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 ). 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.
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.”
Today, while browsing twitter I noticed Abnormal Returns yielding more than 10 year treasuries. It got me thinking again about the fact that large cap stocks look pretty undervalued right now.
You don’t really get popular by being bullish on large cap stocks – most people actually look down upon it, especially as a value investor. We are supposed to find these hidden gems that nobody knows about. Everybody and their mother knows about Johnson and Johnson. Still, it and a number of other large caps are trading at valuations that are really attractive right now.
Value investing can go either two ways:
1. Buy an undervalued stock with some kind of catalyst and sell once it reaches your target price.
That approach is much more akin to Benjamin Graham and Warren Buffett from his partnership days.
2. Find a great business with excellent growth potential that is trading at an absurdly low price.
This is the approach Warren Buffett honed in his later years.
To me, either approach works. And for my own portfolio, if I can crank out an annualized return of around 15% over an extended period of time, I’ll be pretty happy. The way I look at undervalued large caps is you can sometimes find them trading at levels that are low enough to make it so your potential for capital loss is minimal. Worst case – you lose nothing. Best case – you have bought into a large cap that still has great overseas growth prospects and a healthy dividend. An investment like that can enable you to buy and hold for years.
So what are some names that have been interesting to me?
Johnson and Johnson
AR’s comment about treasury yields versus the yield on Johnson and Johnson (NYSE:) reminded me of a chart I saw over at Value Investors Club:
I have updated the original chart to compare the past data with JNJ’s current price and the price it hit during the bottom of the financial crisis. As you can see, the company looks amazingly undervalued — especially when compared to the past. Whenever its forward earnings yield and dividend hit levels like this, it is usually an amazing opportunity for investors.
JNJ is getting some heat right now about a recall from their consumer products division, but the company has a history of being around since the Great Depression. With a minuscule amount of net debt ($6B) and almost $20B in EBITDA, the company is at a really sweet spot. Margins are still healthy at above 25% and a return on equity of around 27.5%.
Yes, sales did decrease for 2009, but it was also during a crisis period described as the worst since the Great Depression. In the longer term, I think there are demographic trends that make the company appealing. With our population expected to grow older, JNJ products should be more in demand. In addition, a substantial amount of revenues come from abroad which means that there will be tailwinds for growth outside of the US.
Walmart
Another one I’ve been looking at is Walmart (NYSE:). A while back after hearing Warren Buffett recommend it, I read Sam Walton’s biography which details how he started Walmart. I came away for a much higher regard for the company, particularly after learning about their humble beginnings. It is truly amazing that Walmart has been able to grow from its humble beginnings as a rural discount retailer to a global corporation. Along the way, they still have not forgotten their ethos of making sure they bring customers the lowest prices.
Some investors have been skeptical about Walmart, especially after the recent decision to let the Chinese yuan rise. Since Walmart sources most of its goods from Chinese manufacturers, a rising yuan will eat into Walmart’s bottom line as they convert from dollars. Since Walmart buys such a massive amount of goods from China, this could impact margins. I think that this is possible, but I am not too worried.
The fact is, capital is mobile and the folks at Walmart are bright enough to realize that if one country becomes too expensive, they can move elsewhere. That kind of mobility is going to pressure the Chinese to keep their currency down because if they don’t, the prices may hurt their exporters. So far, China does not quite have the kind of domestic demand that is necessary to offset a major reduction in American consumption of their goods.
Walmart has a lot going for it. It is by far, the lowest cost distributor and retailer of basic goods. Part of this comes from its amazing supply chain/distribution system. Walmart was one of the first retailers to figure out that a company-wide computerized inventory system would allow them to stock exactly what people want, when they want them. This translates into better inventory turnover numbers.
Vinod Palika (PDF) with plenty of data points that show Walmart’s strength relative to peers. In 2001 Walmart inventory was 51 days, in 2010 it decreased to 40 days. For comparison, at Target inventory was at 58 days in 2001 and is now 56 days in 2010. Walmart’s economies of scale help maintain margins. Take advertising, in 2010 Walmart’s ad budget was only 0.6% of sales, comparatively Target spends 2.15% of sales on their ad budget. The best part? Even though Walmart spends less as a percent, they are still spending more overall – $2.4B versus $1.4B. That means Walmart can outspend Target but keep its margins in tact.
