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Notes From Peking University's Fall 2020 Value Investing Course - Lecture 4 Q&A

Notes from Chang Jing's last lecture of the semester

November 04, 2020 | About:

In this series, I have shared my notes for the lecture part of Chang Jing's presentation, given as part of the Value Investing Course at Peking University. Below are my notes from the question-and-answer section that followed the lecture.

How do you approach the intrinsic value for companies with a short historical record as a public company such as Nongfu Spring (HKSE:9633), which was listed recently?

The intrinsic value estimate itself is very straightforward mathematically. What's difficult is to gain a deep and thorough understanding of the business. For a recently listed company, indeed, there isn't much publicly available information. So you have to do a lot of scuttlebutt work. You need to speak to lots of experts in the industry as part of your research. If you don't do this type of research, you won't understand the business by just reading the annual reports and initial public offering prospectus. You need to read the annual reports and IPO prospectus, but they only tell you some superficial facts about the business. It's the starting point. For instance, in our case study, we discovered that Meituan Dianping's (HKSE:3690) working capital is negative. Then we have to ask why is it? Why can't other companies have negative working capitals? There are a lot of operational tricks that are not discussed in the annual reports such as how Meituan manages the delivery workers. It takes a lot of time and effort to understand a business. It can take years, at least two or three.

What materials should investors read in order to build a circle of competency?

Find one business that you find interesting. Read all the annual reports and all the public information available online. You can get a sense of the business model by reading all the public materials. Then you have to do the scuttlebutt work to verify the information you read. Again, if we use Meituan Dianping as an example, we have to figure out how the company's technology works and how it manages its delivery networks. You are trying to reach a level of understanding similar to that of the management team, so when you speak to them, you can have an effective dialogue about the business. That's a good standard to use when you assess your level of understanding of a business. That's also how you gain an owner's mentality. Without an owner's mentality, you can't go deep. And if you can't go deep, you won't be able to build a circle of competency. On the other hand, the more businesses you learn, the easier it is for you to compound your business knowledge.

In his 2015 lecture, Li Lu (Trades, Portfolio) mentioned that the younger generation's luck is better than the older generation in terms of investing opportunities, why is that so?

It is so for Chinese investors because China is still going through the rapidly growing phase. China's development is in line with Li's law of modernization, which says that the whole process of modernization itself is actually a process of compound interest. According to his definition, modernization is the phenomenon that the whole economy begins to enter a state of continuous progress and unlimited growth due to a combination of free market and technological innovation. China is still going through the modernization process. Therefore, many Chinese companies can still grow very fast. And on top of that, the Chinese stock market is very volatile, so opportunities appear frequently. The market price of a business can swing to both extremes.

Value investors in China cannot only get the margin of safety from asset value, but also from earnings power value and growth value. And because many Chinese companies are still rapidly growing their earnings, the earnings power value and growth value can be very high. The Chinse Mr. Market at times will serve us with fantastic opportunities where we can get the earnings power or growth value for free. Even if you overpay a little bit for a fast-growing company, but it can continue its growth, your principle may still be safe.

To sum up, in the Chinese market, there is more flexibility in terms of the sources of intrinsic value and margin of safety.

What's your opinion on in-vitro diagnostic companies, which might benefit from Covid-19?

I don't know much about these businesses, but as a general framework, you still have to understand these businesses. Without a deep understanding of the businesses, you won't be able to make sound investment decisions.

What's the difference among economic moat, competitive advantages and franchise value?

Competitive advantages and franchise value are both components of an economic moat. The existence of franchise value and competitive advantages enable the business to earn above-average returns on investment in the industry. So economic moat is the combination of franchise value and competitive advantages. But we can break down competitive advantages and franchise value further and ask what the sources of a business' competitive advantages are?

How to estimate the value of franchise value?

Usually if a business has franchise value, it will earn an above-average return on investment. For instance, if the industry average return on investment is 5%, and the company can earn 10% on investment, this 5% difference is the value of the franchise value.

How should we think about management team, culture or organization structural as part of the economic moat?

The founder and management team usually are not components of economic moat. There are some exceptions. The key is whether the management team, culture or organization structure is replicable or not, and whether it is sustainable or not. In most cases, they are not sustainable. It is true that some management team is much better than others, but you have to get to the specific details of why this management team is better. It needs to be a structural advantage. A founder's personal trait can be deeply instilled throughout the company's culture. If so, then culture may be a source of economic moat.

How should we think about balancing learning the big ideas from multiple disciplines such as chemistry, mathematics and physics, and spending time actually analyzing businesses? How to tie the multidisciplinary approach to value investing?

The Chinse culture trains its people to think about macro topics. Our language is relatively vague compared to, say, English. But when doing research, we need rationality based on experiments and evidence. Studying scientific disciplines such as chemistry, physics and mathematics will help us become more rational. We can utilize the scientific method when learning social sciences. And the philosophy can help us think about the world and guide us with philosophical methodologies. So they are all important frameworks in life, but when it comes to investing, we have to take the bottom-up approach and analyze the business itself. It doesn't mean we don't pay any attention to macro factors. We have to think about macro factors to the extent they may affect the businesses we analyze. If we don't understand the business, we can't judge how macro factors will affect it.

With regard to how to tie the multidisciplinary approach to value investing, the big ideas from different disciplines can enhance your understanding of the business you analyze. For instance, big psychological ideas can help you assess management team's behaviors. They won't help you right away, but some days in the future, the big ideas may be the crucial tools for you when analyzing certain parts of the business.

Do you agree with the statement that investors should require a smaller margin of safety in a bull market and a bigger margin of safety in a bear market?

Margin of safety has nothing to do with a bull market or a bear market. Value investors require a margin of safety to deal with business operation risks, external environment risks and our cognitive deficiency risks. It is true that in a bull market, you won't find many ideas with sufficient margin of safety from a price point of view, especially from the asset value perspective. But you may still get margin of safety from earnings power and growth value.

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About the author:

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.

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