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Grahamites
Grahamites
Articles (246) 

Li Lu on Circle of Competency

Excerpts from Li Lu's lectures and interviews on the subject.

December 03, 2017

In the next few weeks, I plan to spend some time focusing on a key concept in value investing – circle of competency. It’s a concept that I’ve been struggling with for many years but recently I’ve had some eureka moments on the subject, which I’ll write about in my future articles. In today’s article, I’d like to share the most important origins and inspirations of my journey of understanding circle of competency. They all come an investor I admire deeply and enormously – Li Lu from Himalaya Capital. He has completely changed not only my understanding of circle of competency but also my research process. You can find Li Lu’s lecture at Colombia University here and the spring 2013 Graham & Doddsville newsletter here. His lecture at Peking University was in Chinese. I took the liberty of translating what he said on the subject into English.

From Li Lu’s 2010 Columbia University Lecture:

So how do you really understand and gain that great insight? Pick one business. Any business. And truly understand it. I tell my interns to work through this exercise – imagine a distant relative passes away and you find out that you have inherited 100% of a business they owned. What are you going to do about it? That is the mentality to take when looking at any business. I strongly encourage you to start and understand 1 business, inside out. That is better than any training possible. It does not have to be a great business; it could be any business. You need to be able to get a feel for how you would do as a 100% owner. If you can do that, you will have a tremendous leg up against the competition. Most people don’t take that first concept correctly, and it is quite sad. People view it as a piece of paper and just trade because it is easy to trade. But if it was a business you inherited, you would not be trading. You would really seek out knowledge on how it should be run, how it works. If you start with that, you will eventually know how much that business is worth.

"A certain industry might have characteristics that make it different than others. In certain industries you might have better prospects than others. Find the best of the players in the industry and the worst players. And see how they perform over time. And if the worst players perform reasonably well relative to the great players — that tells you something about the characteristics about the industry. That is not always the case but it is often the case. Certain industries are better than others.

So if you can understand a business inside out you can then eventually extend that to understanding an industry. If you can get that insight, it is enormously beneficial. If you can then concentrate that on a business with superior economics in an industry with superior economics with good management and you get them at the right price — the chances are that you can stay for a very long time.

From Graham & Doddsville Spring 2013 Issue:

I let my own personal interests define my circle of competence. Obviously I know something about China, Asia, and America – those are things that I am really familiar with. I have also over the years expanded my horizon.

I started out 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 in addition to securities, you begin to become a student of businesses.

Eventually, one thing leads to another and you begin to learn different businesses. You learn the DNAs of businesses, how they progress, and why they are so strong. Over time, I really fell in love with strong businesses.

I morphed into finding strong businesses at bargain prices. I still have a streak in me that favors finding really cheap securities – I just can’t help it! But over time, I’ve become more attracted to looking for great businesses that are inherently superior, more competitive, easier to predict, and with strong management teams. I’m just not quite satisfied with the secondary market. As I said, there is an aspect of the securities business that is zero-sum. And that’s the area in which I don’t feel entirely comfortable. I’m more interested, by my nature, in win-win situations. I want to create wealth together with the business operators and employees when I invest. So that led me to venture businesses. I try to apply the principles of intelligent investing there, but I actually can contribute quite a bit, so it becomes a win-win situation. Over my career, I’ve had the satisfaction of building a number of different venture businesses. Some of them became enormously successful, even after we sold them. You could say we sold them too early! I was the first investor in Capital IQ, and then look at what happened. If we would have kept it, we would have been far richer! It’s not like we didn’t make a lot of money in that investment. We did. But I like it that way. I like to create something that everybody finds useful. We created employment, and we created a beautiful product that’s sustainable, and everybody made a lot of money, even the people who bought the business from us. I like win-win situations. I do not complain about selling Capital IQ too early. We made a lot of money on that investment, and we contributed a great deal. I remain friends with the founders. That aspect gave me enormous pleasure. But the venture side is hard to scale; you must put in a lot of effort. So, over time, I gradually moved into helping in a different way. Even in public securities, you can still be very helpful and constructive. So, that’s who I am. I’m still learning, and I’m still interested. I’m still young, and still incredibly curious. So, who knows? Hopefully, I will continue to gradually expand my circle of competence.

From Li Lu’s 2017 Lecture at Peking University in China:

The essence of investing is to predict the future. Understanding an industry and a company requires judgment of what the business fundamentals will be in 5 or 10 years. It’s not an easy thing to do. When we invest a company, we have to at least understand in the next 10 years what the fundamentals of the business will look like? How would the business’s fundamentals be affected in a downturn? Otherwise, how can we estimate the downside of the investment? We have to make a good guess of the business’ cash flow for the next 15-20 years if we were to do a DCF calculation. But even if you were the founder of the business, do you really know what the cash flow will be for next year? You can’t say with absolute confidence that you can predict the future business development for the next 10 years. Very few people can do that. There are too many uncertainties. For most industries and companies, it’s impossible to see 10 years out. But there are some industries and companies that are predictable. If you spend enough time doing the research, gaining experiences in the industry, you will find out that you really can tell how the business will behave in the next 10 years during normal times, good times and bad times. It requires years of diligence, research and relentless learning. When you can make this judgment ( 10 years outlook), you are starting to build your circle of competency. Your circle will be extremely narrow starting out and it requires a very long time to build it. That’s why value investing is a long journey and very few people can make it to the end. It requires a huge amount of commitment but you may still be much ignorant even if you spend much time for many years.

If you can’t tell the edge of your circle of competency and if you step outside of your circle, you will be destroyed by the market at some point.


Rating: 4.9/5 (10 votes)

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Comments

zyl41
Zyl41 premium member - 1 week ago

This is nice, but I don't see anything new other than already explained by the likes of Buffett and Munger. I've really enjoyed and learned a lot from your articles, they are excellent and usually run deeper than some others which basically reiterate Graham, Buffett, and Munger. Wondering why you admire Li Lu so much?

Grahamites
Grahamites premium member - 1 week ago

Zyl41 - Thanks for the nice words and feedback. The reason why I admire Li Lu so much is because over the years I've gotten to know a few of his analysts and really impressed by their thinking and deep research. Very different from most value funds. They are deep thinkers; they take the time to learn a business inside out; they operate in less efficient markets; they make very few but big bets; they are real long term holders; they create value along with the managers of the companies they invest in. Himalaya is a rare combination of all. I think they really do have an edge against others and the returns reflect that.

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