Street Capitalist: Event Driven Value Investments

Something good to watch over the weekend whenever you get a chance. Physicist Richard Feynman was truly gifted as one of those geniuses who is able to describe his work and field in a manner that is easily understandable by ordinary people.

I came across this great read from Ed Thorp on his experience meeting Warren Buffett. He talks a bit about the relationship between bridge and investing, which might by why Buffett enjoys it so much. I’ve been trying to learn about bridge myself (so far I’ve been reading Winning Contract Bridge). This is what Sharon Osberg, Buffett’s bridge partner says about the game:

Warren would tell you, playing bridge is like running a business. It’s about hunting, chasing, nuance, deception, reward, danger, cooperation and, on a good day, victory.

Bring Bridge Back to the Table (NYTimes)

Here is an excerpt from Thorp’s paper:

“Bridge players know that bridge is what mathematicians call a game of imperfect information. The bidding, which precedes the play of the cards, conveys information about the four concealed hands held by the two pairs of players that are opposing each other. Once play begins, players use information from the bidding and from the cards as they are played to deduce who holds the remaining as yet unseen cards. The stock market also is a game of imperfect information and even resembles bridge in that they
both have their deceptions and swindles. Like bridge, you do better in the market if you get more information, sooner, and put it to better use. It’s no surprise then that Buffett, arguably the greatest investor in history, is a bridge addict.”

The full paper is below:

Bridge With Buffet

Many of you enjoyed my previous transcript of a talk Li Lu gave at Columbia University. Thanks to Joe Koster, you can now view a more recent lecture he gave to Bruce Greenwald’s value investing class in April of 2010.

Based on Berkshire’s investment in BYD, the fact that Lu manages Charlie Munger’s money, and that even Buffett would give money to Lu if he ever retired (according to Greenwald) makes me think Li Lu is an investor worth watching.

With that in mind, I believe it is insightful to study whatever you can find about him and his approach. I think this lecture from 2010 is great. The recording has some audio issues making it difficult to hear and I thought that some of you might enjoy reading notes from the talk. This is not a true transcript, but an approximation of what was said. I think it comes pretty close, having listened to the lecture a few times. I think you will find it helpful and Lu’s talk rewarding.

Bruce Greenwald: Warren Buffett says that when he retires, there are three people he would like to manage his money. First is Seth Klarman of the Baupost Group, who you will hear from later in the course. Next is Greg Alexander of the Sequoia Fund. Third is Li Lu. He happens to manage all of Charlie Munger’s money. I have a small investment with him and in four years it is up 400%.

[Applause]

Li Lu: Columbia is where my whole life in America started. I could barely speak the language. In Columbia it was where I had a new life. It was really in the Value Investing class where I got my career start. I was really worried about my student loan debt at the time and a friend told me about this class and said I need to see a lecture from Warren Buffett.

What I heard that night changed my life. He said three things:

1. A stock is not a piece of paper, it is a piece of ownership in a company.

2. You need a margin of safety so if you are wrong you don’t lose much.

3. In the market, most people are in it for the short term. It allows you a framework for dealing with the day to day volatility.

Those were three powerful concepts. I had never viewed the stock market like that. I viewed it negatively as a place made up of manipulators who were lining their own pockets. I embarked on an intensive two year study learning everything about Buffett.

Two years after that I bought my first stock. After I graduated I worked at an investment bank for a year and realized it was a mistake. I tried to start a fund but I didn’t have a track record. The first year I managed money I lost 19%.

Being a value investor means you look at the downside before looking at the upside. Before becoming an investor you need to look at how you can fail at this game. There are all sorts of ways you can fail. You need to examine who you are and see if you could be good at it. If you could ever find something you can do well that you really like — that will be your best investment. You will do better than competitors. If you can do it with intrinsic passion, that really over time will add enormous value to you.

Back to the game of investing. This concept of margin of safety is an essential concept to be a good investor. The future is unpredictable, you will always be dealt surprises, some positive most negative. 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. If you are truly intellectually honest, you would not do anything.

This class teaches you to know what you are getting into, especially accepting what things you don’t know. The game of investment is really continuous learning. Everything affects an investment, it constantly changes. You are not investing in the past but the accumulative cash flow of the future. You have to want to find a certain set up where you can know something that most people don’t know. There are plenty of things I don’t know but they don’t factor into the purchase because I am using a huge margin of safety. Buying a dollar at 50 cents. So if things turn against you, you will be okay. That is not easy. This business is brutally competitive. It is so impossible to know everything and know exactly what is going to happen to a business from now till the end that you really have to accept that what you don’t know.

Finding an edge really only comes from a right frame of mind and years of continuous study. But when you find those insights along the road of study, you need to have the guts and courage to back up the truck and ignore the opinions of everyone else. To be a better investor, you have to stand on your own. You just can’t copy other people’s insights. 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.

So this is really difficult, but on the other hand, the rewards are huge. Warren says that if you only come up with 10 good investments in your 40 year career, you will be extraordinarily rich. That’s really what it is. This shows how different value investing is than any other subject.

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.

When I started in the business in 1997, it was in the middle of the Asian Financial Crisis. A few years later there was the Internet bubble. A couple years ago was the Great Crash of 2007 – 2008. They are billed as once in a century disasters but happen every few years. Every time it goes against you, your net worth or value of your investments might go down 50%. This is really where that insight and temperament comes in. In a sense, you have to have a certain confidence in your own judgement and not be swayed by other people’s views. It is not easy. But that is life. It is just a given. It happens to everyone. Berkshire had at least three times when the stock went down 50%. It happened to Carnegie too. It happened to Rockefeller. It happens to everyone. If you really made a mistake, it would not stop at 50% but go to 0.

This happens to even mighty companies. Look at the top 50 companies in America every 10 years. By the time 20-40 years go by, 2/3rds of them will be gone. By the time it goes to 100 years, there might be only a couple left. It’s just the way it is. Look at what happened to the once mighty General Motors. So thats why I’m saying is, investing is a continuous learning process because your investments are constantly changing

So for those of you that have curiosity and the temperament, this game couldn’t be better. Capitalism rewards people who are talented at capital allocator. So if you have the aptitude and temperament, it is the great game. If you don’t have that then I urge you not to go and become a nuisance. That is really what Wall Street did, they don’t really create anything they just move money around. Letting the financial industry get too big is bad for the economy, it is just as bad as getting addicted to casinos, drugs, and alcohol. None of them are really useful, they just transfer wealth. That is what I think happened on Wall Street over the last several decades. So avoid being harmful.

With that I am open to questions.

Q: Mohnish Pabrai recently spoke about his reluctance about investing in China due to the multiple accounting books / the possibility of fraud. How do you deal with this given your own investments in China?

