Book Review: Civilization, Modernization, Value Investing & China By Li Lu
A little background on the author, Li Lu. He is the founder and Chairman of Himalaya Capital Management, a hedge fund manager and an avid follower and practitioner of value investing, which according to Investopedia, is an investment strategy that involves picking stocks that appear to be trading for less than their intrinsic or book value. Also worth noting is that Li is one of the 21 student leaders of the Tiananmen Square incident (also called June Fourth incident or 6/4), and the only one allowed back in mainland China to date. Fleeting China after the event, he attended Columbia University. While at Columbia he stumbled upon one of Buffett’s speeches on value investing. Inspired by that speech and cornered by astronomical amount of student debt, he entered the realm of value investing and stayed there ever since.
Li later became one of Charlie Munger’s confidents likely because of his unreserved faith and dedication to the value investing principles pioneered by Munger himself. Rumor has it (okay, what do I know? Wikipedia has it) that Munger and Buffett may pass the baton of Berkshire Hathaway’s investment portfolio on to him after retirement. Given (in the book) that Li has been having breakfast meetings with Munger every single week since the early 2000s and that people are willing to and do pay a fortune just to dine with Buffett once (no less for Munger I assume) — I’d say that wouldn’t be entirely surprising. So, in this book, which is supposed to be the culmination of Li’s 30 years of thinking and reflection, what does he talk about? Well, here is my not-so-brief summary about it.
As the title: Civilization, Modernization, Value Investing and China suggests, the book is divided into roughly four topics. The first half of the book covers civilization, modernization and China. In this part the author borrows ideas and concepts from scholars such as Jared Diamond, Ian Morris, E.O. Wilson, among others, and attempts to apply like perspectives when examining the history of the East, which is often downplayed if not outright omitted in many works attempting to illustrate or document the development of human society.
Now what are the main concepts? One that stood out for me is the idea that there are three major breakthroughs throughout human history. And each was prompted initially by geographical factors — purely incidental and arbitrary you could say, which gave certain areas of the world a leg-up in achieving unprecedented development and subsequently more advanced form of civilization as measured by Morris’ four metrics of human society. However, since we are instinctive animals produced by millions of years of evolution, some of the primal desires are coded in our DNA. That is, by design, we humans gravitate towards some sort of equality; more specifically, “equity in outcomes on emotional grounds and fairness in opportunities on rational basis”. Thus, when the advancement finally spreads to other parts of the world, whether by design or by chance, the inhabitants of those places would naturally want to adapt (if they in fact see it as such). And if they don’t, as exemplified by the Chinese Qing Dynasty refusing to concede to Western “tricks and gimmicks” (what we now call science and technology), there is a dear price to pay. But of course, eventually history will power through any willful ignorance and blind denial, and incorporate them into the process one way or another, no matter how “central” they think they are (Note: China, or Zhong Guo, essentially means “the central country” in Chinese). To adapt or to perish, it’s a question.
According to the author, the three defining stages in human history are: 1) Civilization 1.0: Out of Africa; 2) Civilization 2.0: The appearance and spread of agricultural society; and 3) Civilization 3.0: An era of technological breakthroughs, exponential growth and globalization.
In 1987, geneticist Rebecca Cann and her team traced back the common ancestry of all women to the Mitochondrial Eve, who lived in Africa roughly 150,000 years ago. At the time, the earth was frozen in Ice Age with extremely limited habitable area scattered around the equator. The living conditions are so hostile that at one point that the population of the entire human species summed up to mere 20,000 (imagine!). However, after a long period of slow but drastic climate change, around 60,000 BCE the habitat finally became advantageous enough for humans to venture out of Africa and into the great unknown. Needless to say, in the proceeding millennia, we as a species were hugely successful by any measure: we marched to almost every corner of the planet (before the linkage between Eurasia and Alaska eventually broke), by foot and without any knowledge of what awaits. That alone is quite remarkable. Not to mention the population grew astronomically from the initial 20,000 to 500,000 around 20,000 BCE when the earth finally defrosted and Ice Age was in the past. Since then the existential threats (from natural forces anyway) receded to the backstage. Humans are now rooted in four of five continents and finding their way to the next great leap.
At this stage, the divide between the East and the West is purely geographical: a massive lump right in the middle of the Eurasian continent surrounded by frozen plains and extreme conditions, essentially cutting the continent in half, making the world a perfect lab for experimental design (given natural selection is random). Group E and Group W are about to enter the stage and into the spotlight.
