Li Lu's Investing Masterclass at Columbia Business School

2006 guest lecture in Bruce Greenwald's class

After transcribing Li Lu’s recent interview about value investing in China, I decided to transcribe a lecture at the Columbia Business School. This masterclass had a huge influence on my investing philosophy and I just had to transcribe it, since the audio in the recorded video isn’t easy to understand and often cuts out. I got the stock information from his new book “Modernity, Value Investing and China” (“现代化、价值投资与中国”), where he published the transcript of this lecture in Chinese. The transcript is edited in order to make it easier to read, understand and reference. 

Here is the link to the video: 

Introduction and Philosophy

It’s great to be back in this class again, as it has shaped my career like no other. About 15 years ago, I wasn’t even a business student, I accidentally attended a lecture that was part of Professor Greenwald’s class. The speaker was Warren Buffett, whose name reminded me of lunch and buffet. His talk enlightened me and I realized that I might be able to get into this business. Having recently escaped from China, I was pretty desperate. I arrived with no family, social network, no money and a lot of debt. I was worried how I was going to make a living. Growing up, I was far removed from capitalist culture and Warren talking about the stock market was different from the perception I had. The more I thought about it, the more I felt that investing is the right career for me. 

I assume that most of you, because it is difficult to get into this class,are more or less “self-selecting” and are already biased towards value investors. Let’s do a quick check. How many of you consider yourself value investors or value-prone investors? How many of you know that they want to work in asset management? Roughly the same amount of people who consider themselves value investors also want to go into asset management. 

Who can tell me the one or two characteristics that separate value investors from everyone else? 

Student: Value investing depends on the underlying business rather than valuation multiple increases or stock trading. One needs to have a longer time horizon. 

In other words, you see yourself as the owner of the business and your fortune increases or decreases with the nature of the business. Any additional thoughts? 

Student: One requires a margin of safety.

Yes, you demand a margin of safety. Anybody else? 

Student: A long-term perspective. 

Right. That summarizes the three basic points of value investing, straight out of the teachings from Ben Graham. Firstly, you don’t think of yourself as a paper-shuffler when you buy a stock, but as an owner of the business. Secondly, you demand a huge margin of safety and thirdly is understanding the “Mr.Market” analogy from Graham. 

All three come from the perception that you are a business owner, not a paper holder. Since you only own a small part of the company and can’t control it, you require a margin of safety as self-defense. Any value you perceive might not be there, so you need some protection. If you own the business you don’t trade all day, which makes you different from the usual stock market participant. If we see ourselves as business owners, do we actually need the stock market? The stock market was not created for value investors. It was set to  minimize friction and allow people to trade. Does anyone have a guess how much of the assets are managed by value investors? 

There is not a conclusive study, but there are a number of attempts including one from Professor Lowenstein, a law professor next door. He estimates that just under 5% are held by value investors. This is consistent with what we said, that value investors are not the majority, but the minority with the stock market not being catered towards you. It was created for the other 95% and this is where both your opportunity and challenge lies. 

You need to have an understanding of those principles before entering into the investment industry. This was one of the first things that I learned from Warren Buffett’s talk, and it helped me figure out what person I am. For most of those, especially those going into asset management, your biggest challenge is to understand whether you are the 5% minority or the 95% majority. You might think that coming to this class you get biased towards value investing and you would be amazed how much one can change. When I ran my own fund, early one in my career Julian Robertson, the founder of Tiger Fund invited me to share an office with him. He invited lots of fund managers that he invested money in to work together and share ideas. That gave me an understanding on how the 95% operated. You question yourself why 95% of the people don’t do what you are trying to, despite the spectacular success of Warren Buffett and Munger. Can anyone explain it? 

Student: Emotionally it is very difficult.

Correct. But given the strong evidence, that value investors have superior returns over a long period of time, you would think that this is where the money is. Even if it is emotionally difficult wouldn’t most investors try to make the change? Any other reason? 

Student: They are looking for short-term gains. 

We’re pretty close to the truth. The money is pooled into short term trading. This is because the market was created for people, who want to trade all the time and pay more attention to the short-term. If you have a requirement, an asset is going to find you. As a result, even as statistics show that there is a huge performance discrepancy between value investors and the 95%, the money will still go there. And when the money is there, human nature will lure investors into that short-term thinking. 