Li Lu: Well, you know I think he is right. Every thing has an exception though. Just because a next door neighbor is a fraud doesn’t mean you are. That is one question to ask — whether you can trust the accounting and people running the business. That can have a huge impact on the business. I suggest you spend a lot of time looking at these factors, especially if you are investing for the long haul.

Q: Why did you decide to go into venture capital? How is that different than your other investing?

Li Lu: I always had this bent that I want to build a real business. I started a venture and it was really a lot of fun. Overall, it is a tougher game than simply investing in securities because you have to evolve to the day to day changes in operations and it is just not as easy to build great businesses. Every generation has a handful of great businesses that come from no where and come to dominate their fields. It is much more rewarding as an investor to pick those. Also, you are more likely to find managers much more capable than yourself. Overall, I learned a lot. I learned a lot in how businesses succeed and how businesses fail. It really was a lot of fun. I probably carried it too far — I eventually ran one of the businesses and it was of course a mistake.

Q: I read that when you look at an industry, you look at the most miserable failures of that industry to see whether you will invest in it. Can you talk a bit about that?

Li Lu: It goes back to understanding the business. Once you have that understanding you can extend it to understanding an industry. 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.

Q: Did you have any specific example?

Li Lu: I have studied many over the years. As I have said, don’t copy other people’s insights because it doesn’t work. Automobiles are amazing. If you look at the early days it started with several players and concentrated with just a few players that became enormously profitable. Then they became miserable. You then see how the life cycle turns with new automakers in China and India. Everything has a reason. If you want a good idea — look at General Motors from the early days, look every 5 years and see how the performance metrics change. The Graham and Dodd Center should collect all the data and perform some kind of commentary on it.

Bruce Greenwald: Do you want me to give you the answer to that? In the 1960s, their return on capital was 46%. In the 1970s their return on capital was 28%. In the 1980s it was 9% in the 1990s it was 6%. You want to guess how negative it is now?

Li Lu: So that is really fascinating. If you have that data, the amount of insight that would yield would be astonishing. So instead of just accepting the conventional wisdom that the auto business is bad — that is just not true. Or if you say well those guys just unbelievable money machines — that is not true either. So if you can really examine those statistics and understand it that will give you an advantage for analyzing new situations like in China and India. That is really what turns me on. Understanding this gives you a tremendous leg up.

Q: I wanted to ask you about BYD. I heard that you thought it was important for them to introduce a model to the US and wanted to know why you thought that.

Li Lu: That might be a better question to ask the BYD chairman than myself. Well, If you are just talking about electric vehicles, you know the key — the heart and soul of the electric vehicle age the heart is the battery. There is the battery, electric motor, and the electric control control panel. The electric motor has been there for 100 years, control system is software that can be improved over time.

The battery is really where you get the biggest appreciation and is what determines the value of the electric vehicle. 100 years before the Model-T was introduced, the competition between electric vehicles and gasoline was not nearly as optimistic. Up and till then, 1/3rd of cars being produced were electric. It wasn’t until Rockefeller got oil extracted easily enough that it worked. Henry Ford was able to make the internal combustion work even though it wasted 85% of the energy. He was able to build the engine and produce automobiles that were cheap enough for people to buy and it took off. That is where you find the real winners.

Now, years later, we know that the way that oil is burned contributes to global warming. If it continues, the planet might still be here but all the human beings might not. Human beings have only been on the planet for a tiny bit of the earth’s history. So there are all sorts of good reasons for electric cars. Battery development has advanced so much that it is now comparable to the price and performance of traditional cars. So now with the help of companies like BYD, the balance is about to tilt towards where performance and price are getting to the level that makes them a desirable alternative. It will be desirable everywhere. Eventually, if you have a car that does all that, it will be sold everywhere.

Q: What about BYD versus others in the industry?

Li Lu: The market will determine that.

Q: Yeah – but why BYD versus others?

Li Lu: Well because we also studied all those other guys. We will see when the winner emerges whether we are right or wrong.

Q: Right – but what did you look at to reach that view?

Li Lu: There are a lot of people who have worked over 100 years making great cars. The technology for building a traditional car has been refined enough to where it can be learned in a short period. The place we are still seeing a curve of continuous rapid improvement is with the batteries for cars. Whoever is leading the charge will have a major advantage. There is really only one company that is a leader in battery manufacturing and automobile manufacturing. There is only one company. To put this together you need a Ford to put that together. So far those two elements need to be put together. It is not an easy process.

Q: So you went to BYD in 2005 and then you brought Berkshire as well. I saw that you sold a small amount of your BYD position at the end of last year. Was it just rebalancing? Can I just wanted to get your thoughts on that.

Li Lu: Actually I started my BYD position in 2002. I sold a small amount of shares because an investor of mine had an emergency redemption.

Q: We read your profile online. I had a question – do you have any problems when trying to invest in China?

Li Lu: Yeah I do have some difficulty. I did not really see a factory plant at BYD until the end of 2008. I really did not have a better understanding till then. That really causes you to question what it is before you make an investment. With investing, you have to work with imperfect information because you are buying a piece of the future. I did not really get a chance to get more information because the problem in Asia till much later but it did not stop me from making my investment decision. So there is a point, where if you have enough margin of safety– that is why I kept coming back to the elementary concept of margin of safety– you can allow much more uncertainty and unknowns. So the answer of the question is does that stop you from making the investment? No.

Q: So I did some research on lithium ion batteries, and I saw that BYD has a manufacturing advantage with consumer batteries. But I saw that automobile batteries are much more complex. I did not think that the idea of a good consumer battery manufacturer + an automobile maker made much sense. So when Buffett looked at the stock maybe it was a better deal but today it is this dream of vehicles that is really priced in. It does not feel like a good value investor stock. So why would you own it today?

Li Lu: Well that is interesting. One of the most fascinating things about being an investor is that surprises are part of the game. When you get into situations like BYD, you see lots of good surprises. Chuanfu and his team have this fabulous culture, everything people thought they knew turned out to be a few years late. He got into battery manufacturing in that particular way because he really had no other option. He had no money, he only had $300,000 in venture capital funding before IPO and that was it. He raised money in an IPO and Buffett gave him $200M, now they have 160,000 employees. $6-7B in revenues, $500M in net profit. It is amazing. So he has this ability to adapt in a competitive environment. He has demonstrated that ability again again and again. The way he does automation is far cheaper than anyone else and more reliable. He continues to surprise me with his ingenuity, to figure out ways to do something better than everyone else. What he is currently doing is very different than what everyone else has done. At the end of the day, you might look at what he has done.

