On Aug. 12, a famous investor in China interviewed Li Lu over the phone. It was a short interview, but he asked Lu a few very important questions on investing. Below are my notes:
Question 1: One of the issues we’ve had as investors is that sometimes rational investing is against human nature. It seems like most of the profits in the stock market are made from fluctuations from investors’ sentiment, instead of from the values created by the underlying businesses. Do you agree with this point of view?
Lu: Great investors should possess intellectual honesty (respect the truth), instead of paying too much attention to what others think. Human beings are social animals, meaning that we naturally seek social proof. So from this point of view, investing is against human nature. Logics and evidences matter much more than others’ opinion of you. You are right in that perspective.
But for long-term value investors, we need to ask this question – where does long-term value come from? I think the value of a long-term investment comes ultimately from the value that the business has created over its existence. We all know the intrinsic value of a company is the present value of the all the future cash flows available to its shareholders, discounted back at the appropriate discount rate. Because all the cash flows are in the future, we have to make estimates regarding the future and everyone will have different opinions on what the future cash flows will be, and everyone’s discount rate is different. Therefore, the intrinsic value of a business, by its definition, is very subjective.
On top of that (subjective evaluation of intrinsic value), human greed and fear will amplify the subjective nature of intrinsic value in the form of extreme price fluctuations. The definition of a reasonable price when one is optimistic is almost certainly different from when one is pessimistic. And the change of one investor’s assessment of a reasonable price will affect another and so on because we are social animals. This contagious effect is what makes valuation fluctuate between extremes.
Independent thinkers will find great opportunities when valuation is at an extreme level because, over time, the price of a business will revert to the intrinsic value of a business.
Investment returns, therefore, come from two sources: the upward reversion to intrinsic value and the growth of intrinsic value over time.
Let’s use Kweichow Maotai (SHSE:600519, Financial) as an example. Maotai’s earning power increases every year, and with the increase in its earnings power comes the increase in free cash flow-generating capacity. If you are a short-term investor, most of your return comes from the elimination or narrowing of the gap between price and value. Price is what you pay, value is what you get. But if you are a long-term investor, most of your return will come from the cumulative value that is created by Maotai.
This (way of thinking) applies to nations as well. We can think of China as a huge corporation. Four decades ago, China was so poor that we didn’t have enough to eat. But look at today, after 40 years, the wealth in China has grown phenomenally. If you were a short seller and you shorted the country 40 years, you’d suffer enormously. But if you were long China 40 years ago and never sold, you will do really well because the country has created so much wealth over the past four decades. Of course, you could have gotten in and gotten out and made your money that way. But if you think of China as a company and you invested with it for four decades, you’ll get great returns, which you deserve as a super long-term investor.
Over the long term, your return on investment in a company will be very close to the return on capital of the underlying business. Now if you bought the business cheap, during the early years, your return on capital would be much higher than the return on capital of the company. But as time passes, your return on capital will get very close to the return on capital of the business.
Question 2: What should we do if a high-quality company trades at an expensive multiple?
Lu: It depends on your opportunity cost. But in general, the higher the price of an asset, the lower the expected return and the higher your opportunity cost should be. The lower the price, the higher the expected return and the lower your opportunity cost should be. What’s important is to have an opportunity cost mindset.
Question 3: What characteristics should an investor intentionally cultivate?
Lu: Everyone’s experience and background is different. But in general, I think one should live a meaningful life and try to help other people grow. You also want to avoid greed as much as possible. As an investor, you should seek rationality and intellectual honesty. This means knowing what you don’t know and what’s unknowable. It also means you shouldn’t invest in things you don’t understand, or things you only understand a little bit. You really need to know your circle of competency and circle of incompetency.