Walmart initially had some hurdles breaking into overseas markets, but so far they have corrected that and if you look you can see some impressive growth there. I think for a business as huge as Walmart, which generates large benefits from its size (bargaining power with suppliers) the company should at least get a forward P/E multiple that is greater than 11x. A 15x multiple on 2011′s EPS would result in a share price of about $66 compared to $49 today.
Kraft
If you study Warren Buffett, you’ll see that some of his best investments occur at a time before a business is about to embark on an upward trend in margin expansion. Basically, what he does is find great businesses that are down in the dumps.
When Roberto Goizueta came to Coca-Cola, the business lagged behind Pepsi. Goizueta applied his background as a chemical engineer to the company, in order to standardize certain processes and add efficiency to the Coca-Cola’s operations. These actions reduced expenses. Then, he he culled low return on invested capital operating units from the business to boost overall profitability. These actions dramatically increased margins and magnified shareholder value: Coca-Cola’s market capitalization increased from $4.3B in 1981 to $152B in 1997. To learn more about how Goizueta did it, be sure to read , his biography.
You might be wondering why I am mentioning Coca-Cola when I’m supposed to be talking about Kraft (NYSE:). Back when Irene Rosenfeld announced the merger with Cadbury, Pershing Square’s Bill Ackman released a report which detailed the potential for margin expansion at Kraft:
Ackman’s thesis appears sound. A merger between Kraft and Cadbury, means there is less competition in the marketplace and the combined company may have the ability to raise prices. That might help increase EBIT margins in 2011 to Ackman’s projected 15%. Plus, I think you really cannot ignore the gains in Kraft’s supply chains that will come from this deal. Most people underestimate just how difficult it is to get consumer goods to shops in developing nations where there might be no paved roads. It’s the kind of investment that takes years to refine, but will pay dividends in the future as we increasingly rely on the developing world for growth.
With leading consumer brands from chocolates to macaroni and cheese, combined with 25% of revenues from developing markets (more than any other North American peer) Ackman’s 15x 2012 EPS ($2.70) multiple appears possible. Ackman provides an upper range of 17x 2012 EPS ($2.90). That gives us a share valuation of $41 to $49 versus today’s $28.30. Plus, you get a 4% dividend.
Kraft is obviously not going to have the same kind of dramatic growth that you saw from Coca-Cola during Goizueta’s time as CEO, but it is an illustrative example of how changes in the business can increase its valuation.
Anheuser-Busch InBev
Another interesting large cap that looks undervalued is Anheuser-Busch InBev (NYSE:). The company, formed by the merger of Anheuser-Busch and Brazil’s InBev looks like another case where through a merger there is a potential for substantial cost savings. Anheuser-Busch is a powerhouse in the beer market. The merger effectively created the largest brewer by market cap, at $77.4B. The company boasts 200 different brands, 13 of which have over $1B in sales. Moreover, BUD occupies the #1 or #2 rank in 25 of its top 31 markets.
BUD trades at basically a 9.6% FCF yield which is great given its side. Free cash flow is expected to increase over the next two years, as Anheuser-Busch InBev is able to reduce costs as the two companies integrate. In contrast, Diageo, a market leader in the beer and spirits area has a FCF yield of 6.2% — even though it is less than half ABInBev’s size. I could see BUD trading at about a 6% yield which would be about $77 per share, 60% higher than today’s prices.
So far BUD seems to be making the right inroads in trying to break into the Chinese market. I think that beer and spirits companies are increasingly going to look at Asia for growth. It wont be an overnight process and so if there is some lag between that Asia growth and US sales growth, you might see some pessimism. One thing I particularly like about BUD is because of its size, it should be able to have better margins because of its size. As in the Walmart case, BUD looks poised to spend more on advertising than its peers at a lower percent of sales. This company should be a bargain as long as the management at BUD are willing to take FCF and use it intelligently by paying down debt and pursuing buybacks.
For anyone interested in learning more about the industry, I suggest checking out , a documentary about the beer business. It contrasts small craft breweries with the majors like Budweiser and Molson Coors. You get to learn a lot about how the major breweries have been able to take advantage of our fragmented legal structure to erect huge barriers to entry in the beer business.
