Li Lu is one of Charlie Munger (Trades, Portfolio)'s favorite investors and was once tapped to take over the leadership role at Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) whenever Warren Buffett (Trades, Portfolio) leaves.
It's not hard to understand why. Li has established a reputation for himself as one of the world's best value investors.
According to various sources, Li's firm, Himalaya Capital Investors L.P., has produced an annual return for investors of more than 20% since its founding in 1998.
Li's best advice
In 2010, Bruce Greenwald invited Li to come speak at his value investing class at Columbia Business School. This lecture is very informative, so I recommend you go and find a copy to read through in order to gain the full effect.
One of the critical issues the lecture covers is the research process, specifically, the need for every investor to conduct their own rigorous due diligence process before buying into any stock.
"You need to build in a level of safety so that whatever happens, you will not get crushed. If you can really successfully know what you are getting into, you can pretty much navigate. Most people are troubled by what they don’t know. The world is divided by those who know and those who don’t know. If you really know — you will not pull triggers like Wall St. traders."
Li says that to be a successful investor, you have to find an edge over the rest of the market. By having an advantage, you can focus on areas that might be overlooked and have a better understanding of why securities are undervalued compared to the rest of the market.
Finding this frame of mind and edge takes "years of continuous study" Li notes, but it should yield tremendous results over time. Indeed, by building the right frame of mind, when the time comes, you will "have the guts and courage to back up the truck and ignore the opinions of everyone else."
You can only build the guts and courage to back up the truck and ignore everyone's opinions if you have spent the time to refine your art. And this is one of the primary takeaways from Li's lecture. To be a better investor, "you have to stand on your own." That means doing your own research and understanding why the companies in your portfolio are undervalued, rather than just copying someone else and blindly following so-called investment gurus. "You can't just copy other people's insights," Li said.
Of course, investor's regularly do copy other people's investment ideas, particularly when it comes to gurus like Buffett.
In a bull market, this strategy might work. After all, a rising tide lifts all boats. However, it is when the market starts falling that the problems will begin to emerge. As Buffett once said, "Only when the tide goes out do you discover who's been swimming naked." When the going gets tough, you can see who's been relying on good luck to make money and who has been relying on research. As Li puts it:
"Sooner or later, the position turns against you. If you don’t have any insights into the business, when it goes from $100 to $50 you aren’t going to know if it will back to $100 or $200."
For the past decade, U.S. equity investors have been blessed by one of the most extended bull markets in history. Now that volatility has returned, it is far more critical than it has been for any other time since the financial crisis for rigorous fundamental analysis and due diligence.
The best way to reduce the risk in investing is to do your research. If you can't, it's probably best to leave the process to someone who can.
Disclosure: The author owns shares of Berkshire Hathaway.
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