The first point I want to emphasize is to understand who you are, because you will be tested throughout your career. You need to find out if you are a value investor or if you aren’t. Only a small number of people are value investors and that is maybe because you are genetically mutated. You are very comfortable being in the minority -  and this is not natural for humans. Due to our natural evolution process we survived, because we stuck with the group. We have done so for thousands of years and it is deeply ingrained in our genes. However, occasionally you will find those people who are built differently and it is most likely that a genetic mutation has occurred. You have to be comfortable being yourself. You don’t get your ideas because people agree with you, but because of evidence, logic and reason. It is common sense, but as the saying goes “Common sense is the least common commodity” and most don’t think that way. 

Secondly, is that you will spend most of your time being an academic researcher instead of being a professional investor. You have to spend time to be a researcher and investigative journalist with an insatiable curiosity. The more you know, and the deeper your knowledge, the better you will be as an investor. Learning from politics, science, technology, humanity, history, literature or even poetry. Being interested in everything will aid you to find those few insights that give you tremendous opportunities. Others might miss them because of psychological factors, limits to their thinking or because of institutional constraints. 

When an opportunity presents itself, I have a checklist to go  through: 

• Is it cheap?

• Is the business good?

• Is the management trustworthy and good or is there enough external validation?

• What else am I missing?

• Why does this opportunity exist in the market? 

If you feel comfortable after going through those points, one only has to go over the last psychological barrier to act. 

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Case Study: Timberland

Let’s go through a couple of examples. While I don’t talk about what I own anymore, I can tell you what I owned in the past. I started my company in 1997, and there were several traumatic events along the way. The Asian financial crisis and the technology bubble both tend to present some interesting opportunities. In the fall off 1998, I found one. Being interested in all kinds of businesses, I was obsessed with reading Value Line as a student. 

I read every issue that was released and it was a great education if you want to acquire encyclopedic knowledge and a business database. It is the best business training and going through it page by page is enormously helpful. The first thing I usually do is check the new low lists. “All-time lows”, new lows in P/E, new lows in P/B etc.. They are more attractive than the new high list. 

Looking at the information on this graphic, please note that the $46 share price isn’t correct but should be around $28-$30 in August/September 1998. What is the first thing you notice? Can someone give me a quick summary? 

Student: The stock price difference between high and low is substantial and the price has just fallen off a cliff. 

If you are a value investor, you aren’t concerned with how a company traded in the past. All you should care about is the valuations. If the valuation isn’t attractive I won’t continue. What do we know about the valuation? 

Student: P/B value is relatively low. 

Good point. What is in the book, what are the book assets? How much are the assets worth? It’s simple, just take an estimate. The working capital is around $300 million and this report was issued at the end of the third quarter. If you have a lot of encyclopedic knowledge and study industries, you would know that all retailers built up a large amount of inventory to be ready for the last quarter, so looking at previous years fourth quarter we can estimate it. The company has $300 million in book value, $275 million in working capital and with the results of previous years, we can probably add around $100 million more. So we have $200 million in liquid assets and $100 million in fixed assets. With additional research you find out that these fixed assets are buildings and real estate. A decent protection on the downside. 

What do we know about the earnings and the cash flows. The things you want to pay attention to is the pre-tax and pre-interest without leveraged capital to see how profitable it really is. What is the operating profit? It should only take you a few seconds to find out. With $850 million in sales and an operating margin of 13%, you get to roughly $110 million in operating earnings. What about the deployed capital? Around $200 million is in liquid assets and around $100 million is in fixed assets. Of that $200 million, $100 million is cash, so we got roughly $200 million deployed which returns $110 million dollars. Your return on deployed capital is around 50%. That is not a bad business.  

You see that the business is trading right around the book value. The book value consists of tangible liquid assets, working capital and $100 million in real estate. The deployed capital is two.thirds of that and returns you $110 million. Why is it so cheap? If you are a business owner, you would buy this company for this price. Timberland is a brand that people know, so what is the reason it trades so cheaply? At the time it was the height of the Asian financial crisis and Timberland’s competitors like Nike and Rebook saw their sales fall off massively. The whole contingency is that every consumer product with a connection to Asia falls apart. You also try to find out what others think about the companies. Are there analyst reports? Turns out, there are no analyst reports. No one covers this company which is rather big with $1 billion in sales and a big brand. Is there a reasonable explanation?  