Killing a Large Cap
I’ve outlined short reasons why I would be bullish on these companies. The question you have to ask is why these great companies are trading at such low prices. I think there are a few factors. More broadly, into and during the financial crisis, money poured into these stocks as they were seen as safe havens. Some held up and others only had slight price declines relative to the market. When things started to turn, money exited and went into the stocks that got clobbered. So there might be less money in some of these large cap blue chip stocks than others.
Secondly, when you start hearing worries about global growth some of these stocks get affected. Many of them are large enough to provide the liquidity necessary to allow large macro funds to exit in and out. So they might be more susceptible to day-to-day volatility than smaller, less noticed stocks.
Then there is sell side pessimism. Large cap stocks are particularly vulnerable to sell side pessimism. They tend to attract the masses who sell whenever they hear an analyst downgrade a company. Most sell side calls are for the medium term, so whenever there there is some temporary panic the sell side erupts. Such reports tend to discount the longer term potential earnings power behind some of these businesses.
During the financial crisis some analysts claimed people would stop drinking Coca-Cola because of the deteriorating economic situation. Or with Kraft, some analysts feared that private labels made by supermarkets would undercut Kraft’s products. But, the fact is, you can make a bear case for almost any investment. Most people I know kept chugging cans of Coke, even during the March 2009 bottom. People still ate Kraft Mac ‘n Cheese. But none of these companies are a perfect hedge, they almost all hit 52 week lows during the crisis. At the same time, their longer term prospects were much better than the broader market. If you are willing to wait years I’d expect these companies to do quite well. They should at least be able to preserve your capital — especially at the P/Es we see today. That is a critical factor you need to look for in equities given the concerns about inflation.
More Depth
Now, I’ve outlined reasons for why some of the above companies look undervalued and have sustainable competitive advantages. That’s not enough to warrant an investment though — more research needs to be done. Over the next coming weeks I plan to look at a few of them in more depth in terms of analyzing financials and putting together models. If I get some indication of what company readers would be interested in (either by comments or e-mail) I’ll start there first. They can even be large caps not explored in this post. I’ve also started looking at: MasterCard (NYSE:) – at 17x EPS for basically an oligopoly, it looks really appealing, Monsanto (NYSE:) – their seeds and pesticides are going to be needed by the rest of the world’s farmers, and even some foreign telecoms.
For those of you happy to do your own reading, one of the neat things I noticed is certain big companies have very generous annual report policies. I was able to get 5 years worth of 10Ks mailed to me within a couple days from JNJ and McDonalds.
Some people fret about whether or not they can get an edge when looking at companies that are so large. I think with these blue chip companies, you’re edge is going to come from your discipline. Being willing to ignore downgrade calls and buy when most people are selling. If you can do that, you might be able to own part of a growing business at a price that is low enough to provide you with a satisfactory margin of safety.
Many of you enjoyed my previous transcript of a talk Li Lu gave at Columbia University. Thanks to Joe Koster, you can now 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.
Yesterday, at the CFA Institute conference, Seth Klarman gave a talk on how he sees things today. Reuters was there to report and I thought I’d excerpt the article:
Star hedge fund manager Seth Klarman sees few bargains in the current environment and predicted on Tuesday that the stock market could suffer another lost decade without any gains.
“Given the recent run-up, I’d be worried that we’ll have another 10 years of zero returns,” Klarman, who rarely speaks in public, said at the CFA Institute’s annual conference in Boston.
Current market conditions remind Klarman of a Hostess Twinkie snack cake because “everything is being manipulated by the government” and appears “artificial.”
“I’m more worried about the world broadly than I’ve ever been in my whole career,” Klarman said.
Klarman has 30 percent of assets at his $22 billion Baupost Group in cash, he said. He started the firm in 1982 with $27 million and has averaged 20 percent annual gains ever since. In 2007, amid the depths of the credit crash, Baupost had its best year, gaining 52 percent.
One of the key traits you will see Klarman exhibit, year in year out, is his willingness to put a substantial portion of his assets into cash. In Margin of Safety, Klarman sees shorting as flawed because of the potential for unlimited losses. Studying his career, you will see that he also tends to use out-of-the-money options to hedge against risk. He did this in the late 80′s/early 90′s with Nikkei puts and later with gold. In Michael Lewis’ The Big Short, you can read about hedge fund Cornwall Capital’s use of a similar strategy (they did remarkably well).
