Before We Start
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Overview
I recently came across a transcription of Li Lu’s lecture at Columbia. The entire transcript is worth reading, but I found the most valuable part to be Li’s case study of his investment in Hyundai Department Store H&S. He found this investment by going through the Standard And Poor’s book for South Korea.
I found this very valuable because Li Lu quizzes the students on this one page overview of Hyundai Department Store. They answer that the stock is cheap, but he digs in, continually asking them why it’s cheap.
Then, he gives a breakdown himself of how he valued this company in 5 minutes, and how they should be able to do so as well.
This stands in pretty stark contrast to the valuation methods I have previously learned in academia, but lines up with what I have read about how Buffett, Munger and Pabrai value a company.
Before We Start
Before starting, I recommend you read the full transcript, here.
(As well, since this company was based in Korea, Li Lu had to find the values in USD, not Korean Won. To do that, he divided all numbers on the Standard and Poor sheet by 1000. So 1000 Korean Won = 1 USD at the time.)
Case Study — Finding The Intrinsic Value of Hyundai Department Store
Step 1: Li Quizzes The Students On Company Data
- The price per share is $12
- There are around 5.5M shares (just round it — the actual number was 5.6)
- So 12 X 5.5 is roughly 65M
- Pre-tax earnings are $31M
- This gives us a PE of 2 ($65M / $31M)
- Net income is $25M
- He makes a quick evaluation of book value at $240M
He Dives Deeper On Book Value (Second Pass)
Li says book value is fixed assets and working capital
- He says they can’t count on the goodwill, so leave it out
- They have $70M in working capital
- They have $180M in fixed assets
- So that’s $250M in book value
Li Lu expected the students to know this and wondered what they were learning. So it is imperative you are able to calculate this quickly when valuing a company.
He Dives Deeper On Book Value AGAIN (Third Pass)
Doing some work, he finds 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 million book, 13% of a department store, recorded at $13 million book
- They find that the department store has a market cap of $600 million, so 13% of that is $80M
- They find that the department store’s book value is understated by $50 million and they own three cable companies and some real estate
He Looks Into The Department Store (Fourth Pass)
- He looks at the department store and finds it has the same profile
- It trades right around cash value, around 2 P/E and they own a lot of assets
- They are the second largest cable operator
- He understands the business model — the department stores in Korea 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.
He Sums It All Up
- Adding everything up, you pay $60 million dollars,
- You get $70 million in cash
- There is no debt
- You get $100 million in stock
- You get $30 million in a hotel (which hadn’t been evaluated in the last ten years, with Korean property prices going up)
He Inspected The Assets In Person — Does A Very Deep Dive (Fifth Pass)
- He found the hotel hadn’t been evaluated/assessed in the last ten years
- He went to Korea and inspected the hotels and the department stores
- Checking the recent property transaction in the neighbourhood, he found the true value was three or four times the book value
- So this gave him another $150M in asset value
Now — He Knows It’s Cheap For Sure.
Why It’s Cheap
Finally, we can now see why Li Lu thought it was cheap:
- He gets around $320M of assets ($70M cash + $100M in stock + 150M in the hotel + department stores = $320M)
- He knows it will cost him $60M for the entire business
- He also gets $30M in annual profits
How Li Lu Determines Intrinsic Value
In a nutshell, Li Lu only needed to look at a few numbers, but he did a deep dive on them to ensure they were actually real.
He found the market cap, and used that as the price to buy the entire company. So $65M was his cost to buy the entire business.
He measured his return against the value he got, versus the price he paid.
The value he got, were the pre-tax earnings and the book value of the assets.
He didn’t trust the stated book value, he found the real book value.
Valuation — The Math
The math itself is very simple.