Student: The company doesn’t have a lot of debt on their balance sheet, maybe the company has no claim to the capital market and as a result no analyst from the sell side is covering them. 

Which is fabulous for you as an investor. Looking back over the company’s history, in the last 10-15 you can see if they had the need for financing from the capital markets. What can we find out about the company's history? It has been growing, the profitability has improved and they have always been profitable. Their need for the financial markets were limited. Any other reason? What is the ownership or shareholder structure? 

Student: It’s a family owned business. 

The family controls 40% of the equity and 98% of the voting rights. How have investors reacted to them in the past? Being an investor is really being an investigative journalist. Going through all those questions, one has to find the answers quickly and never settle with one-sided answers. After looking into it, you find that there are a bunch of shareholder lawsuits. With the family controlling nearly all votes and no voting rights for other shareholders, no analyst coverage and a bunch of lawsuits. If you are an average 95% investor what conclusion would you draw from that? 

Student: There is not enough information to touch the stock, it’s not worth owning and it is too risky. 

Student: I would think that the problem is temporary, but the stock is illiquid so my quarterly numbers might not look good. 

You are not sceptical enough. Aren’t you worried that the management stole money or falsified the accounts? They might manipulate their book and because they have full control of the company, they don’t have restrictions. There are several lawsuits from shareholders, so there must be a good reason for it, so what’s the next step?

Student: Check the court records. 

Absolutely. Go and download every single case file and read them carefully from the first to the last page. It is important to have a curious mind, because if you only do it for the money it is hard to dig as deep. Be curious and go into every detail. After reading through all the cases you can see that the shareholder lawsuits are one complaint that was filed multiple times. The company used to provide earnings guidance, but because they missed it and investors were outraged, the  owner stopped providing earnings guidance. The investors, being even more annoyed, filed lawsuits, and the owner stopped talking to Wall Street, as the business is wonderful enough.

With that mystery resolved, maybe they are not crooked, but how do we know if they are good managers? How do we know if they are decent people? How do we find that out? 

Student: Call his neighbours.

Good idea, what do you tell their neighbours? 

Student: The truth, that I am an investor and would like their opinion if they are decent people

What if they say, go to hell? Do you hang and give up? Most people would tell you to go to hell, but nice try .

Student: You can google their names. 

There was no google back then, but that is a good idea. You should be like an investigative journalist. People who founded a company have big personalities, a history and left a trail of evidence of what they have done and how they cope with complex situations. Most professional investors won’t consider it as part of the job, but if you belong to the 5% here is what you need to do. You go to their community, their church or synagogue and integrate yourself into that community. Introduce yourself to their friends and neighbours and spend a few weeks there, it is worth it. You would find out that the owner only graduated from high school and never went to college.He is a philanthropist and goes to the synagogue without being fanatically devoted. Interestingly he has a son, who went to business school and was close to my age at the time (mid 30s) and already a COO of the company. One of the boards the son was on, was founded by a friend of mine, and we became close friends. It turns out that they are one of the most admiring families I have ever met. People of the highest integrity and brilliant businessman. After all that research, the stock was still trading right around $30. Then you need to go through the checklist again and see if you left anything out. What will you do next? 

Student: Buy

How much do you want to buy , suppose we have 100$? 

Student: 40$

Student: 200$

What was that, 200$ (laughs). I like talking to this class, because you are not polluted. If you join a fund, you find out that they use Basis Points and say: “Don’t do more than 25 basis points, and then we go to 50 and then to 100 -  or 1 percent”. Every number sounds big. “Wow 50 basis points, that’s a big deal!”. So keep your innocence, because what you are thinking is common sense. Think about all the effort you put in. How good it is and your downside protection. It trades at around 5 P/E and the last two year margin improved substantially. I went to different Timberland stores and found out that there is a fad going on and kids saw Timberland as fashionable. Everyone wanted to buy Timberland shoes and jeans and store managers couldn’t even get enough stock. 

To mitigate the Asian crisis risk, you read through their earnings and find out that the international business accounts for 27% and Asian shoe sales were less than 10%. Even if we discount that completely we would lose less than 5% of the earnings. So I put shitloads of money into it. Anybody know what happened in the next two years? 

