Lei Zhang's Lecture at Columbia Business School (Hillhouse Capital) ~ market folly

Wednesday, July 29, 2015

Lei Zhang's Lecture at Columbia Business School (Hillhouse Capital)

Below are notes from Hillhouse Capital's Lei Zhang's lecture at Columbia Business School courtesy of Zong Z. Peng.

Notes From Lei Zhang's Lecture at Columbia Business School

In the high flying world of investing, Lei Zhang maintains a relatively low profile. Yet since he was seeded by David Swesen of Yale Endowment with $20 million in 2005, he has achieved a ~40% compounded annual return (28x not adjusting for inflation), making him one of the best performing investment managers. To put it into perspective, Warren Buffet has achieved a compounded annual return of ~22%, albeit for the past 50 years!! Today, Lei Zhang’s Hillhouse Capital, named after a street nearby Yale where Lei received his MBA and master’s in public policy, manages ~$18 billion. Thought not just focused on tech, Lei is best known for backing several most successful Chinese internet entrepreneurs and start-ups (e.g. Tencent, JD.com). On April 29th, Lei paid a visit to the “Temple of Value Investing” Columbia Business School to share his investing and life lessons. Below are my synthesis of his wisdom:

For those who crave for brevity, here is the essence of the lessons that Lei Zhang shared:

  • Being a long-term investor gives you a big advantage from the starting line.
  • Do deep fundamental research, make few bets instead of keeping on chasing ideas. This way you simply your life and your business. 
  • Hillhouse invests in changes and strives to help create value through entrepreneur-like thinking and problem solving. “We are entrepreneurs so happen to be investors” 
  • Spend quality time with quality people, doing quality things. Hopefully part of the outcome is making money. 
  • Stay connected to reality and everyday life, do not become a victim of your own success. 
  • Four most important traits in people that Lei looks for: intellectual curiosity, intellectual independence, intellectual honesty, and empathy.

For those who want more details and articulations, read on:

1. Investment Strategy

Flexibility – Lei only had one investor in his fund when starting out Hillhouse – David Swensen from Yale Endowment seeded Hillhouse with $20 million. He could have raised more money with Swensen’s endorsement but did not. He wanted to start with a solid foundation, a strategy that allows him 100% flexibility to invest in whatever he believes in and is passionate about, be it public equity, venture capital, or private equity. In Lei’s words “it’s not about the format but about the essence.” To him the essence is to invest in companies that he thinks make sense, truly believes in, run by people who he respects and are open-minded, and could compound capital over a long stretch of time no matter what stage the company is in. In terms of his investment team, Lei believes in a generalist model and prides himself on being one of the analysts.

Long Term Orientation – Hillhouse is a long-term investor. Lei thinks that when you have a long-term orientation, from day one you have a huge advantage over most people – it’s what he calls free option value of time arbitrage. His view on the Chinese stock market at the time of this speech? “It’s like 1999 all over again, but times three.” The environment is so bubbly that any company that changes its name into something internet related could get an elevated multiple on their valuations. Some say long-term investing does not work in China because everybody trades so much. Speaking at one mutual fund conference, some managers asked Lei “how do you make so much money despite being a long term investor” (everyone in the room laughed really hard on this comment). Some Chinese mutual fund managers complain to regulators, “I know you want long term investors, but we need to make money, we have a fiduciary duty.” The understanding of long-term investing in China is so distorted, people think there is a cost to being a long-term investor.

Note: Lei’s comments on China looks squarely on mark in hindsight, given the on-going chaos in the Chinese A shares market, which just had its biggest single day drop (8.5%) since 2007 at the writing of this post.  

Bias Toward Inaction – But how does Hillhouse find high quality names? The way is to do deep fundamental value research and only research things that could potentially compound value over time. There are many people in China that are successful at trading, but traders have capacity issues because they have to trade all the time. In China, an average portfolio manager has 600% annual turnover, Lei’s public equity portfolio has only 15% turnover and he continues to own his private equity portfolio. Hillhouse does not attempt to constantly chase different horses. In a given year, Hillhouse takes on 2-4 positions at best and sometimes only one. By taking away the action, Lei believes you simplify your life and the investment business, and you let the portfolio compound for you instead of you doing the work. By being patient and not too active, he was able to accumulate a portfolio of high quality names.

Note: All these principles are pretty much the  the bias toward inaction is very similar to another value investing legend Monish Pabrai, whose book “The Dhandho Investor” I highly recommend. 

2. Deviation From Traditional Value Investing Philosophies

Investing in changes – Lei Zhang is a big believer in value investing, but where he deviates from the traditional value investing philosophy is that he likes investing in changes. He believes that it is change that derives value and he would like to invest in people driving them. In particular with China, and globally as well, technology has become a bigger part of the game, either in traditional or new industries. Changes are driving forces for creative destruction and value creation. He spends a lot of time understanding the changes and the people behind them. Lei says that one thing about investing in early stage company is that some companies look distracted on the outside, but if you look at the core they are intensely focused. On the other hand, the traditional sense of value investing represented by Warren Buffet dislikes changes and prefers long-term stable businesses with strong moat, hence why Warren ends up with big positions in names like in Coca Cola, Amex, Wells Fargo, and IBM.