So how do you look at it as an investor with imperfect information? Well I suggest you look at what he has accomplished. 8 years ago I had no idea they would go into the automobile or laptop or cellphone battery business. So that demonstrates how he is. This investment is not easy to understand because it is changing so fast, at such a large scale. An almost unheard of speed. Their manufacturing capabilities will double soon. This year they will hire 10,000 college graduates, 8 or 9 thousand engineers. The scale is almost unparalleled. So this is why the study of history, of all the great corporations will give you a good insight in seeing what will happen with BYD. I suggested that we start with GM and analyze its performance every 5 years for 100 years to understand at least one aspect of BYD’s business.

Q: One investor came in and said talking to management is a waste of time. They will say what you want them to say. Obviously it sounds like you don’t agree with that. What do you think? Will you pay a premium for a business with a moat?

Li Lu: There is no general rule. The key in investing is to know what you know and know what you don’t know. You can know about management teams without meeting with them. Every situation is slightly different. So I come back to the point that if you know enough on other things that there is enough margin of safety. Even if you meet with management, you may not learn something. Obviously, actions speak louder. You want to see what they have done. Everything being equal, the more you know about management, the more honest and upfront they are, the more motive they have, the better the situation is and the deeper the discount. You have to analyze it all. The key to analyzing it is you have to ask: do I really know what I think I know, do I really know what I don’t know? If you can’t answer that question, chances are you are gambling.

Q: What kind of preparation do you do before meeting a management team?

Li Lu: I don’t really have a set method. Because I usually am just curious about the business and don’t know a lot. So you are prepared and not prepared. If you are really curious, you want to learn more and study it more. When working at a hedge fund or mutual fund, you are expected to learn a business in one week. You can’t truly understand everything about a business in one week. It took me 10 years and I am still learning new things about BYD. It is a continuous learning process. You could spend a lifetime studying a business or industry, but in a few seconds I can tell you whether or not I like it. You want to build knowledge by continually learning. There is not set preparation.

Q: Recently, Jim Chanos gave us his thesis on the China Syndrome with there possibly being a bubble.

Li Lu: Well, it is too big of a question for me. I don’t know

Q: 20 years ago you said you challenged conventional wisdom in China. Out of curiosity, in terms of value investing what do you challenge in the conventional wisdom?

Li Lu: Well, the fundamental philosophy of value investing is very sound. Its basically the three things:

1. A stock is not a piece of paper, it is a piece of ownership in a company.

2. You need a margin of safety so if you are wrong you don’t lose much.

3. In the market, most people are in it for the short term. It allows you a framework for dealing with the day to day volatility.

That is really an intelligent approach. So therefor any intelligent investing is really value investing. There is a certain level of intellectual honesty. If you have all that insight going into analyzing businesses I don’t have any arguments with it.

Q: What is your point of view on long / short positions in value investing?

Li Lu: The most profitable kind of investing is long term investing. You want to allow the time that it might take because you don’t know when the market will catch on. If you can find a business with good management with good industry fundamentals blowing it forward, you have a good opportunity and you can save money on taxes.

A short cannot be a fundamentally long term position. In the long game, the upside is unlimited. Your downside is 100%. In shorting it is opposite. Shorting is also essentially borrowing, so you need money and time on your side. If time is not on your side, you can be right but lose all your money. The best kind of short usually has some kind of fraud. In those situations, management is determined to keep the fraud. Look at Bernie Madoff, 20 years time. You cannot afford to borrow money for 20 years. So shorting is a short term game. When those positions go against you, there is huge leverage that can utterly crush you.

In theory, long / short is okay, but if you are trading all the time you need to be in tune with all the things moving the market. None of them might be fundamental to the actual business. So you spend all your time chasing noise than studying a long term situation. If you cannot concentrate on things in the long term, and spend all your time thinking about the short term, you will not be able to develop the kinds of insights necessary to identify great investments.

From time to time, you will lose some money on paper. But it is just part of the game. This is why I closed long / short. You know I went through three bubbles. The Asian Financial Crisis, the Internet Bubble, and this most recent financial crisis. The biggest mistake I made is not being able to pick up undervalued companies where I had a unique insight but was tied up with this whole long / short thing. The money I left on the table is still adding up. I am still paying for those mistakes.

Q: In a bull market environment, how do you re-evaluate your thesis?

Li Lu: I don’t ever want to profit from a bubble. Soros does that, that is just not my game. I don’t profess any ability to understand how long a crowd will buy into a bubble. I invest in things that appear to be compelling values that continues. So that is why this game is a continuous learning process – because everything affecting the investment is constantly changing. Including the price. Including the prospects and elements of business success. You really do want to never stop learning. This game looks to be easy but it is not easy.

Q: Given your focus on international investments, how do you think about diversifying your investments regionally?

Li Lu: First of all, I did not really specialize in international investments. I started off doing most of my investments in the US and Canada. In recent years, I just find better bargains outside of it. One of the great things about being an investor is you can look anywhere and find great pockets of opportunities. You cannot do that as a venture capitalist as I experienced myself. So you can look anywhere for opportunities. I do not take a regional approach to diversification. I have views towards certain countries and currencies, but it is not the driving force for a potential investment. If you have your fundamental things right, if you happen to have macro economic factors behind you, you can run a great wave.

Q: How is your investment style different today than when you started the fund?

Li Lu: A lot of things have changed. One bonus about this profession is you get better over time. Most professions, as you get older, you get out of the game. Take the example of competitive sports. If you are a figure skater or gymnast, after your teenage years you are out of the game. With investing, if you are doing it the right way, you get better over time. Your knowledge accumulates exponentially. When I look back at everything I have done, I would have done it all slightly differently, but that is because I am better at it today. So if you approach it in a fundamentally sound way, as you mature, you become better and better. That process and progression is like compounding money. In fact, you can compound knowledge faster than money. If you truly love this game, I would suggest that you don’t take short cuts. It might take longer but it is more rewarding.

Q: What is the difference between being a top political criminal in China versus a hedge fund manager today (referring to the ire directed at Wall Street)?

Li Lu: I don’t consider myself a criminal. I don’t think China considers me a criminal. What I think we are doing today with our investment in BYD in China is really helping China march towards a modern era of prosperity. BYD is providing a solution to both China and the US, to migrate from the past to a way that gets us out of the unsustainable carbon age that we live in. Global warming is a vital concern to every human being, so China is providing a great contribution to everybody with BYD. America has had a great history of invention and here is a great company in China that is about to make a major contribution to human civilization with cheap electric vehicles and solar power.