You are right, not because people agree with you, but because you did your homework and have the numbers and reason to back it up. Analyzing the numbers should take less than five minutes. If you are not a good analyst, you will not be a good investor. You must train these skills to be proficient. 

I’ll tell you what happened. The next two year this company went up seven times and it was matched by earnings growth. So the downside was still limited. You didn’t buy a technology company that tripled just on earnings multiples. It was never over 15 times P/E, but if you go from 5 P/E to 15 P/E, add 30% of growing earnings yearly and it adds up. Later, a new CEO started and he had different ideas on how to run the company. He started to receive investors and talked to analysts. He didn’t issue any guidance, but he started analyst meetings. At the first meeting it was just three people: the CEO, an analyst and myself. At the end of 2000 the room was packed with 50 or more people and major institutions started to look at the company. That’s when I knew it was time to sell. 

Bruce: Are you worried what happened to Timbers in 1994-1996? 

I did, because that is when the lawsuits popped up. They did have a misstep, because they built their reputation on being waterproof, but sent mixed signals with waterproof and non-waterproof shoes, misleading the market. They confused the market and they suffered. They had one year of blemish, but they still grew their revenues the other years. Buying cheap is important and when you do, you sit on your ass and don’t do something stupid. A good business will take care of itself and your money will grow with the strength of the company. 

Student: How much time did you spend on this investment before buying? 

Not more than a few weeks, and it doesn't take as long as one thing, especially if you devote day and night into it. I’m glad my wife is here, so I can explain what I did missing all those nights. Opportunities don’t come very often, so you have to seize them. You have to get your research done quickly and accurately. That is why you have to train yourself all the time. You don’t have to buy anything. Put your money in the bank until you have the opportunity to jump in and you have to devote intense work for a short, concentrated time period. 

Student: Do you normally run screeners, why do you manuals like Value Line? 

They are fun to read and I learn about businesses. You won’t always find an opportunity, but if you do you will be able to tell in seconds. You can smell opportunity. The only way to develop that smell is by reading a lot. Value Line is great because they have data from multiple sources and cover many years, so it is the easiest way to learn about lots of companies. 

Student: What percentage of your money did you invest into Timberland? 

That is still confidential, but it was a shitload of money (Note: Looking at Himalaya Capitals old 13f filings, a 30% position wasn’t unusual, so changes are high it was quite more than 60%). 

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Case Study: Hyundai Department Store H&S

The next case is more recent and happened a year and a half ago. It comes from a Standard & Poors book. They have one for every country. In the US I like Value Line more because it is more practical, but for Korea Value Linie isn’t available, so I went through the book page by page. One page caught my eye, the graphic below. What do you see in it? 

Student: It is really cheap. 

What do you mean by cheap? 

Student: The earnings per share compared to the price of the company. 

If you really see yourself as a business owner, don’t think about per-share numbers. Train yourself to think as an owner. What is the market cap? Come on it is not difficult. The exchange rate is simple and you don’t have to be exact. Divide the Korean Won by 1000 and you got the dollar. What is the market cap? 

Student: 87 million? 

87 million? Price is $12 and there are around 5.5 million shares. Don’t use a calculator. There are a lot of companies in this manual and each page shouldn’t take you more than a few minutes. 12 times 5.5 is $65 million, a few million short is ok. What were their earnings last year? Give me the pre-tax number. Come one, you’re Columbia Business School, you expect to make $150,000 base pay, what are we paying you for? Give me the pre-tax earnings and net income. We got $31 million before tax, trading at $60 million market cap, so we have a P/E of 2. What is your working capital, the book value? Bruce I don’t know what you are teaching them. 

Bruce: They are still thinking about dividing by 1000 (laughs) 

Divided by 1000 we have $240 million in book, $60 million in market cap, $25 millions of net earnings and $36 million of pretax earnings. What do we do next? We find out what the book is. It is fixed assets and working capital, as we can’t count on goodwill. If you are the owner you should be able to tell it quickly and if you can’t  blame Bruce. These are the basics that come out from this manual, but it doesn’t tell you details. With $70 million in working capital and $180 million in fixed assets, what do we do next? 

Student: Figure out why it’s so cheap? 

How do we know it is cheap? It looks cheap, but it is not conclusive yet. We have to go deep to find out what the earnings, the book, the working capital and the fixed assets are. I’m using common sense and logic here. I never hired anyone who went through business school or worked for an asset management company, as they are much easier to train. 