Note: the above differentiation may be an over-simplification as Warren also has a much larger capital base to deploy.  

Example 1: Blue Moon and JD.com. Blue Moon is in a traditional business, liquid laundry detergent. Hillhouse would never have invested in it if everything is done the same way, as there is P&G and Uniliver, which you invest in for their brand value and moat. After investing in Blue Moon, Lei arranged its executives to meet with those from JD, having Blue Moon learning about ecommerce from JD and have JD learning about merchandising from Blue Moon. Subsequently, Blue Moon redesigned its detergent packs so that they could fit into JD’s delivery bins. Leveraging social media and ecommerce, Blue Moon achieved the largest brand build up in years and now is the largest liquid detergent brand in China.

Value Investing Taken to the Next Level – Lei believes his approach is value investing taken to the next Level. In addition to investing in changes and long-term fundamental value, he also wants to compound that value by participating in the value creation process via deep research. The traditional Ben Graham value mismatch alone is not good enough (current price vs. intrinsic value), he wants to grow that value mismatch over time, not just to take advantage of an arbitrage opportunity. To this end, Lei thinks his approach is more like constructive (or suggestive) activism, though Lei rejects the notion that he is an activist. For him, the traditional sense of activism falls into the category of “life is too short” (too much work and headache? Ackman’s battle with Herbalife comes to mind).

Example 2: Strategic partnership between Tencent and JD.com

Lei is an early investor in both companies and brought many senior executives to JD, Tencent was one of one of Hillhouse’s earliest investments and remains in the portfolio. In 2013, Lei saw a new trend – JD had a great retail gene, but was having difficulty confronting mobile commerce on the technology front. On the other hand, Tencent had just acquired an ecommerce business. The core problem is that Pony Ma had never dealt with inventory before and suddenly had lots of physical goods on hand. Lei brought the two companies together, summarizing their problems with one word each, mobile vs. inventory. The solution is for Tencent to hand inventory to JD and JD to hand mobile to Tencent. Pony and Richard hated each other and had been fighting to win the ecommerce war, but the deal just makes all the sense.

Through research, Hillhouse was able to present and close the biggest ecommerce deal at the time. In the process, Hillhouse did get diluted, but got a lot of certainty for both companies out of it. The idea is through research, you could present to founders compelling ideas and add value in the process. Through this example, Lei conveyed that he loves entrepreneurs that are confident, open-minded, and willing to learn from competitors.

Example 3: WeChat moves into Southeast Asia

In Indonesia, for example, Lei helped create a joint venture between Tencent’s WeChat and Global Mediacom, Indonesia’s largest media, television and pay TV conglomerate. At the time, WeChat was behind Facebook Messenger, WhatsApp, and Line in user count, and today has surpassed the first two and is on par with Line. Again, Lei emphasized that he found the opportunity through “research.”

Note: In this sense, I think Lei’s approach is not just deep research, it is thinking as entrepreneurs. Focus the research on seeking truth, finding solutions to cracking business problems, and analyzing how value could be created instead of focusing on coverage and fishing for the next stock picking idea. In his own words, “we are entrepreneurs happen to be investors.”

3. What Hillhouse Looks For in Entrepreneurs and People?

Lei finds the most impressive people are the people who have deep passion and execute that passion with discipline, instead of people who exhibit habitual behavior. Specifically Lei looks for four qualities:

- Intellectual curiosity - driver of passion.  Have seen really smart people who are No. 1 in whatever they do, but in the end do not necessarily have the capacity to realize their full potential.  The reason is that they are No. 1 not because they want to understand how things work, it's because they are in the habit of being No. 1.  This makes life miserable.  If there is no passion in what you do, you will get burned out early on or reach a plateau soon.

- Intellectual independence - this allows a person to grow over long-period of time (I say this is the compounding value of knowledge and wisdom)

- Intellectual honesty - being authentic and intellectually honest is so important.  Lei also does not like people who are overly promotional and who are focused on organizing bureaucracy.  At Hillhouse, the team does not do 150-page presentations and sell internally.  Repeat your lies 100 times you believe in it yourself.

- Empathy not sympathy - the most powerful tool to be a successful entrepreneur or investor is to understand the pain points of consumers, employees, analysts, and entrepreneurs.

If you have the above qualities and a long-term oriented mentality, the rest of it is luck and law of large numbers, do what you are passionate about over and over again, and enjoy doing it over and over again, success will follow in time.

Note: I would like to put my own spin on the above comment, "even if you do not achieve exceptional success in the end, I bet you will have a heck of a lot of fun along the way."

4. Other Lessons From Lei

- Don't say I am going to work for this firm or that firm, don’t get into the argument with yourself. Just ask the simple question, are they the quality people you want to spend time with, who are you working with, working for, what kind of people are they, are they the kind of people who give “positive energy.”

- The world has already evolved way beyond the traditional employment relationship but to a more partnership model. It’s all about in what capacity and in what environment you could bring the best of yourself.

- Don’t wait for the opportunity to analyze your mistakes, spend 10x more effort trying to analyze your mistakes than success.

Thanks again to Zong Z. Peng for the notes.

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