Ultimately we will have to get our energy from the sun. Most of the energy, even fossil fuels (plants that die and then go into the ground), all originally come from the sun. So if you can figure out a way to take energy from the sun and power vehicles, while using batteries to store it, inexpensively — will really make renewable energy power everything. The combination of those things holds the key to the future of industrial civilization that we are about to embark on. We didn’t set out with BYD with this in mind, it just happened that way. With great companies, it only looks logical in retrospect. Think about how Bill Gates started Microsoft. I don’t think he knew up front that he would take the entire market — at that time it did not exist. It is the same way with our investment in BYD. Ultimately, I think finding an inexpensive way to store energy that we harness from the sun will be a huge contribution for both China and the US, but more broadly our entire civilization.

This is a great guide for seeing different types of cognitive biases. It is split into three groups: social, memory, and decision making cognitive biases.

Cognitive Biases – A Visual Study Guide by the Royal Society of Account Planning

Ben Claremon of the Inoculated Investor released his notes from Charlie Munger’s 2010 Wesco AGM. The notes are awesome and Munger’s talk is wonderful. I found this Q&A session to be much more insightful than Berkshire’s:

2010 Wesco Annual Meeting Notes

Be sure to head over to Ben’s site. He has notes from Berkshire’s and Markel’s meetings as well.

This past weekend was the Berkshire Hathaway (NYSE:BRK.A / BRK.B) annual shareholder meeting. At one point during the Q&A, a questioner asked Warren Buffett about the status of Berkshire’s CIO candidates. Charlie Munger remarked that one candidate who he is particular close with was up 200% in 2009 with 0 leverage. Some people think that the person Munger is referring to is Li Lu, a fund manager who turned Munger and Buffett onto BYD.

Lu personally owns at least 2% of BYD, which rose 400% in 2009. I don’t know anything about his investments beyond that one position, but I know he is a huge believer in taking concentrated, high conviction positions. If that is the case here, BYD’s spectacular results must have contributed a lot to his returns for 2009 which may make a 200% for the year possible.

Here is a brief bio on Lu:

Li Lu was born in China in 1966. He attended Nanjing University in China and later came to the U.S., and earned three degrees (BA, JD, MBA) simultaneously from Columbia University. After graduation, he worked in an investment bank until 1997, when he founded Himalaya Capital Management, which today manages both LL Investment Partners and Himalaya Capital Ventures, funds focused on publicly traded securities and venture capital. Li Lu was named a global leader for tomorrow by the World Economic Forum in 2001, and a Henry Crown fellow by the Aspen Institute in 1998. He is a member of Council on Foreign Relations and Young Presidents’ Organization.

Fortune: Barnstorm Green

There isn’t a whole lot of information about Lu’s investing style out there. But I thought I would share some notes from a lecture he gave to Columbia Business School back in 2006. All of this is paraphrased, so don’t take anything as a direct quote and there may even be some inaccuracies. Still, I believe you will find these notes insightful, especially with respect to improving your own abilities as an analyst and investor. Even if Lu is not a Berkshire Hathaway CIO candidate, he is an investor with a tremendous work ethic that we could all learn from.

Below are my notes from Lu’s lecture:

Li Lu at Columbia Business School – 2006

-15 years ago, Lu was accidentally brought in to a lecture by Warren Buffett. Had epiphany moment, Lu thought he could do something in the investment business.
-At the time, Lu had just escaped China. Did not know very many people. No money, deep in debt. Worried about making a living in the US.
-In the middle of Buffett speech, made him think differently about the stock market.
-The more Lu thought about it, the more he thought it was something he could do.
-Value investors see themselves as owners of a business. Therefore, fortunes are up and down with the nature of the business.
-You demand a margin of safety.

3 Traits of a Value Investor:

1. Basically, you don’t think of yourself as a paper shuffler who constantly buys and sells securities. You think of yourself as a real owner of the business.
2. You only own a small piece of the business, so you demand a huge margin of safety.
3. Because you think of yourself as an owner, not trading all the time, you think everyone else is different — like Ben Graham’s Mr. Market

On Value Investing

-Under 5% of all assets are run under value investors, a real minority in the investment world.
-The stock market is created for the other 95% of people, that is where your opportunity and challenge is.
-That was one lesson that stuck in Lu’s mind when listening to Buffett’s lecture.
-Biggest challenge: understand whether you are the 5% or the 95%
-It is tempting to do what the other 95% of people do. Emotionally very difficult to be in the 5%, but value investors typically have better returns. The money is really for traders and they tend to amass more assets.
-5% have a spectacular return, but 95% of money probably always resides to somewhere else.
-Understand who you are. You will be tested. You will have to ask yourself whether you are or aren’t a value investor.
-If you are a value investor, you are probably genetically mutated and comfortable being in the minority. This is unnatural to human beings. You have to be comfortable being by yourself. You have to adopt the idea that you are right because your reason and evidence, not because others agree with you.
-You will probably spend most of your time being an academic researcher rather than a professional. You are a researcher or journalist, with insatiable curiosity. You are trying to figure out how everything works.
-The more you know, the better you are as an investor.
-Politics, science, technology, literature, poetry, everything can affect businesses and help you.
-Occasionally you can find insights that will give you tremendous insights that other people don’t have.
-Then you find if the business is cheap. Is the management good? What else? Why is the opportunity there?
-Started fund in late 1997. Been through really traumatic events: Asian Financial Crisis, Tech Bubble.
-Fall of 1998: Lu’s search process is very general. Got hooked on value line, loved to read the whole thing from beginning to end. The best kind of education, you should do this if you want encyclopedic knowledge of companies. Go through it page after page, it is enormously helpful.
-First thing Lu checks is new low list. New low P/Es, P/Bs, etc.
-Does not care where something traded before.
-First looks at valuation. If the valuation doesn’t fit, doesn’t go beyond it.
-If you see a low P/B ratio, ask – What is in the book? How much is the book?
-Encyclopedic knowledge is helpful when looking across different industries.
-Look at pre-tax and pre-interest earnings. Look from an un-leveraged basis. Figure out how much capital is deployed in the business. Look at ROIC.