Back to the financial of this company. Doing some work, we find out that of the $70 million in current assets it is all cash or cash-equivalent securities. Of the $180 million in fixed assets, they own 100% of a hotel recorded at $30 millon book, 13% of a department store, recorded at $13 million book. It just so happens that the department store is on the next page of this book. This department store has a market cap of $600 million, so what is 13% of that? 

Student: $80 million. 

So the department store’s book value is understated by 50 million and they own three cable companies and some real estate. Next I look at the department store and it has the same profile. It trades right around cash value, around 2 P/E and they own a lot of assets. Turns out they are also the second largest cable operator as well. Those department stores are different to the ones we have in the US. It is more like a shopping mall where they charge based on their merchants revenues. Adding everything up, you pay $60 million dollars, get $70 million in cash, no debt, $100 million in stock and $30 million in a hotel which hadn’t been evaluated in the last ten years, with Korean property prices going up. I went to Korea and inspected the hotels and the department stores. Checking the recent property transaction in the neighbourhood, the true value was three or four times the book value, adding another $150 million of asset value. How much do we have now? Around $320 million, which would cost me $60 million and I still earn $30 million annual profits. What did I miss? 

Student: Corporate governance? 

Good answer. What about it? 

Student: We covered with Bruce that there are several family owned companies in Korea that only act in their best interest and not in those of other shareholders.

Terrific point. You have to go through each point and address them rationally and carefully. There were no foreign institutions who owned the company, so you should go through all points and add what local investors think about the company. So after I went through my checklist, I bought it. What happened afterwards? If you have a computer, you can check. 

Student: We’ll trust you.

We have two charts that I printed directly from Bloomberg. One is the department store and it went from $22 to  $100.

And then Timberland,which accounted for a stock split went from $12 to $70. Both five or six times higher.

I gave you those examples to show you that this approach is not natural for most investors. However if you come to the conclusion that your personality fits, there is a lot of money in it. It has been repeatedly proven by Ben Graham, Warren Buffet and several others. I am grateful that I came to this class and was taught by Bruce. It changed my life forever and I am a little bit disappointed that you have done so little today. I made over $100,000 in the short period I took this class, listening to 14-15 people. You can make a lot of money, but you have to act. You spend a lot of money on tuition so you need to make that up. The way I showed you is a terrific way to do so. I don’t talk about my current holdings and we sold those two companies already, but what makes this course unique is that there is no bullshit theory. They tell you what works, and if you don’t you should ask them. There are countless opportunities ahead of you and I would be ashamed if you didn’t use them. There is gold in those pages, those books, Value Line and so on, but you need to use it.

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Q&A Section

Student: What do you look for when you do your research?

 If you are an analyst I only need two things. Accurate and complete information. The vast majority of people don’t go in depth to get it, so you will stand alone and have to put in effort and time. If you are not confident you won’t be able to stomach it when things go into a freefall, you lose money and everyone laughs at you. The second thing is that most of your money is not made in those two companies we have discussed. There are two schools of thoughts: Tweedy Brown, Bren Graham or the Buffett and Munger school. The latter is the one I am more interested in. As a result the returns will come from very few insights. In 50 years of tremendous insights into companies, there will probably only be ten or so insights. 

Bruce: In your career doing those analysis, what particular mistakes did you make? 

Everytime I failed on one of those three scores, I made a mistake. Whenever I don’t have accurate and complete information or think I have an insight which turns out to not be one. I made plenty of mistakes. 

Bruce: Can you give specific examples? 

On the big bets I can’t recall if I lost money. My biggest mistakes were the ones where I did not make the bets. During the course of my career I had spectacular careers, but couldn’t raise any money. People wanted me to go up in a down market and be a piggy bank with great yields. I moved into Julian Robertson office and learned the practices of hedge fund managers, including letting someone handle the shorting. It turned out to be pretty useless. I busied myself. If you are shorting, you have to trade. If your upside is 100% and your downside is unlimited you have to trade, and as a result your mentality changes. I stopped gaining and acting on insights. Charlie Munger said that it is like going to an ass-kicking contest with your hands tied behind your back, and it’s true. It was a period of time where I had absolute insight into a company, management I knew, trading below cash and it went up 50-100 times. I missed it because I couldn’t give it my all at the time and was distracted by frequent trading. It is not about the money I lost, but how much money I had forgone. Usually you make a mistake because you haven’t done all the work, but that is ok. I bought Timberland at $28, before I finished doing my research. I felt that the odds were in my favor, so after doing the research, I bought even more. Sometimes however I finish the research and find that the small position I started lost 20-30% and that I was wrong about the company. It is ok, I have to accept my misjudgment and my mistake and continue to look for opportunities. If you buy with sufficient margin of safety you will be fine, but If you have tremendous insight and do not act on it, that is the big mistake. 