Fast forward to 9,600 BCE, agriculture appeared around the Hilly Flanks thanks to its abundant rainfall and domesticatable crops and beasts. China’s agriculture came to the scene right around 7,500 BCE for similar reasons. Other areas, deprived of such natal advantages had to wait a few millennia to be reached by civilization 2.0. But ultimately everyone except for those in the Americas and Australia entered this stage by 1,500 BCE. The places that were left out were left out for geographical reasons: Eurasia and America separated completely long before agriculture was even in sight, impeding the spread of this new way of human life; Australia was even harder to reach in that regard. Secondly, there was an utter lack (if not absence) of domesticatable plans and animals in those continents. Therefore, despite of America’s ideal climate and vast, harvestable land, it was not graced by civilization 2.0 until the territorialization of the Europeans.
During this state, East and West were by and large on par, with the West taking a slight lead in the establishment of the Roman Empire; and subsequently after its downfall, the East dominated by the Chinese Empire surpassed the West at around 500 CE, again, in terms of Morris’ measures of civilization. According to the author, part of the rise of the East, or China, more strictly speaking, had to be credited to the Keju system originated in the Qin Dynasty. The exam-based system introduced meritocracy to China’s political structure and ensured equal opportunities at least for most men. Whereas after the Roman Empire, various Western countries struggled to find an effective way to organize and unify themselves politically, and thus regressed to the same level as 800 years ago in the 5th century.
In the proceeding millennium, the East continues to lead thanks to the vitality injected by its political meritocracy. Nevertheless, the paradigm began to shift — quite unnoticeably at first but the cumulative effect after several centuries was enough to turn the world topsy-turvy.
Lying beneath the seemly mundane surface are two protruding factors that likely affected the trajectory of either societies as far as I can see based on what I learned from the book. First of all, despite of its tremendous benefits, Keju has its flaws and is far from enough to sustain China’s evergrowing population and advancing society. It grants political privileges to whomever willing to and capable of passing a series of examinations, that promised a pathway for anyone (theoretically) to rise to political prominence. But! Ultimately there’s a limit to how far one can go. That is, the throne. And given the position of the highest ruler can only be inherited, not earned, it is up to that one individual and his (yes, the vast majority, if not all, of them were men) select trustees, often related to him by blood or through marriage as well, to determine what happens to the entire empire — the largest on earth at the time. It is their wisdom, character, knowledge and ability the whole country relies upon for peace, survival and continuation. If that’s not a crapshoot I don’t know what is.
Keju was also limited in its rigidity, though technically it didn’t have to be. Ming Dynasty is infamous for its turning its bureaucrat selection system into a “word prison” or, perhaps more fittingly, “hell of words”. The empire’s gradual loss of toleration in free thoughts and original ideas, and eventually loss of interest in assessing candidates on what could be practical or functional in serving the empire, which is what the Keju system was designed to do, probably predated the rise of Ming Tai Zu (first Emperor of Ming Dynasty) by many centuries. And the reason behind that, in hindsight at least, is pretty clear. Whatever the system was selecting, it was meant to serve the ruler, the throne, the product of the crapshoot that may or may not (and most likely not) care about the millions of people outside of his fortress, whom supposedly were born to serve him, not the other way around.
Additionally, there is no mentioning of economic meritocracy alongside its political counterpart. It is well-known that businessmen are at the very bottom in terms of the traditional Chinese hierarchy of noble career choices for the plebs. I’m referring to the “bureaucrats, peasants, craftsmen, and businessmen” (in descending order) I was taught in grade school history class, of course. So that doesn’t help the vast majority of the non-intellects or intellects with no appetite for Baguwen, a strict format in writing and speaking mandated by the Keju system in later eras of the empire to streamline and purge the bureaucrats’ mind, very much at all.
Admittedly, political power may translate into economic prosperity but that may take many generations. After all, it is extremely unlikely for an ordinary man to rise to high political rank, such as the hand of the Emperor, Zai Xiang, within his lifetime. More likely scenario is that, if he is extremely lucky, he’d rise to become a regional bureaucrat, which would afford him and his several wives and many children a decent if not lavish life. Then from there, one or more of the sons will build upon their father’s achievements and continue to climb the political ladder, if again they are extremely lucky. This painfully slow process of wealth accumulation is a stark contrast to what started to appear in the British Empire, which since Magna Carta had sought to limit the power of the monarchs in order to make room for the rising business class and its thirst for power.
In line with that tradition, economic meritocracy started to flex its muscles in the Great Britain and many of its close neighbors. Still, no commoners were allowed at the side of Queens and Kings, but the monarchs’ palace was no longer the only place where political power resides. Eventually, rising business class, the new economic elites, can exert their political influence at various forms of the House of Commons, a democratically elected branch of the government that, dare I say, can be purchased by wealth. To that end, some aristocrats, even the Queens and Kings themselves, had to borrow from these shrewd businessmen, perhaps after learning the hard way, that seizing their wealth by force probably won’t end very well for anyone. To that, the new upper class had God, the Western world’s long-running democratic tradition, and Europe’s natural geographic divides, which prevented a powerful, omnipotent central government from forming, to thank.