Example: Timberland

-Start by giving a 5 second look at the business. Timberland. The business is trading around clean book value, consisting mostly of tangible liquid assets, working capital, plus 100M in real estate. Deployed capital is 200M with 100M return.
-Then check why the business fell apart and became cheap. Think if you had owned the entire business at that price.
-At the time, was the height of the Asian Financial Crisis, saw their sales falling off the cliff in Asia. Any thing with exposure to Asia was falling apart. Try to check what other people are thinking about this. You may not listen to their advice but you may want to know what other people are looking at.
-Timberland had no other analysts covering it.
-Why no coverage?
-Look at business across years. Timberland has been growing, pretty profitable, did not need financial markets. Family owned. Owns 40% controlling 98% vote.
-Immediately, that is a turnoff to most people. You can do a quick data search.
-You need to have a curious, active mind to ask questions and find answers.
-Timberland had most of the vote, no analyst coverage, a bunch of shareholder lawsuits. If you were a member of the other 95% of the investment business you might say maybe management is milking the business.
-Download every court document lawsuit. Read it. You NEED a very curious mind to figure out WHAT is happening. Dig every single time. READ EVERYTHING.
-The first time, it takes a couple minutes to look over financials. Then gather questions and do deep research.
-Most lawsuits came from Timberland missing guidance, annoying investors, which annoyed the owner of the business. They decided to stop talking to Wall Street. So it was not about milking the business or fraud. They were not crooks.
-How do you determine if they are good managers? Decent people?
-Act like an investigative journalist. Most business owners leave a trail for you to follow and see how they deal with different situations. Most professional managers would not see this as part of their job, but YOU are part of their 5%.
-Go to their community, visit people they know, their Church, their Synagogue, introduce yourself to their friends and neighbors. It is worth it to spend as much time as possible, to find what these business people have done and what their neighbors say about them to accurately get an idea of their personality.
-The father seemed like a simple, decent guy, just a high school graduate. the son went to business school, was already COO of the company even though he was Lu’s age. Lu saw what boards the son sat on, and noticed that they had a mutual friend. Managed to get himself on the board with the son and became friends quickly. Came to realize these where high quality, very ethical businessmen.
-After all that, saw the stock was still trading low. Decided he did not miss anything. The other 95% may not have done enough research to see this or have some kind of institutional imperative that prevents them from owning.
-If you are not a good analyst, you will never be a good investor.
-But we decide to buy. How much do we buy? Imagine having $900. The other 95% will take tiny positions, 50 basis points. You need to use concentration, a $200 position. Think of how much work you did. Lu visited all the stores to see how margins improved – they had a fad going on where kids wanted the shoes. Their asian business is tiny, reduced earnings by less than 5%.
-Lu put a ton into Timberland. What happened after next 2 years? Stock went up 700%. Propelled by earnings. No real risk – went from trading at 5x earnings to 15x with earnings growing 30% a year. It adds up.

Be a Learning Machine
-When an investment opportunity comes, you have to seize it. Devote day and night so you can act quickly. Do everything complete but do it fast. You have to train yourself to jump on opportunity.
-When opportunity presents itself you can smell it. The only way to do that is by training yourself and reading page after page of financial report.
-Uses S&P manuals for viewing foreign stocks.
-As an owner, don’t think about per share information.
-Use your brain, when looking at stock manuals, each page should really only take 5 minutes. Don’t use calculators. Use mental math.

Example: Korean Company
-60M market cap, pre-tax earnings of 31M, roughly 2x pre-tax earnings.
-Book value of 230M, what constitutes book value? If you are an owner, look at: fixed assets, working capital, don’t count on goodwill.
-Basically you see with 60M in market cap, 30M in pre-tax, $240M in book value ($180M in fixed assets)
-It might be cheap.
-Determine what the earnings is. The book. The working capital.
-Use common sense, common logic and think about the business.
-Most employees never went to business school, Lu finds they are easier to train.
-Of the 70M in current assets, it is all cash
-Of 180M in fixed assets, they own 100% of a hotel, recorded 30M as book. Own 13% of a department store recorded as 30M.
-Look up the department store, it roughly has a market cap of 600M. 13% gives you roughly 80M. So the book value undervalues it by another 50M.
-They own 15% of 3 cable companies and a whole bunch of real estate.
-The department store has exactly the same profile. Trading roughly around cash and investments, good earnings, and own a whole bunch of assets. Turns out they are the second largest cable operator as well
-The department store operates like a hotel, do not take inventory, more like a shopping mall.
-They charge a percentage on the top line of all merchant sales.
-Put it all together: Paying 60M, 70M in net cash, another 100M in stock, 30M in hotel with a value that has not been changed in last 10 years while real estate market has gone up in 10 years. Went to Korea, looked at hotel and department stores.
-Checked recent transaction of properties in neighborhood, value is likely 2-3x what is on the book. But take what is on the book anyway, add 150M. Add that to rest and you get 320M in assets that you are paying 60M for and earning 30M annually from operations.
-Insiders own 50%
-Many factors going in your favor, but you need to look at how local investors see it. They need to be buying it for the price to go up.
-Department store used to trade at 22 went to 100
-This company was at 12 now trades around 70
-each went up 5-6x

Don’t just listen. Do it.

-This type of an approach is not natural to an investor.
-If you decide your personality fits in with the mutated gene pool, that this is something you might be looking to do, there is a lot of money in it — proven by Ben Graham to Buffett
-You have to put in a lot of work into your analysis.
-You can make a lot of money if you are really interested, listening, and actually DOING IT.
-Lu benefited from listening to his value investing class and then actually going out and doing the work required.
-Value investing is not really about theory, it is about what works.
-Young analysts have energy and nothing to lose, so they should go and do the work.
-Before you become a good investor, you need to be a good analyst.

Lu says you need two things to be a good analyst:

1. Provide accurate and complete information. You have to go to an extra length to get it done. Most of the time you will stand alone against everybody else. If you are not competent about what you know, you cannot possibly take conviction positions when things go into free fall and everybody else is laughing at you.

2. Most money is not made in stocks from the examples. They do not provide out-sized returns. You can do the Tweedy Brown/Graham or the Buffett/Munger school. Your returns will come from a handful of stocks. You need tremendous insight by continuous intense curiosity and study.

Investment Mistakes

-Most mistakes come from inaccurate or incomplete information.
-Biggest mistake: most people wanted 2 week or monthly returns. They wanted to go up in down markets.
-Lu’s biggest mistake was straying, was working with Julian Robertson, started shorting — have to think like a trader when you are shorting because your downside can be unlimited. It’s like Charlie Munger says — having your hands tied behind your back while getting into a fight.
-Missed the opportunity to buy a business below cash, even though Lu knew the management and had great insights. The business subsequently went up 50-100x. Could not bring himself to buy it because of his mindset at the time.
-You make a mistake when you have not finished your work but like it enough. You start betting on probabilities instead of real analysis.