Return: If you pay $65M and get $31M in pre-tax earnings every year, that’s a return of 31/65 = 48% a year if earnings continue
Margin of Safety On Return: If you are wrong by half, you still earn a 24% return — so this checks out
The Book Value (Assets minus liabilities): This would be the total value of the company’s assets that shareholders would theoretically receive if a company was liquidated. Li Lu found it was $240M quickly, but then was able to re-value it by doing a deep dive. He found the real value was actually $320M.
Margin of Safety On Book Value: He paid $60M and got $320M. He has $260M margin of safety here.
Note On Valuation:
The stock should have been selling for at least $320M. The book value would be the margin of safety in this case, especially since Lu did the hard work to ensure those assets were actually there. On top of that, he got the earnings, which was the icing on the cake.
Summary Of Valuation:
So, Li Lu was able to buy $320M for $60M. Or, put another way, he was buying $1 for 0.19. Then, he also got $31M a year, on a $60M investment.
Essentially, Li stood to 5X his money if the stock market valued the assets properly. He would also double his money every 2 years if the earnings continued into the future.
His downside was protected, because if was wrong about the earnings, he still had $260M in asset protection.
For the assets he dug deep and found for certain they were actually there by going and checking himself and doing the valuation work in-person. Valuing these assets in Korea for Li Lu was no different then it would be for you, if you were thinking of buying a house. You’d look at comparable properties, talk to some experts locally and get a sense of the relative valuation.
What Happened?
Li ended up making a 5X on the investment, and it appears he invested in 2003 and sold in 2006 or so.
Why Did Li Lu Notice This Stock?
I think Li Lu saw 3 things while he was flipping pages in Standard and Poor’s that made him stop and do some work:
- They have $70M in working capital
- They have $240M in book value
- They have $31M in EBIT
- It’s selling for $60M
Right there, you get $70M for $60M and the earnings and reamining assets are free.
He also would have seen that you get a 50% ROI if you pay $60M and get $31M
Finally, he saw $240M for $60M, which is like saying you get $4 for the price of $1
I think he noticed all 3 of these things, which sent off alarm bells to do a deep dive.
Why Did Li Lu Sell?
I think Lu sold this investment once the market recognized the company’s book value. He didn’t put too much reliability in the 48% yield of the earnings. In a sense, those might have been his margin of safety too.
The reason I say this is that once the value of the assets was realized in the market (5X his original investment), from $60 to roughly $300M, Li sold, getting a 5X. I don’t think this is a coincidence. He waited for it to reach it’s correct book value, and exited.
Value As The Catalyst
One thing I found interesting was that Li Lu didn’t seem overly concerned with finding a catalyst. In this case, value was its own catalyst.
I think Li Lu followed the Ben Graham approach where price was its own catalyst, and trusted the market to eventually recognize the real value.
Overall, Buffett said you should look for investments where the value “hits you over the head”, and this is definitely an example of one of those cases.
Imagine you found a stock where buying it at the current price yielded you a return of nearly 50% a year, and the assets were undervalued by 5X as well.
There’s such a large margin of safety, it’s worth a shot.
This struck me as a classic Mohnish Pabrai “Dhando” investment -> Heads you win. Tails you don’t lose much.
Li Lu focussed mostly on the NAV approach to valuing this company. I suppose that makes sense because the EPV was not protected by a moat. This was a Ben Graham, vs a Warren Buffett type investment. Having said that, he didn’t discount the earnings either, but he kept it simple. He didn’t do a multi-stage DCF or plug all these numbers in the spreadsheet.
He just saw that the assets were much higher than the purchase price, and perhaps even higher than the accountants listed them to be too, plus the business had some earnings that could keep him safe.
It’s clear to me though that this was a NAV investment vs an EPV and he certainly didn’t pay up for growth.
He also wasn’t spending hours to find the reproduction value of every asset and liability. He didn’t mention how he reverse engineered the value of the Product Portfolio or Customer Relations for example.
He just honed in on a few big things — the real estate, the stores. Then he seemed to trust that the liabilities were stated accurately.
As he said, the screening took 5 minutes, then valuing the assets involved a trip to Korea. He didn’t mention much else.