Later on when the West started funding large-scale Maritime explorations (still tiny compared Zheng He’s voyages), Ming Dynasty wrapped up its first and last attempt to venture overseas and subsequently shut its door to the outside world. Ironically, the Mongolian raiders that plagued China since the very first Dynasty (the Great Wall was built in defence of their ferocious horse-back attacks) and most of Northern and Western Asia, somehow spared Europe from their conquest and did not continue to expand its territory in the 15th century. As a result, various European kingdoms were allowed to develope and flourish in peace whilst benefiting from the oriental treasures and spectacles brought closer to home by the Mongolians. Lured by the Far East brought in-sight and the constant encouraging news from the earlier expeditions, Western explorers, and perhaps the Western society in general, were now more eager for discoveries. And the spirit of inquisitiveness grew and grew until it blossomed into the Renaissance, the Age of Exploration, the Enlightenment, and finally, the Industrial Revolutions which led humanity into civilization 3.0.
The fundamental difference between civilizations 2.0 and 3.0 is that 2.0 operates under a system characterized by shortages. That is, the growth of a society is limited by its agricultural output, which is in turn dictated by natural forces such as seasons, climate and photosynthesis. Once a society grows to a certain size, it inevitably falls into the Malthusian trap, where a significant amount of the population has to die out in order for the society to revert back to a point of equilibrium. Sounds incredibly cruel and reminiscent of Marvel’s almighty, mission-driven, almost reasonable villain, Thanos, who decided that half of randomly selected humans must perish (like, literally turning into ashes) in order to save the Earth and so he set out to do just that. Well, guess what? Civilization 3.0 powered by free market and technological advancements and capable of unlimited growth, come to rescue. I know, I know. We also run a greater risk of perishing altogether thanks to our unbounded power to destroy, you smart son of a gun. Can we just play along for now? Anyhow, the West boarded the first 3.0 train this time around and developed so quickly like no one had seen before. In the proceeding centuries, several Asian countries followed, first Japan, then South Korea, Singapore, now China. They all showed likewise pattern regardless of their political systems: one-party, two-party or multi-party rule; direct or indirect democracy; capitalism or communism — different paths, same destination that is unlimited, explosive, constant economic growth and a civilization of materialistic abundance.
The secret ingredient of this growth pattern, according to Li Lu, is a free market economy powered by scientific and technological innovation. The end game? The largest market economy will become the one and only market. Globalization is now the inevitable and irreversible. I’ll take that over turning into ashes, thank you. To that end, both worlds will converge and to quote historians Ariel and William Durants’ incredibly perceptive prediction from more than half a century ago: “East is West and West is East and soon the twain will meet”. Maybe with the physical barrier that stood to separate the worlds for millennia becoming less and less relevant, the line is finally blurring and will someday dissolve completely.
That pretty much sums up the first half of the book. The later chapters move on to talk about some of Li’s personal history, investment philosophy, his friendship with Munger and so on. Below are a few things I learned about this part, which includes a few speeches he had given over the years, both in China and overseas.
First of all, the stock market as we have it today is far the most part a zero-sum game, not unlike a casino at the elephantine scale. The investment community is filled with apathetic opportunists alike whose ultimate goal is but their own financial interests (prototype for typical Wall Street villains I imagine). Specifically, Li shines light on an absurd yet prevalent fee structure. That is, whether the wealth managers generated any above-benchmark returns or not, they charge an advisory fee proportional to the amount they are entrusted with — arguably the money they have not earned. As I see it, these people are emboldened by plausible alibis which are abundant Nobel Prize winning economic theories that (rightfully) assert an investment decision cannot be readily judged without enough historical data. How convenient that no one can quite tell whether an investment product is good or bad within a short time horizon (the definition of “short” here is widely open for interpretation), if ever. I’m not suggesting there’s anything wrong these theories or their proponents per se — surely they were meant to inform rather than to mislead. And granted, if short-term gains or losses were to be accredited one might as well go to the casino. It’s just that the absence of an objectively sound evaluation system makes the stock market seem to me awfully like a fertile ground for costly, misleading information if not outright fraud.
This is where the value of value investors come in, Li argues. With the right tools and intention on their side, value investors are the true price setters of the market and the only reason why the stock exchange around the world are more than a casino. A bit of a conceited claim, but I can see how someone may hold such view. This rare bunch (less than 5% of all investors) spend their lifetime searching for a handful of investment opportunities and see themselves (in a somewhat illusory manner) as part of the ownership. After all, as Li puts it, that’s what the stock market is there for: to get everyday people’s savings into the right hands in order to raise capital for promising businesses, generate wealth for stakeholders, and invigorate the economy. They search for worthwhile companies like a treasure hunter, and learn about anything related or unrelated to their targets along the way. In Li Lu’s words, ideally a value investor is more of researcher than an investor. Once they confirm their “kill”, sometimes after decades of studying and contemplating, they pull the trigger with unflinching conviction and hold it for a long time. “That’s how I sleep tight at night unlike some of my colleagues”, he reckons. As cool as it may sound, I can’t help but notice the “conscientious bankers” never made it in Hollywood. Too bad.
