Inside the Mind of Warren Buffet's Probable Successor

Buffet's Successor? Who is Li Lu?

Li Lu is rumored to be the front runner in managing Berkshire Hathaway's investment portfolio after Warren Buffet steps down. After hearing Warren Buffet speak at a Columbia alumnus lecture, Li Lu was inspired to work in investment banking. After his stint in investment banking, he founded Himalaya Capital Management (a hedge fund, which later was transformed into a long-only vehicle).

His claim to fame was introducing the Chinese battery and auto maker BYD Company to Charlie Munger and Warren Buffet. In 2008, Warren Buffet invested about $230M in BYD for 10% of the company at HK$8/share. In Sept of 2014, the value ballooned to about HK$53/share.

From left to right: David Sokol of MidAmerican, Warren Buffett, Wang Chuan-Fu of BYD and Li Lu. Photo: David Yellen
Recently Li Lu spoke in front of an audience about his investing principals. There are three basic principals surrounding value stock investing.

1) A stock is not a piece of paper that you trade. Instead it represents a fraction of ownership in a company. Therefore when valuing a stock, you are valuing a portion of the business.

2) When valuing a financial asset you should be able to reasonably predict future cash flows. However, should you be wrong, make sure you've left yourself a "margin of safety".

The future is a distribution of all probabilities. Even though you may be 90% certain that an asset will continue to grow, that 10% of stagnation or devaluation is still a possibility. Should all that could go wrong go wrong just make sure you will still be in the game. That is the core behind the concept of margin of safety.

3) The market can be emotional and neurotic causing irrational behaviors among investors.

When value investing you have to be in a frame of mind that allows you to be comfortable in standing alone even when the whole market is against you and everyone thinks you are wrong. What allows you to do this is your research. Trusting your research even when everyone else thinks otherwise is a difficult and unnatural thing to do.

All the successful value investors have a couple of things in common. First of all, they do not bet often. Instead they wait for the best situation. A situation that allows has margin of safety enough so that they are able to stand against the whole market, which requires immense amount of discipline.

Real World Value Stock Examples
In the early 1990s, Russia privatized most of their state assets almost overnight. Many people did not understand privatization, so those who received shares were selling them at discounted prices. For example, a Russian oil company's stock was trading at 1 cent on the dollar per barrel of oil it held on its books. At the time oil was trading at $20/barrel. Even with excluding earnings and considering the political uncertainty, you would have came up on top at these discounted prices.

A couple of years ago there were non-voting common shares trading at 70-80% discount compared to the common voting shares equivalents. This was a company that had been growing on a compounded basis for three to four decades. Furthermore there is virtually no difference between the voting and non-voting common shares because the family has controlling interest.

The holy grail of investing is finding businesses trading at inexpensive prices that also have the ability to generate cash on a compounded basis.

How do you decide when to sell a stock?
Every situation is different. The upside and downside of a business can change based on factors outside of the company, therefore it is important to reevaluate the situation on an ongoing basis. While you may not feel comfortable with a 70% discount on a company based in Russia, a 20% discount in a large US corporation may be enough of a margin of safety. When a stock becomes valued at extreme levels or the situation turns unfavorable - that is when you sell. However, if the company's earnings continue to grow, there is less of a hurry to sell. Because you are essentially letting your investment grow interest free by avoiding the capital gain tax when you do sell.

Finding a stock with a large margin of safety could require long periods of time where you don't swing at all. But, you should be studying all the time to be ready for opportunities when they do arise. Investment ideas can come from anywhere from the Wall Street Journal to maybe even billboard signs. Diversification is necessary to stay in the game in the long run. However, the extent to which you diversify is based on your opportunity cost. What else can do you with the cash?

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