Richard Lawrence's Margin of Safety

Last week, I had the pleasure of listening to Mr. Richard Lawrence, Chariman and Executive Director of the Overlook Group, speak at the Chinese University of Hong Kong as part of a value investing competition sponsored by his firm.

Richard is enormously generous with his time, helping us at ValueAsia too to launch the first of our annual conferences back in 2017. I find him very inspiring because of his plain-spoken probity and passion for his job. And he is an excellent teacher because he is just as much an entrepreneur as he is a stock-picker. That’s unique because few investors appear to think about their practice in the context of their business. But Richard has sat at the intersection of these two spheres and thought deeply about both for almost three decades. And the lesson is that you can’t succeed in one without succeeding in the other.

I learn something new each time I hear Richard speak. Last week he said that “your margin of safety is your path to outperformance”. If I had to boil down everything I’ve learned from him over the years, it would be that your margin of safety must start and end by putting your clients’ interests first.

Why is that? Many of us look at Buffett and see the genius of a permanent capital base. This is the foundation on which Berkshire Hathaway was built because it allowed Buffett to be a contrarian and fully exploit extreme mispricings in the market - to be greedy when others were fearful, as he puts it. The way for an investment manager to approximate a permanent capital base is by earning his or her clients’ trust. Because if you have their trust, they will stick with you at the bottom when stocks are at their lowest. And having capital on hand at that point creates a win-win outcome for both you and them, where risk should be lower and returns higher. If you think about it, your clients’ trust is your ultimate margin of safety. And by extension, if you truly have your clients’ interests at heart, you should work hard to earn their trust and give them that margin of safety too.

To appreciate this virtuous cycle, just consider the opposite: you don’t put your clients’ interest first; your clients don’t trust you; they pull money out at the bottom; you don’t have capital to buy when prices are low; your track record suffers; and your clients trust you less - if they’re even still with you! It’s a vicious cycle in which everyone loses.

So how do Richard and his colleagues put their clients’ interests first, build trust and earn their margin of safety?

First and foremost, they invest with a margin of safety. Since Overlook was founded in 1991, it has accumulated scores of overlapping and mutually-reinforcing techniques, tools and frameworks which shape the team’s research process and portfolio construction. This is the tradecraft: a search for superior businesses; an emphasis on profitability (return on operating assets) and cashflow (four definitions!); net cash balance sheets; good capital allocation; and the patience to wait for bargain prices. In isolation, none of these ideas are revolutionary. But few investors have the discipline to commit to them consistently. Richard cites Charlie Ellis’ book, “Winning the Losers’ Game: Timeless Strategies for Successful Investing”. Discipline helps you to avoid mistakes. Fewer mistakes helps performance.

Another aspect of this is Overlook’s emphasis on ‘duration’. They know the evidence shows that the best performing managers over a decade or more are not the best performers in every given year. As the saying goes, to finish first, you first have to finish. So they don’t try to shoot the lights out and make clear their clients understand this. Rather, the team extends their time horizons and will invest only in businesses which do the same. Richard describes himself as “a low beta manager” who wants consistent profitability and sustainable earnings growth (low teens p.a.). Their investment in China Yangtze Power is a classic example of this (which you can read about it in OAM’s 2015 and 2016 letters).

Second, they resolutely avoid conflicts of interest. This includes obvious policies like banning soft dollar commissions, or claiming only relevant management expenses. It also means no PA trading in the markets they cover and investing instead directly in their fund alongside clients. Even more profound are the decisions Richard made to restrict Overlook’s growth. From launch, he capped the assets the fund could raise in any given year. This meant that he could never enrich himself at the expense of his fund’s performance. Similarly, he never accepted outside equity because of the risk a partner would push him to gather assets. Richard has also only ever managed one fund at Overlook (excluding a side car to hold the investment in China Yangtze). Today, he boasts a solid 28 year record. But it must have looked dreadful after the Asian Financial Crisis. He could have easily shut his fund and started again. And yet he did the right thing and persisted, even though it must have taken him years to return to his high water mark. Finally, Overlook regularly cuts fees to share the benefits of scale with its clients.

Third, they are professional. Overlook’s team wear suits and ties at virtually all times. Richard boasts that he gets tax returns to clients before anyone else. These are small things but in aggregate they signal dependability. If you can’t trust your manager to get you your tax return on time, how can you trust him with your money when the market is down 50%?

Finally, and most importantly, they communicate well and they communicate often. Richard is a master storyteller, expert at conveying in simple language the values and principles upon which Overlook was founded. Listen to this interview he gave with Ted Seides (here) and this presentation at Western Ontario University (here), and notice how he riffs on exactly the same themes. I think the repetition of - and implied adherence to - the values in these stories builds enormous goodwill. It communicates Overlook’s culture and invites you to be a part of it. And by reducing his formula down to six simple and understandable principles - the Overlook Model - and repeating them almost ad nauseam, Richard builds a powerful association in his clients’ minds: Overlook puts clients’ interests first.

Engineers build bridges with multiple points of independent and over-lapping redundancy. Richard Lawrence has done the same with his business. And by consistently putting their clients’ interests first, Richard and his team have earned their clients’ trust, giving themselves the ultimate margin of safety as investors. Richard closed his talk by reminding us that, “Real money is made slowly over time. Don’t let your greed get in your way.” The brilliant thing is that so few people are willing to listen to his advice. And that means that Richard’s margin of safety is hiding in plain sight for all who do.