Another thought-provoking takeaway from the later part of the book is central government’s place in a nation’s economy. After all, “free market is by no means free”, Li observes. Indeed, to ensure the proper functioning of a large free market is no small undertaking. It requires tremendous amount of funds and effort that no individual company or industry could or, I would argue, should provide. That said, Li agrees that governments have different roles to play depending on a country’s stage of economic development. There are two turning points marking three stages of economic development in a post-agricultural society. The first being the Lewis Turning Point raised by English economist W. Arthur Lewis. Before the arrival of this turning point, Lewis proposes, capital has absolute dominating power over labor. Labor skills are low and often in high supply thanks to former agricultural workers pouring into cities for higher-paying modern jobs. Therefore, wages are uniformly low, so are unit price and profit margin. At this stage saving may be citizens’ main goal; thus, it makes sense for government to indirectly participate in the economy — borrowing money from the savers and invest it into the economy either by lending to sprouting businesses or by establishing state-owned enterprises to build and strengthen infrastructure. Great.
Clearly, this stage will not last forever as companies grow in numbers and capacity. New and more sophisticated technologies will be employed and so will high-skilled workers to wield the new tools. Labor’s bargaining power grows with their skills; income rises as a result, and so does spending. This is where the economy hits a sweet spot of continuous growth. High spending drives demand; growing demand spurs more investment and enterprises which in turn fuel higher wage and income. US entered this phase soon after WWII, followed by Europe and a few Asian countries: Japan, Singapore, and South Korea to name a few. All of these countries and regions entered stage II one after another by the 1970s and their GDP per capita reached $30,000 soon after. During this period of growth, monetary policy becomes the optimal tool in aiding the free market work its magic. In short, the government and central banks should sit back, give the stage to private companies and let them borrow directly from the savers who are also their customers and employees, so that these people earn 100% of their well-deserved dividends. The government, Li argues, should only step in with mild nudges by regulating money supply so as not to discourage the incentive for wealth accumulation.
It would be nice to see all economies hang out in this sweet spot till the end of time; however, history teaches us that nothing lasts. Increasingly we see developed countries, burdened by low birth rate and aging population, having low or negative interest rates. Fiscal policy that used to work like magic for the longest time stopped working; people became more and more reluctant to spend no matter how low interest rates are. This phenomenon was brought to spotlight by economist Richard Koo, observing the lack of vitality in Japanese economy since the 1990s. Once a society arrives at this stage, it would again make sense for the “Big Brother” to take action and assume an active role in the economy as in stage I.
Reality, of course, is not as clear-cut. And governments around the world are generally large, cumbersome political machines characterized by bureaucracy, inertia and latency in execution. The size of a country matters, and so do culture and ingrained beliefs and perception about the government’s role. For countries like China, where for centuries central government has always taken on an active role on the economic stage, it may be hard to convince policy makers at various levels to chill out a little and loosen their grip on the economy. However, with China approaching (some may say having passed) the Lewis Turning Point, this becomes increasingly important and should be done sooner rather than later. I’m fairly hopeful it will happen though. After all, thanks to modern-day version of Keju, China’s got the most capable and efficient bunch of bureaucrats working towards its renaissance.
Conversely, countries heading towards or perhaps had already crossed the second turning point, given their long-running democratic tradition, may have a hard time adjusting to the fact that even the most powerful machine — the free market — may need an oil change. This can finally become reality in the US with Trump disgracefully shooed out of the White House. Will American government show as much vigor and determination as T.R.’s administration did back in the Great Depression? Will Americans, increasingly radicalized and divided, be on board? I sure hope so.
To conclude, this book was packed with knowledge and insights rooted in anthropology, history, economics as well as the author’s own life experience and professional views. I learned a ton from the book, not to mention it clicked with me on a personal level. How so? Li Lu also grew up in China, came to the US to receive higher education and built a life from ground up — a bigger and more exciting life, but not without similarities I’m sure. In one of his speeches he describes his experience: “I’ve struggled with cultural identities, having spent half of my life in each country. Now I’m more certain than ever, that I am a hundred percent American as well as Chinese”. I applaud him for having found that self-assurance (among many other accomplishments) and hope to get there someday myself. I’m glad he wrote this book and shared what he did with his readers.