Bruce: Would you tell them the name of the company?  

No, because there might be an opportunity to invest in them late. In your life you probably won’t have more than five or ten insights, and you will develop them over years of study. 15 years ago I studied American companies, and now I find the Aisan counterpart. Only by studying the company and industry for 15 years can I be sure to invest in them. If you have the insight, then you need to act with conviction. If you can’t do that psychologically or because you are ill prepared you won’t get the chance to make a lot of money. You can study Ben Graham and Tweedy Brown and get an annualized return of around 15 percent a year, doing much better than the majority of investors even the professional ones, but you won’t achieve an exceptional performance like Warren Buffett’s. Maybe you never find such an opportunity. They increase your wealth thousandfold or even ten thousandfold, so why should it be easy. It requires you to combine a lot of insights and factors, which Munger calls the Lollapalooza effect. Sound, complete and accurate information combined with the conscious, subconscious and psychological factors. This is what drives me and what is so exciting about that business. You have to learn everything. My wife has a PhD in biology and I learned a lot of biology from her, which helped me with my investments. You have to learn from everything and be curious and you will occasionally come across big opportunities. Meanwhile you will have plenty of Timberlands or Hyundai Department Store which give you three to five times your money, still not bad. 

Student: How many companies do you invest in a given year? 

It depends, a number is meaningless. There are years where you don’t have a single opportunity and years where there are many. It depends on your circle of competence and the right valuation. They don't come at a steady pace. When I started to learn, this process had a cumulative effect, so now I am able to find and process opportunities much faster. However sometimes the market is not cooperating and not giving you an opportunity, but that’s fine. It is ok to have a year where you don’t invest into a company, it is not ok to waste my time not learning and not creating a new insight. If you live with that principle you will learn a lot of time. 

Student: How did you make a living after arriving in the US? 

I wrote a book and someone paid me to turn the book into a movie. My net worth was negative because I had a lot of debt, but I had cash, I was lucky to invest it. 

Student: How did you find your ideas? Do you use screeners or talk to people? 

All the things and more. When I read biology, history or physics I am always searching for ideas. The rest of the time I learn from my wife and kids. When I research a company I always go back to my checklist: Is it cheap? Is it a good business? Who is running it? What did I miss? When looking at that last item you start to understand the importance of psychology, human cognition and human misjudgements. 

Adding one more point, there are three things that establish a value investor. The business owner mentality, a different time horizon and the demand for a huge margin of safety. These all come from the business owner mentality. If you can’t control the business you want a big margin of safety and because you are a business owner, you tend to think long term. The stock market is not for the business owners, but the traders. 95% of the people don’t align themselves with those three points. Suppose 100% of people would be value investors. There wouldn’t be a stock market. Who the hell would buy IPO? Without IPOs there wouldn’t be a stock market or a secondary market. If everyone needed a big margin of safety nobody would sell. That is why I started the lecture saying that you don’t belong to the stock market and you need to understand that and not be influenced by others. If you are a businessman, you will be attracted to even running a business. That is what Buffett and Munger did. YOu might become entrepreneurial or work in private equity. 

As long as humans are irrational, a value investor will find something profitable in the market. The market is designed for people, who are flawed in their thinking and are attracted because they like to trade and make fast money. If you trade, you are bound to make mistakes as emotions will assure that.  Fear and Greed open up the opportunities for value investors. 

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Selling and finding great companies

Student: What drives your decision to sell? 