Here is what Klarman had to say about options:
Inflation is a risk that Klarman said he is particularly concerned with given the government’s high rate of borrowing to bail out the financial system. Baupost has purchased far out-of-the-money puts on bonds to hedge the risk, he said.
The puts, which Klarman said he viewed as “cheap insurance,” will expire worthless even if long-term interest rates rise to 6 or 7 percent. But if rates rise to 10 percent, Baupost would make large gains, and if rates exceed 20 percent the firm could make 50 or 100 times its outlay.
Many long-only value managers try to stay fully invested in the market because they are afraid to miss out on upswings in the market. With that kind of attitude, they are almost always crushed more than others with a downturn (concentration juices returns in both directions). But if you study Klarman and Warren Buffett, you will see that there are periods when they put a lot of their assets into cash. Cash allows them to opportunistically invest after the fallout of a market downturn while leaving out the guess-work of picking the right shorts.
So where is Klarman finding opportunities right now? Commercial Real Estate:
One area Klarman said he is currently scouring for potential investments is private commercial real estate below the top quality. Publicly traded real estate investment trusts, however, have “rallied enormously” and are “quite unattractive,” he said.
Now the trick for us small investors is to see if there are any indirect ways to play distressed CRE markets. As Klarman says, REITs have mostly rallied. That means we would have to look at some more creative, less direct investments.
This past weekend was the Berkshire Hathaway (NYSE: / ) 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.
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.
I’m not in Omaha this year to attend the Berkshire Hathaway annual meeting. But, I saw Warren Buffett’s advice for entrepreneurs at the meeting and thought it was worth sharing:
There’s nothing like following your passion. Find your passion and don’t let anything stop you. $500 built Nebraska Furniture Mart’s 78 acres of store in Omaha. Rose Blumkin loved what she did. Think about what that produced. It is incredible.
For those of you unfamiliar with Nebraska Furniture Mart:
Nebraska Furniture Mart is the largest home furnishing store in North America selling Furniture, Flooring, Appliances and Electronics. NFM was founded in 1937 by Mrs. B (Rose Blumkin) in Omaha, Nebraska. She worked in the business until age 103. In 1983, Mrs. B sold a majority interest to Berkshire Hathaway with the famous handshake deal with Warren Buffett. NFM now has three stores. The Omaha store is over 420,000 square feet (39,000 m2) of retail space and is on 77 acres (310,000 m2) of land. The Kansas City, Kansas store is also 420,000 square feet (39,000 m2) of retail space and is on 88 acres (360,000 m2) of land and sits across from the Kansas Speedway. The third store is in Des Moines, Iowa and is 24,000 square feet (2,200 m2) and sells appliances, flooring and televisions.
From the 1983 letter, we get a good idea of just how great of an entrepreneur Rose Blumkin really was:
Last year, in discussing how managers with bright, but adrenalin-soaked minds scramble after foolish acquisitions, I quoted Pascal: “It has struck me that all the misfortunes of men spring from the single cause that they are unable to stay quietly in one room.”
Even Pascal would have left the room for Mrs. Blumkin.
About 67 years ago Mrs. Blumkin, then 23, talked her way past a border guard to leave Russia for America. She had no formal education, not even at the grammar school level, and knew no English. After some years in this country, she learned the language when her older daughter taught her, every evening, the words she had learned in school during the day.
In 1937, after many years of selling used clothing, Mrs. Blumkin had saved $500 with which to realize her dream of opening a furniture store. Upon seeing the American Furniture Mart in Chicago – then the center of the nation’s wholesale furniture activity – she decided to christen her dream Nebraska Furniture Mart.
She met every obstacle you would expect (and a few you wouldn’t) when a business endowed with only $500 and no locational or product advantage goes up against rich, long-entrenched competition. At one early point, when her tiny resources ran out, “Mrs. B” (a personal trademark now as well recognized in Greater Omaha as Coca-Cola or Sanka) coped in a way not taught at business schools: she simply sold the furniture and appliances from her home in order to pay creditors precisely as promised.
Omaha retailers began to recognize that Mrs. B would offer customers far better deals than they had been giving, and they pressured furniture and carpet manufacturers not to sell to her. But by various strategies she obtained merchandise and cut prices sharply. Mrs. B was then hauled into court for violation of Fair Trade laws. She not only won all the cases, but received
invaluable publicity. At the end of one case, after demonstrating to the court that she could profitably sell carpet at a huge discount from the prevailing price, she sold the judge $1400 worth of carpet.