Simplifying Li Lu’s Valuation
Pretend I have a Vending machine I want to sell you for $50.
The first thing you might do, is look at the vending machine and see if it actually works. You’d want to make sure it was actually something of value.
Let’s say while you were looking, you also noticed that there’s about $50 worth of chips and drinks in there you get for free when you buy the vending machine.
Then, after taking a really deep look, you also see that there appears to be a $100 bill stuck in the bottom, but you can see it even though it’s hidden. The owner doesn’t know it’s there, but you do.
Next, you go on eBay and see that vending machines always sell for $100. You anticipate you could get a quick sale for $75 for sure in a worst case.
Finally, you see the vending machine company’s accounting statements and you see it makes $100 a year profit (after buying the chips and candy and doing repairs).
Now there’s also a vending machine down the hall that’s way better. It’s selling for $500 and gets twice as much business.
Is this vending machine I am selling you a bad investment?
The answer is no. Just because there’s another business that’s great, this vending machine is still worthwhile.
But I also wouldn’t plan to keep it forever.
That’s the difference between a Ben Graham investment and a Buffett investment.
This vending machine is a Ben Graham company. They can be worth something too.
So, I make a plan. I will sell the $50 worth of chips and pop. I’ll also take the $100 bill from the machine for myself. I’ll keep running the business as long as it makes $100 a year. Even $10 a year is worth it. Then, when the business no longer makes $10, I’ll sell the machine for $75.
Let’s say my holding period is just 2 years. In that time, I’d make $100 a year, so $200. Plus $50 for the chips and pop I get for free. Plus the $100 cash. Then at the end of 2 years, I get the $75.
$200 + $50 + $100 + $75 = $425
All for $50.
My profit is $425 minus $50 = $375.
Or, $187.50 per year on a $50 investment, a rate of return of 375% a year.
Is this a good investment?
Definitely.
Part 2
I’m going to do a part-2 shortly where I outline Li Lu’s checklist and some of the interesting qualitative items he went over in analyzing this investment.
Li Lu’s Advice To The Students
- Don’t just say a stock is cheap, explain why it’s cheap
- Don’t use a calculator
- Focus on market cap (not price per share)
- Don’t count on goodwill as an asset
- Think of yourself as an owner of the entire business. As the owner, you wouldn’t think about per-share numbers. Instead, look at the market cap. Don’t look at book value per share, just look at book value of the entire business.
- Use common sense and logic
- He never hires anyone who went to business school or who worked in asset management
- If you can, inspect the assets in person (ex. Li said “I went to Korea and inspected the hotels and the department stores”)
- You can value a business by looking at what you have to pay, and what you get (assets and liabilities and earnings)
- Also identify trends in your favour (ex. Korean property prices going up)
- He really understood the assets were underpriced and did his homework to ensure he was correct about that
- In this example, Li Lu valued the earnings as the previous years’ pre-tax earnings (EBIT)
Definitions:
Book Value
Book value is the accounting value of the company’s assets less all claims senior to common equity (such as the company’s liabilities). … It serves as the total value of the company’s assets that shareholders would theoretically receive if a company was liquidated.
Working Capital
Working capital, also known as net working capital (NWC), is the difference between a company’s current assets — such as cash, accounts receivable/customers’ unpaid bills, and inventories of raw materials and finished goods — and its current liabilities, such as accounts payable and debts.
EBIT (Pre-Tax Profit)
EBIT (earnings before interest and taxes) is a company’s net income before income tax expense and interest expenses are deducted.
Why Does Li Lu Use EBIT?
EBIT is used to analyze the performance of a company’s core operations without the costs of the capital structure and tax expenses impacting profit.
Resources:
I found this awesome transcript of the class online here: https://roiss.substack.com/p/li-lus-investing-masterclass-at-columbia
(Thanks for putting this together Roiss.)
You can watch the full class here:
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