guanghua School of Management teamed up to offer a value investing course for students of Peking University. The course is offered in each fall semester and is taught by Peking University's Professor Jiang Guohua and Himalaya Capital's Chang Jing.
I had the honor to sit in for the class sessions last year. It was a fantastic learning experience. This year, the class will be held online. Throughout this month and next month, I'll be sharing my notes from the class sessions. Below are my notes for Chang's first lecture.
What is value investing?
There are many investment styles that can be broadly categorized into two categories – arbitrage and investing. Arbitrage is about finding temporary mispricing of securities and profiting from the mispricing. Investing is about profiting from the value created by the underlying assets. On one extreme of the arbitrage style is high frequency trading. On the other end of the spectrum is value investing.
You can also categorize investment styles by passive versus active, conservative versus aggressive, fundamental analysis versus technical analysis and short term trading versus long term holding. Every style is different. As value investors, we also have to differentiate ourselves.
Value Investing can be defined according to four dimensions:
- Stocks represent fractional ownership in businesses.
- The concept of Mr. Market (as defined by Benjamin Graham
- Margin of safety: The essence of investing is predicting the future of a company. Future is a probability distribution of different outcomes.
- Circle of competency.
Fractional ownership in a business
Legally speaking, when you buy a stock you own a stock certificate, which grants you certain legal rights as a shareholder. But because the certificate is tradable and liquid, arbitrage opportunities exist.
You can also choose to be a debtor, not a shareholder. There are rights available to debtholders only and there are certain rights only available to shareholders.
Controlling shareholders' interests might be very different from those of minority shareholders. As minority shareholders you always have to think about whether there's alignment of interests. As value investors, you have to have an owner's mentality.
Being a long-term investor
First of all, you can enjoy the power of compounding being a long term investor. One dollar invested at 5% will get you $4.30 after 30 years, and at 15% it will get you $66.20 after 30 years. But the most fundamental reason is what is often called "Li Lu's Law," which can be described as "the sustainable continuous compounding growth of the economy due to a combination of technology and market economy."
How long is long term? Three years? Five years? 10 years? As a value investor, you have to figure it out for yourself. Otherwise you are like that quote from John Maynard Keynes, that goes, "In the long run, we are all dead."
Intrinsic value vs. market price
A good example of this is water and diamond. In the dessert, water is more valuable than diamond. The moral of the story is that price is determined by supply and demand, but value is determined by utility. Intrinsic value can only influence price indirectly but cannot set the price.
The value formula
Chang defines the "value formula" as follows:
"Value of stock = Value of ownership = DCF of value of future cash flows = Intrinsic Value"
The key assumption is that you can predict the future cash flows of the business. But in many cases, future cash flows are not predictable. Fortunately there are other components of intrinsic value. There are three potential sources of intrinsic value: assets value, earnings power and future earnings growth.
Valuation is an art rather than a math. It is far better to be roughly right than precisely wrong. Whatever math you use, you will have to make some assumptions, and these assumptions are inherently not precise, so you need to be aware of what assumptions have been made. Are your assumptions right? What are the most important parameters?
How to think about market price?
Why do people buy stocks of tech companies with no earnings? Why are such stocks awarded a high valuation? It's because of demand and supply. It's determined by Mr. Market's emotional state. Usually a business has some intrinsic value, so the stock certificate represents some imaginary value. Value can be imaginary, such as bitcoin.
Mispricing happens
The assumption behind the efficient market theory is the rationality of market participants. There are two levels of assumption – individual level and aggregate level. At the individual level, not everyone is rational. But the collective opinion of all the individual participants might reflect the aggregate rationality. The biggest issue with the efficient market assumption is that we know in fact that everyone's understanding of the value of the asset is different.
What is risk?
It's not uncertainty, because uncertainty can be good or bad. It is not missing key information. It is not cognitive incompetency. Risk means the possibility of permanent loss of capital.
You don't have to bear high risks for high returns. There are three sources of risks: internal, external and our own cognitive deficiency. There's asymmetry between leveraged risk and return. By using leverage you may boost your return by a little but vast magnify the risk. Bankruptcy is a great example of asymmetric leveraged risk and returns.
Black swan risk versus grey rhino risk
A black swan risk is a low probability but high impact risk. A grey rhino risk is a high probability and high impact risk.
How to deal with risk
Traditionally there are three ways to deal with risk – hedging, diversification and margin of safety. Value investors shouldn't use hedging or diversification as primary tools to deal with risks. Instead, value investors should use margin of safety as the primary guard against risks. Margin of safety is not a revolutionary idea, but it was a significant breakthrough in investing when Graham incorporated it.
Mr. Market
In the short term, price change in the market is like a random walk. It's a zero sum game. Upward swing and downward swing offset each other in the long run. Volatility is not risk for long term investors, but it is a real risk for short term traders.
Margin of safety
What is a margin of safety? It's like wearing safety belt. It's like showing up early for flights. It's the most important concept in value investing. Margin of safety is a discount. But how much of a discount is margin of safety?
It boils down to how big the risk is, what your level of understanding of the business is, etc. When you buy something that you think is worth $1 for 10 cents, the risk is the $1 is actually worth $0. On the other hand, if you buy a great company at a smaller discount, is it safe enough? It depends on how much you understand the business. You may not leave enough room for black swan risks. There are different layers of margin of safety.
Economic moat
What is economic moat? It's the characteristics of a business that protect it from its competitors. It could be high barrier to enter. It could be its cost advantages.
Sources of economic moat are multifaceted and multi-dimensional. How wide is it? How deep is it? How well constructed is the moat? We can think about economic moat from different perspectives. The most important source of economic moat is a business's competitive advantage. You need to differentiate between competitive advantages versus comparative advantages.
For instance, a lawyer can build competitive advantages in other fields, but it's not the best use of his talent. This mental model can be applied to thinking about diversification. Some companies' diversification attempts widen their competitive advantages. Economic moat is an extension of margin of safety.
Circle of competency
How do you build a circle of competency? How do you find the edge of competency? The most important factor is intellectual honesty. You need to know what your competency is and the diameter of the circle. The four most important factors in establishing circle of competency are: intellectual curiosity, critical thinking, an open-minded mindset and focus.
There are a few ways to find the edge of circle of competency. At the core it's all about Intellectual honesty. You can ask others to help you, explaining your ideas to others. Can you answer all their questions? In reality, you can also verify your assumptions. You can compare your projections versus what happens subsequently. If there's a large deviation, if something surprises you, it means there's a gap.
There are three dimensions of understanding circle of competency: the ability to make good judgement, the ability to generate insight and the ability to predict.
Read more here:
- Li Lu and Zhang Lei's Differences
- Why Li Lu Is 'The Warren Buffett of China'
- Case Study: Li Lu's Investment in a South Korean Company
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