Today Nebraska Furniture Mart generates over $100 million of sales annually out of one 200,000 square-foot store. No other home furnishings store in the country comes close to that volume. That single store also sells more furniture, carpets, and appliances than do all Omaha competitors combined.
One question I always ask myself in appraising a business is how I would like, assuming I had ample capital and skilled personnel, to compete with it. I’d rather wrestle grizzlies than compete with Mrs. B and her progeny. They buy brilliantly, they operate at expense ratios competitors don’t even dream about, and they then pass on to their customers much of the savings. It’s the ideal business – one built upon exceptional value to the customer that in turn translates into exceptional economics for its owners.
Mrs. B is wise as well as smart and, for far-sighted family reasons, was willing to sell the business last year. I had admired both the family and the business for decades, and a deal was quickly made. But Mrs. B, now 90, is not one to go home and risk, as she puts it, “losing her marbles”. She remains Chairman and is on the sales floor seven days a week. Carpet sales are
her specialty. She personally sells quantities that would be a good departmental total for other carpet retailers.
We purchased 90% of the business – leaving 10% with members of the family who are involved in management – and have optioned 10% to certain key young family managers.
Rose Blumkin was an amazing entrepreneur. She continued to be involved with day-to-day operations until shortly before her death at 104 years old.
A while back, Warren Buffett mentioned that he often looks at rail freight traffic to get an idea of the wellbeing of the economy. With transportation, you can figure out how goods are moving through the country in response to consumer demand, allowing you extrapolate how those sales will affect the broader economy.
Today there are a number of news releases that are pointing to a rebound:
Freight companies’ shares rose early Thursday after strong results from several companies in the sector showed a pickup in demand, which bodes well as an early sign of recovery for the economy as a whole.
The companies had been seeing a slow recovery as the economy started to improve. Pricing pressures and slumping freight demand hurt the companies in the last year and a half. But results from several of the companies, including United Parcel Service Inc. (UPS), in the last two days have offered new optimism for the freight-transport sector and sent shares soaring. Several companies posted gains in some of their metrics, such as revenue or volumes, that hadn’t been seen in nearly two years.
UPS is often viewed as a key barometer for global trading activity, and the freight sector as a whole offers a glimpse into how the economy is doing because it moves manufactured goods before they are sold.
“Seeing transport volumes pick up is a sign the economy isn’t far behind,” FBR Capital Markets analyst Christian Wetherbee said. A pickup in freight volumes points to improvement in manufacturing activity, along with coming improvement in retail sales, he said, which will eventually translate into gross domestic product.
Here is a closer look at UPS (NYSE:):
United Parcel Service Inc. said its first-quarter earnings jumped a better-than-expected 33%, in another sign of improvement in shipping, a bellwether of the broader economy.
Disclosing its results two weeks early, UPS said on Wednesday that growth was powered by a “significant acceleration” in international shipping with daily volumes up 18% in the quarter compared with a year ago. U.S. daily shipping volumes rose less than 1%, but that is the first increase in U.S. volume reported by the company in two years.
UPS said international sales jumped and the U.S. had its first year-over-year gain in two years. Above, workers load packages in Louisville, Ky.
“We expected the first quarter to be the most challenging of 2010 as the economic recovery gathered steam through the year,” Kurt Kuehn, UPS’s chief financial officer, said in a statement. “As it turned out, revenue was stronger than we expected due to international volume gains, increased yields in the U.S. and growth in forwarding and logistics.”
Kevin Sterling, a transportation analyst with BB & T Capital Markets, said: “What I find encouraging is that the growth is top-line driven; it’s revenue driven. Really, I think it speaks to the economy gaining steam,” he said.
Mr. Sterling said that overall, international freight shipments are up 35% compared to a year ago, and up between 6% and 8% over 2008.
Railroad company CSX (NYSE:) also reported strong results:
Railroad operator CSX posted double-digit increases in sales and income on gains in productivity and volumes. Above, a CSX locomotive at the Barr Rail Yard in Riverdale, Ill., in January.
CSX Corp., the first major U.S. railroad to report first-quarter results, cited the economy’s “gradual and steady” gain for a 24% profit rise that topped Wall Street expectations.