Constantly search for ideas

-In your life, you may only have 5-10 key moments of insight. You only get it from continuous learning. Find an American business and then find the Asian counterpart. Some businesses studied for 15 years. You need to know what that business is, how it ticks, so you can swing with conviction. If you cannot do that you will not make huge out-sized returns.
-If you do what Ben Graham or Tweedy Brown does, you will make 15-20% returns but you wont make the huge returns of Buffett.
-The biggest ideas can give 10,000x returns.
-Opportunities are not easy to find. They require a lot of factors to come together – Charlie Munger’s lollapalooza. You need a whole bunch of things working together where you have the insight and are willing to bet.
-This is what drives Lu in business.
-Lu started in physics, mathematics, law, economics, got interested in other subjects. Wife has a PhD in biology, he has learned a lot from her.
-Learn from everything, be intensely curious
-Eventually you will stumble into one big opportunity.
-In the meantime, you will stumble into Timberland style investments which aren’t bad.
-There might be years without opportunities, then years with a lot of opportunities.
-Depends on what becomes available to you.
-They do not come in a steady pace, not like once a week an idea.
-In 6 years, Lu had maybe 3-4 great ideas. But you get progressively better and better, improving the amount of opportunities for you since you will be quicker at your analysis.
-Go through every day by learning something. In a year you have to learn a great deal.
-When Lu reads biology, physics, history, it is all searching for ideas. If one idea jumps out, it is all Lu does. Rest of the time is spent with wife and kids and Lu learns from them too, especially with seeing how human cognition develops which is enormously important.

Li Lu’s Investing Checklist:

1. Is that cheap?
2. Is it a good business?
2. Who is running it?
3. What did I miss?

-Lu goes through the checklist, ‘what did I miss’ is greatly affected by psychology. This kind of cognition happens early on and Lu learns it from interacting with his girls.

Three characteristics of a value investor:

1. Business owner mentality
2. Difference in time horizon
3. Demand a huge margin of safety

Think like a Business Owner

-It all comes from one thing, that you are a business owner. You cannot force management changes, so you demand a margin of safety. You have a long time horizon because you think like an owner.
-But why dabble with stock market? Stock markets are made for people who can dream. That is why 95% of people never buy into value investing. Human nature prevents it.
-You do not belong to the stock market but you have to understand its perspective to position yourself properly. If you are truly think like a business owner, you will eventually leave the asset management business and run a real company. That is why Buffett and Munger left it.
-Or you become a private equity investor.
-The people who the stock market is designed for are fundamentally flawed people. Traders are bound to make mistakes due to fear or greed. They will always make room for value investors.
-Used to be strict about selling with great business. Now, sometimes Lu feels he has insights about the business that allows him to believe the probabilities are in his favor for the business actually improving year after year.
-That is the law of distribution in good businesses. The leaders perform spectacularly well.
-Selling makes you pay a huge amount of tax and you might not get that good buying price again.
-If a business can generate 50-100% ROIC, the mathematics get interesting very quickly.
-Caveat: you have to be very confident. Investment bankers use BS and project into infinity. You cannot project that long. There are only a few opportunities where you can project that long.
-If you are good, and spend your entire lifetime studying, across 50 year career maybe 5-10 opportunities where you can confidently project the next 10-20 years. At that point, you don’t want to sell. By holding you don’t pay the tax on capital gains, so you are really compounding 40% interest free, the business is deploying the capital at 40-100% a year in a tax efficient manner. That is what you do.
-You have to identify businesses that are getting stronger and stronger every year.
-What makes one business more successful than others? Why are they making more and more money compared to others?
-The only way you can find that is by studying the ones that are established.
-Look for great businesses, not just businesses owned by Warren Buffett

Example of a great business: Bloomberg LP

-Product was superior to others, high switching costs
-Bloomberg is a fabulous case study, it came out of no where.
-Gained market share little by little, crossed a milestone point, became a monopoly
-At a certain point, after being highly relied upon for daily work, the switching costs become to high so winner takes all.
-Suppose you have an opportunity to see how an industry evolves early on. At a certain point they cross the line
-Maybe when introduced to all businesses. There is a time when that line gets crossed and a public company is poised to benefit by becoming a monopoly business.
-Why did Microsoft succeed over Apple? Little by little they eroded Apple’s 100% market share.
-Offices were using Windows. Today – do you have a choice of not using Bloomberg?
-Bloomberg visits almost every month and asks what you do, how you use the system. Bloomberg terminals have tens of thousands of functions, they don’t give you a manual
-They want you visually hooked so it is a behavioral connection and you don’t mind paying tens of thousands of years where you don’t have a choice if they raise prices
-They keep coming back to you because they know you are a trader and want to provide you with more services so you are hooked.
-That is why Bloomberg is a fabulous business because you get hooked. Think about switching from that or a competitor coming up with a rival product. How do you compete with that?
-Lu doesn’t know. Suppose you know the inflexion point. Do you want to invest? Lu would invest in Bloomberg at that point.
-You need insight. Study every business. They all have more or less this type of dynamic.
-Your job as a good financial analyst is to study that business ALL THE TIME. Observe those trends.
-Once in your life, maybe you will find that opportunity.
-Why doesn’t Bloomberg want to sell? He doesn’t need to sell.
-When you have a business like that, you don’t need to sell.
-Lu has made many private investments, ex: CapitalIQ, which copies Bloomberg’s business model. Same method with an investment in an engineering service.
-Lu likes to know as much as he can. He likes to be friends with people, with Timberland, the CEO and his son actually became investors in Lu’s fund.
-You can learn and observe from everyday business decisions and learn dynamics.
-Nothing is constant. Everything is changing that is why you have to keep learning.
-Businesses change, Microsoft has threats now.
-You need an active mind, so you are prepared to act and you can seize opportunity due to your insights.

In a previous post, I described my attraction to the theory of deliberate practice. Deliberate practice is an idea popularized by Malcolm Gladwell in his excellent book Outliers (read it — even Charlie Munger recommends it). The idea goes something like this:

When we look at any kind of cognitively complex field — for example, playing chess, writing fiction or being a neurosurgeon — we find that you are unlikely to master it unless you have practiced for 10,000 hours. That’s 20 hours a week for 10 years. The brain takes that long to assimilate all it needs to know to achieve true mastery.

The ’10,000 Hour Rule’ (Bottom Line Secrets)

But sheer hours aren’t enough. You have to ensure that you are putting in a lot of hours of the right type of work. To me, this is where most new investors trip up. Instead of actually analyzing companies, they often become fixated on celebrity-investor navel gazing. What I mean is, instead of going out and finding undervalued companies, they spend most of their time reading about what famous investors are doing. They have no real knowledge of the companies they invest in aside from the fact that someone famous has a stake in the company. You become the equivalent of a chicken running around with your head cut off. The other problem I saw was that some investors merely advocated the daily reading of a 10k. This kind of practice does not yield much if you are not able to connect what you read with the company and the industry they inhabit.