Great question. I used to have the philosophy that if I wouldn’t buy at that price, I would sell. I evolved because I find myself being a real owner, and as a result not willing to let go of the business without earning  a premium. If it is a good business the probability is there that it will just get better. That is the law of businesses, leaders will take a proportional amount of capital. When I sell I also have to pay a huge amount of taxes, whereas the business can deploy the capital and return 50-100% of it, if it is truly great. There are only a handful of opportunities where you are able to project into the future confidently enough to stay invested. Investment bankers think they can foresee into infinity and that’s bullshit. Only if I have an insight I can predict it, otherwise I can’t even predict what will happen tomorrow. Why would I want to sell if I do have those insights? 

Student: Why did you sell Timberland

Timberland doesn’t have those characteristics. It is not an exceptional company. There are companies I own that belong in that category, but I won’t talk about them. 

Bruce: Can you describe what you look for to find those businesses? 

They need to have a competitive advantage that is getting stronger and stronger. What are some examples? What makes one business more successful than others? What is their advantage? Why do they make more and more money? 

Student: If you have a product like nicotine or Coca Cola, which is addicting you are able to sell to your customers for 50 years or longer, if you have a good brand. 

Student:  Exchanges or Toll Roads. 

Bruce: Are you agreeing with all of these? 

They are rehashing Buffett's holdings and you can’t disagree with that. I want something that he hasn’t bought, don’t just buy something because you get a stamp of approval. Give me names that he hasn’t bought yet? 

Student: Ebay. 

That’s a good one. Anyone else? 

Student: Cell phone towers. They are geographically restricted, require government approval to be built, have a long runway and little maintenance capital expenditures. 

So why did nearly all tower companies fail and virtually all went bankrupt? Even American Towers came close. It is a good example, one of my three companies was American Towers when I was a student. Anything else? 

Student:  Building materials, people will always have to build. 

What about the competitors, how many are there?

Student: Millions.

Well you answered my question, anything else? What do you use everyday to do your research other than Value Line 

Student: CapitalIQ

Great that you mentioned it, let’s talk about a similar company Bloomberg. Before Bloomberg there were already several established players. Why did they win in the end? 

Student: High switching costs. It takes a long time to learn all the functionality of bloomberg 

This is the best answer. Yes they have good data, but so have the others. Virtually all companies go through a similar transformation.. From a company that came from nowhere, that little by little began to gain an advantage until they hit a breaking point and usurped the established players becoming a monopoly. Where are they know? They disappeared. Partially it is because when you have something that is hard to learn, but highly used and relied upon, you don’t want to learn it again. If everyone else is using it, that’s even better. In those businesses, the winner takes it all. How you get there is an interesting question, but if you have that insight that is worth a shitload of money. Why did Microsoft succeed over Apple, when it was initially so much bigger? Everyone had to use it for work, so suddenly you had no other choice. Do you even have the choice  of not using Bloomberg? What is the cost of Bloomberg? 

Student: A few thousand a month.

Nothing ! You can almost call that zero. Most of it goes to the highly salaried employees of Bloomberg. Why can they ask for that money? They don’t do any research. They visit you regularly and ask you what you use. If you are a trader, they create functions just for me and Bloomberg has tens of thousands of them. Yet Blloomberg doesn’t give you an operating manual. They want you to get hooked on things you use everyday, and then they charge you a lot. If a trader can make a million, the $30,000 a year won’t be neckbreaking. If they increase the price 10% a year, you don’t have a choice. They keep coming back to you, because they know you are trading and need new numbers until you are hooked and hopeless. 

Think about switching from that. How do you compete for a product that 100,000 professionals use in a different way? If it would be a public company and know that inflection point, of course you would want to invest. That is why you study every business. Your job as an analyst, value investor and business owner is to study them and observe those trends. Once you find them, you don’t have or even want to sell. 

Student: After you invest, how involved do you get with management? 

Depends. I made a bunch of private investments and served as the chairman of two on the board including CapitalIQ. All the insights you learn can be applied to different businesses. In that case I am very active. A lot of the time I am the largest shareholder and sometimes like the Hyundai department store I can’t even get a receptionist to answer my calls. By in large I like to know as much as I can and be friends with the management. With Timberland, the son became a friend and one of my investors. That is the relationship I want to have. 

You have to search for that opportunity and nothing is constant. The only constant is change and that is why you need to relearn things. People with active minds and who are prepared will always have the chance to be fabulously rich. 

Bruce: That's a good ending to the lecture. 

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 I hope you enjoyed the lesson as much as I did. Feel free to contact me on Twitter @InvestRoiss