The Jacksonville, Fla., railroad operator said its freight volume rose 5% overall and climbed in most categories, compared with the depressed year-earlier period, with big increases in shipments of metals, fertilizers, autos and auto parts.
A 27% increase in metals shipments was driven by “rebounding steel consumption consistent with the ongoing economic recovery,” the company said in a statement. But its big coal-transportation business remained weak as volume shrank 13% in the quarter due to high coal stockpiles at U.S. utilities. Last month, CSX said it expects its coal shipments this year to rise a bit despite weak first-quarter trends.
The transport sector is poised for a rebound this year, with freight traffic on U.S. railroads up 2.2% in the quarter, according to figures complied by the Association of American Railroads. Still, traffic remains well off 2008 levels, indicating a slow turnaround is underway.
The railroad traffic specifically can give us an idea of how construction and new builds are progressing in the US via their activity in steel transportation. However, it is worth noting that coal demand and overall traffic still remains lower than before. So while we are gaining momentum in the recovery, we aren’t quite there yet.
If you think about it, Berkshire Hathaway (NYSE:) must give Buffett a number of indicators for how the consumer economy is working. Besides Burlington Northern’s railroad traffic data, his various operations give him data on t-shirt sales, jewelry, furniture, fast food, energy consumption, and more. I’d argue that some of this data is probably more helpful than the kind the Federal Reserve gathers.
For us mere mortals without billion dollar conglomerates, we can rely more on transportation data for an approximate take on the economy since many businesses rely on trucks and rail freights to move goods from one point to the other in the supply chain.
Over the last few weeks, I have spent a lot of time trying to find certain industries that appear undervalued. One area is insurance, where many insurers with good combined ratios and past performance are trading below book. I was happy to see Wilbur Ross agree in this Q&A with Fortune:
Where do you think the biggest opportunities are now?
There are deep value opportunities in insurance stocks, which were beaten down because of their exposure to the subprime crisis, annuities, and commercial real estate. I won’t name names, but some well-managed life insurance and fire and casualty companies will come through this stronger. They used to trade at one or two times book value but now trade at three-quarters book…
A quick look at shows us how the sector is looking for reinsurance players:
Most appear pretty cheap on the basis of book value. For the moment, it seems as if these companies are trading at discounts mainly due to market conditions. Most insurance companies are reporting that they are still in a soft market. I know that the folks at W.R. Berkley are expecting that things will start to turn. One indicator of that, to me, seems to be with the uptick in M&A activity. We saw Fairfax Financial acquire Zenith, and recently Perry Capital urged Endurance Services to find a merger partner:
PEMBROKE, Bermuda—One of the largest shareholders of Endurance Specialty Holdings Ltd. has urged the Pembroke, Bermuda-based insurer to find a merger partner.
New York-based hedge fund manager Perry Corp.—which owns 12.6% of Endurance and whose president, Richard C. Perry, is a member of its board of directors—said in a regulatory filing Monday that it expects consolidation in the Bermuda reinsurance market to accelerate in the near term.
Endurance “should undertake an evaluation of its strategic alternatives and pursue a possible merger or other strategic transaction in order to create a stronger company with a defined growth strategy,” Perry, which does business as Perry Capital L.L.C., wrote in the filing with the Securities and Exchange Commission.
In addition, Perry said recent executive appointments at Endurance will “not position the insurer to capitalize on consolidation opportunities.”
Richard Perry might also see the reinsurance sector as undervalued, which is why he thinks opportunities are ripe for Endurance Services. If that is not enough, we also saw Warren Buffett and Swiss Re. Smart, value savvy investors appear to be really interested in these companies and I think they are worth a look.
To me, the key will be to find insurance companies that are trading at low multiples with the capacity to increase policy volumes as the market improves.
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I still like Fairfax given its book value growth, great management team, and current price. However, I see plenty of other opportunities worth analyzing, especially with P&C insurers. I plan on posting some work that I have been doing on insurance companies sometime this week, so be sure to look for that.
My name is Tariq Ali, I run Street Capitalist. I recently graduated from the University of Texas at Austin. There, I stumbled onto value investing via the school library. I read everything I could and now I'm here, writing out my thoughts and investment ideas.
I have a lot of heroes when it comes to investing, it seems like every investor has some kind of niche. Some, whose books and writings have had the biggest impact on me are: , ,, , and .
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Feel free to e-mail me at TariqTX@gmail.com
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