Recently, Cal Newport used Dr. James McLurkin as an example for how to become a star in your field by using deliberate practice:

In 2008, when James McLurkin graduated with a PhD in Computer Science from MIT, he was unquestionably a star. Four years earlier, Time Magazine profiled James and his research on swarm robotics as part of theirInnovators series. The next year, he was featured on an episode of NovaScienceNOW. The producer of the show, WGBH in Boston, built an interactive web site dedicated to James, where, among other activities, you can watch a photo slide show of his life and find out what he carries in his backpack. Earlier this year, TheGrio, a popular African American-focused news portal, named James one of their 100 History Makers in the Making — a list that also includes Oprah Winfrey and Newark, NJ mayor Cory Booker…

“Every semester, my supervisor, Anita [Flynn], had me write out goals,” James told me. “We would go back at the end of the semester and look at what I did and didn’t do. She would tell me, ‘it’s fine that you didn’t get this all done, but what’s not fine is your inability to estimate how long something will take.’”

James describes this lesson as perhaps the most valuable he learned as an undergrad at MIT. Under the tutelage of his supervisor, he honed his ability to choose projects that were hard enough to stretch his ability, but still reasonable enough that he could complete them. She wanted him to be ambitious and set big goals, but she had no tolerance for goals so big that they were beyond his ability to finish in a reasonable time frame.

How to Become a Star Grad Student: James McLurkin and the Power of Stretch Churn (Study Hacks)

Newport calls this stretch churn:

With this in mind, I argue that the secret to James McLurkin’s success is his ability to choose the right projects. By resisting work that reinforced what he’s comfortable with, yet also sidestepping overly-ambitious projects, he consistently advanced his skill until he arrived at the bleeding edge of research robotics. Once there, the “breakthrough” projects that cemented his reputation became obvious next steps.

Put another way: stretch projects are an effective way to integrate deliberate practice into fields without clear competitive structures and coaching. If you’re a figure skater, a top coach can walk you through the hard jumps you need to get better. If you’re a grad student (or entrepreneur, writer, or knowledge worker), however, there are no such coaches to guide you through this process.

Stretch projects can fill this role.

To make this more concrete, let me give you a couple definitions:

Stretch Project: A project that requires a skill you don’t have at the outset.
Stretch Churn: The number of stretch projects you complete per unit of time.

How to Become a Star Grad Student: James McLurkin and the Power of Stretch Churn (Study Hacks)

I believe stretch projects and stretch churn can be implemented by those of us hoping to improve our abilities as investors. We often hear Warren Buffett talk about circles of competence and having a ‘too hard pile’ for investments. The problem is, some investors hide behind these ideas and in turn, limit their ability to improve as investors.

I want to outline some of the steps I’ve taken and actually implemented in order to improve my abilities as an analyst.

1. Seek out peers and mentors

James McLurkin benefited from working in MIT’s robotics lab with people who were more experienced researchers. Advisers like Anita Flynn were able to provide the kind of feedback and guidance that he needed for self-improving.

I’ve also sought out mentors. What I try to do is find investors from diverse backgrounds with differing amounts of experience and viewpoints. You must be open to different perspectives when it comes to investing because bias is your worst enemy. Finding people with an expertise in an area you are trying to master is always helpful. For instance, starting in the summer of 2009, one of my goals became improving as a financials analyst. During the crisis I had no luck with analyzing banks, I defaulted and claimed they were in my ‘too hard pile’ or out of my circle of competence. But I wanted to get better. I now know four different analysts that have a speciality in financials, with their help, I can start analyzing a company and then converse with them on whether my thought process is correct. They have also in turn, helped my by teaching me their different approaches to analyzing banks.

The result? I’ve become comfortable with looking at banks. I can’t say I am confident in a valuation for something like Citigroup, but I can analyze smaller, more community-focused banks. I’ve completed write ups and valuation models on four different banks so far.

Beyond that, I’ve also made contact with peers/mentors that specialize in everything from global value investing to special situations. Whenever I am looking at a situation that fits into one of their specialties, I can run it by them to get constructive criticism.

2. Increase your skills (stretch projects)

McLurkin figured out how to expand his knowledge by setting goals that would stretch and increase his knowledge. For me, this means striving to analyze and value companies with business models I’ve never encountered before.

For example, as many of you know, I enjoy looking at spinoffs. They are my favorite type of special situation. One spinoff that I analyzed a couple of months ago was Madison Square Garden (NASDAQ:MSG). Madison Square Garden is a company that might be daunting to value at first. There is no readily available comp for the company. With three different operations (sports, television networks, and entertainment) you must to take a sum of the parts approach when valuing it. From there, each part could be valued by more traditional methods, e.g.: the television network might be an EBITDA multiple or the sports franchise value might be determined using recent transactions. For me though, MSG was made up of three different businesses that I had never valued before. The benefits of that experience were tremendous. Now, I can apply some of those same principles when looking at companies that are tangentially connected. As an example: the methods for valuing MSG’s television business might be applicable when valuing Liberty Media Starz, a premium cable TV network.

To me, the more types of companies you can value, the more opportunities you can have. By being a generalist, you can look at practically anything. You should strive to be a generalist because there are times when one sector or another becomes overvalued. If you strictly stick within that domain, you need to be extremely disciplined in your approach. What I have seen is that most investors end up lowering their standards so they can remain active. Or, they over estimate their expertise – Wall Street is a great cautionary tale for this, for all their sector specific expertise, they missed the crisis.

3. Pick projects that you can complete (stretch churn)

With Anita Flynn’s advising, McLurkin picked projects that would not only stretch his ability, but also get completed on time. Setting goals and then accomplishing them creates a motivation loop that keeps you going.

At the moment I have a spreadsheet in Google Docs that contains my watch list of 90+ stocks. Why 90+ stocks? In my research on Michael Burry, I was really taken back by his drive for valuing companies. I remember that he had a watch list of 80 businesses that he would buy at specific prices. In light of the most recent crisis, I didn’t do much buying. I actually made just one investment. If I had a watch list of 90 companies that I knew really well, I believe I would have been able to profit to a greater degree from the market’s draw down.

Part of my goal with using deliberate practice is to value all 90 companies on the list and expand my circle of competence as much as possible with it. In order to get through so many companies in a reasonable amount of time, say 2-3 per week, I tend to gravitate towards smaller businesses. They have fewer moving parts and are easier to analyze (for more on analyzing nano-caps, read my interview with Paul Sonkin) than large conglomerates, but offer varying business models. Value can be anywhere, so you don’t have to strictly look at nano/microcaps, but they make wonderful starting points.

More practically, it might take you an entire month to really master your analysis of General Electric. The trade off is that during that month, you may have been able to learn 8 different nano-caps. You’re better off working on those 8 because you increase your chances of finding an undervalued company. I’d rather know the value of 90 companies than 12 because it expands my hunting ground for profitable opportunities.

In the last 30 days, I can say that I have somewhat met my weekly goal. I’ve valued about 10 companies which is within my ideal range of 8-12. When I mean I’ve valued them, I don’t simply mean that I have opened their latest 10K, pulled an earnings figure, and slapped a multiple on them.

5 of the companies valued over the last 30 days were in the same industry. I had to go back about 6 years and collect data to see how they traded at different points in the capital cycle (they are cyclical), furthermore, I spoke to the management teams at two of them. Two of the companies were nano-caps, where I spoke not only to management but also customers and competitors. With nano-caps, this kind of approach is key because they often have significant customers as a percentage of revenues. The loss of one can be devastating to the business. You must get comfortable with their abilities as businessmen and I think the scuttlebutt approach works extremely well for this. One company was in a sector where I had little expertise, but where I had analysts as friends. I tapped their knowledge for valuing the company and learned a lot.

To deviate, the last two companies were special situations. These are a bit different because the past is rarely a good predictor of the future, with special situations you are often analyzing the intricacies of a transaction. Often, in something like a spinoff, when you do the pro-forma analysis you might find you can buy the parent and get the spinoff for free. Much of the analysis comes down to seeing how much one share of the parent gives you of the spinoff and then separate analyses on the two different businesses. These can require more work on your behalf, since you are valuing two companies, but the rewards are wonderful. What’s great is as you go through more and more of these transactions, you pick up a lot of knowledge about the granular transaction details which makes looking at the next situation less complicated. Plus, Special situations can help give value investors investments that have clearly defined catalysts in place and can sometimes be market neutral. Two qualities that are helpful in choppy markets.

So far I’ve been really pleased with my progress through my watch list. I don’t want to say that the list is my only source of investment ideas, I still look every day for new ideas, which is why the list is hovering over 90. But, I have found it useful for formalizing my learning process with clearly defined goals in place. For newer investors hoping to improve their abilities as analysts, this formal approach to practicing is probably better than looking at 13F filings all day.

My friend Miguel Barbosa has an excellent interview with James Montier (of GMO and author of: Value Investing: Tools and Techniques for Intelligent Investment). I thought I would give you a couple of excerpts, I believe the whole interview is worth reading and suggest you do so. Miguel tells me that he should have his second part up soon.

A few days ago, when discussing value investing, a friend asked me why value investing does not stop working. Value investing thrives because of certain inefficiencies in the market and it has been written about for more than 70 years now. So why doesn’t the market catch on? Montier provides us with an answer:

Miguel: Tell us about the price = quality heuristic? Why do investors overpay for beauty and underpay for toads…after all they are one step away from becoming princes are they not? This heuristic complements the Anginer et all study where ugly defendants are more likely to be found guilty and receive longer sentences than attractive defendants.

James Montier: We humans have a bizarre bias against a bargain. For instance, my friend Dan Ariely has done some great experiments in this field showing some pretty odd findings. Imagine you taste two glasses of wine one you are told comes from a $10 bottle, the other comes from a $90 bottle. You will almost certainly say that the $90 wine tastes much better. The only snag is that the two wines are exactly the same. So never come to dinner at my house, because I’ll give $10 wine, and tell you it costs $90!

The same thing happens with pain killers. It is why branded pain killers exist alongside generic equivalents. They both have exactly the same active ingredient, but people report the branded version works better.

I suspect that something similar happens with stocks. Stocks are the one thing we don’t like to see on sale. So a ‘cheap’ stock must have something wrong with it, and an ‘expensive’ stock must be a sign of quality – at least that’s the way we tend to view things.

The Anginer et al study shows some similar findings in the legal context. Ugly defendants get far worse sentences, than attractive defendants. We have a hard time believing that attractive people could have been bad – a kind of halo effect, if you will.

If you haven’t already, I really suggest you read Dan Ariely’s book Predictably Irrational, it is one of my favorites. Montier gets at why I think markets wont figure out value investing — the participants are too irrational. Usually, what you will see are investors who claim to practice value investing, only to abandon it when things get tough. It is a style of investing that requires levelheadedness, courage, and patience, which many investors lack.

One of the topics Montier touches on is short selling, which I thought was pretty interesting. Most value investors don’t short, so it is always nice to take a look at the ones who do:

Miguel: Tell us about the folly of using price to sales as a proxy for value.

James Montier: Price to sales is fine if you are looking for short candidates, but as a long side value criteria it makes no sense to be at all. After all as long as you promise to value me on price to sales, I’ll set up a business selling $20 bills for $19…I’ll never make a profit, but if you are looking at price to sales you won’t care.

Price to sales is typical of the drift up the income statement when the bottom line gets too demanding. If your PE starts to look expensive, get everyone to look at a less demanding metric, enter stage left price to sales. If that starts to look tough, abandon the income statement and look at the value based on eyeballs and clicks!

Miguel: What I enjoy about your writing is that you aren’t afraid to talk about “controversial topics” – yes I’m talking about your work on short selling. Can you quickly tell us what you have learned about short sellers (their characteristics, screens, etc).

James Montier: Short sellers are everyone’s favorite scapegoats. They make money when things go ‘wrong’. Of course, what the authorities forget is that simply because a short seller sells a stock, doesn’t mean it goes down – if only it were that easy we’d all be short sellers. As David Einhorn observed, I’m not critical because I’m short, I’m short because I‘m critical.

In my experience, short sellers are amongst the most fundamental investors you’ll come across. They understand the ins and outs of a business better than just about everyone else. They are highly skilled at figuring out poor economics when they see if. They act as acting police, helping to uncover fraud – something that the regulators used to do (a very long time ago).

My own work on short selling has focused on a number of areas. In general, shorts tend to come into a couple of categories: bad businesses (i.e. poor economics), bad accounting (obvious), bad management (the guys at the top haven’t got a clue). In addition I often look for several traits, such as expensive, unrealistic growth expectations, too much debt, and poor capital discipline (i.e. needless and tangential M&A).

I also created a measure called the C-score (C is for cheating or cooking the books). It aims to look for the quantitative red flags which often accompany bad accounting.

Excerpt: Details of the C score Page 263 of Value Investing Tools & Techniques for Intelligent Investment

1. A growing difference between net income and cash flow from operations.
2. Day sales outstanding is increasing.
3. Growing days sales of inventory
4. Increasing other current assets to revenues.
5. Declines in depreciation relative to gross property plant and equipment.
6. High total asset growth.

Miguel Barbosa interviews James Montier (Simoleon Sense)

Those are just two questions that Montier answered. There are many more over at Simoleon Sense and I highly recommend the interview.