LI LU LECTURE NOTES

Spring 2012

These are my notes from Li Lu’s 2012 lecture at Columbia University. They’re incomplete and edited for clarity, so
this shouldn’t be considered a transcript. If you have questions or comments, please reach out to me at turtlebay.io.

It’s good to be back in Professor Greenwald’s classroom. I took his class when I was a student. His class, in fact,
helped launch my investment career. So it’s an honor to come back and do this lecture. I’ve done it for twelve
years, and I look forward to it every year.

I want to start by going over the three basic concepts of value investing:

(1) Stocks represent partial ownership in a business—they aren’t just pieces of paper;
(2) Investing demands a margin of safety; and
(3) The concept of Mr. Market.

The first concept, stocks aren’t just pieces of paper, is easy to understand but hard to apply. When you have a piece
of paper that gets quoted all the time, you tend to trade it. That’s human nature. Some people, however, view these
pieces of paper as fractional interests in businesses. And those are the people we’re referring to when we talk about
value investors.

The second concept, margin of safety, is also easy to understand. Investing involves making predictions, but the
future is unpredictable. No matter how smart you are, how much you know or how much work you’ve done,
you’re still dealing with probabilities. The odds should be high enough so that over a lifetime you end up ahead—
way ahead. But because you’re dealing with probabilities, nothing is 100% certain. You need a margin of safety to
allow for mistakes and misfortune.

What about the third concept: Mr. Market? You’ve all heard about Ben Graham’s Mr. Market. Tell me about him.

[Student: Mr. Market is the irrational and erratic fellow that’s always willing to trade with you.]

Right. Of course, Mr. Market is a fictional character. You can’t point to someone and say, “That’s Mr. Market.”
We use him as a mental model to help ignore market noise and have confidence in our convictions.

It’s another concept that’s easy to understand but hard to apply. Over your career, you won’t just encounter
irrational and erratic people. This business has lots of thoughtful people, too. What happens when one of them
presents a well-reasoned case against you? You’ll think to yourself, “This fellow is smart, he knows more than I do
and he holds the opposite view.” You end up asking, “What am I doing [betting against this person]?” That’s the
more common experience, and it’s why many of you will be influenced by what others have to say.

Every investor must develop the frame of mind to deal with thoughtful people disagreeing with them. But how do
you do this? How do you get to the point where you’re comfortable being told you’re wrong? How do you get to
the point where you think it’s all noise?

Charlie Munger has a saying: “I never allow myself to have an opinion on anything that I don’t know the other
side’s argument better than they do.” What does he mean? He means you’re entitled to your opinion after reading
everything you can find, talking to everyone who will talk to you and listening to all the arguments. Only then can
you say, “I can hold this view because I can’t find anyone who knows more than I do.”

Let’s move on to the case studies.

First Case Study: Megastudy

Picture the following: It’s December 2004 and a South Korean company called Megastudy is about to go public.
You’ve decided to research the company as a potential investment.

You have the handouts with Megastudy’s information. Tell me about the company.

[Student: They provide educational services.]

What type of educational services?

[Student: They offer online tutoring services that help students prepare for the Suneung, which is the Korean
college entrance exam.]

Do we have any South Koreans in the room? Tell us about your college entrance exam.

[Korean student: You take the Suneung in high school. It determines where you go to college.]

What about your school grades, class rank or other test scores? Do colleges look at those as well?

[Korean student: Colleges look at your Suneung score above everything else.]

Does the college you attend matter more in Korea than in other countries?

[Korean student: Yes. A lot more.]

Why?

[Student: Your college degree determines your career prospects. You can’t get a job at a top Korean company
unless you have a degree from a good school.]

Is it fair to say that the college entrance exam is one of the most important things a Korean will do in their life?

[Korean student: Yes.]

How do parents help their kids prepare for the test? Can they, for instance, send them to private schools?

[Korean student: You can send your kids to a private school in elementary and middle school. But all students must
attend the same public high schools.]

So how do parents prepare their kids for the exam?

[Korean student: They send them to after-school tutors.]

Right. In Korea, everyone goes to tutors. And because this exam is so important, you want to go to the best tutor
you can afford. But there are only so many good tutors, and their time is limited. With so much demand for their
time, good tutors end up with a lot of pricing power.

It’s no different than someone facing a life-threatening medical condition. That person wants the best surgeon they
can find. There’s a problem though: Everyone else dealing with the same life-threatening condition wants that
surgeon, too. The surgeon can charge a premium, and only a few people can afford the procedure.

How does Megastudy help students prepare for the entrance exam?

[Student: Megastudy provides a platform for the best tutors to teach online classes.]

They hire the top teachers, tape them and put the material online. Students pay a fee that’s less than the cost of an
offline tutor. Now everyone, not just the rich, can afford the best test preparation.

The model has caught on with customers. And it’s turned into a great business: triple-digit revenue growth, 40%
operating margins, no capital requirements, etc.

MEGASTUDY CO.
KRW billions; USD millions at 1,000:1 fx rate
Year ended December 31,
2003 2002 2001
Online lectures 35 16 4
Offline lectures 4 1 -
Supplies & other 7 3 1
Total revenues………………………………..
…………………………………… 46 20 4
year-over-year 126% 376% 638%

Gross profit …………………………………………………….

……………………………….. 30 14 3
gross margin 66% 67% 66%

Operating profit………………………………..
……………………………………. 20 9 1
operating margin 45% 46% 30%

Net profit 15 7 1
Shares outstanding 4.7 4.7 4.7
Net profit per ………………………………..
share ……………………………………………….
3,234 1,459 189

Return on beginning shareholders' equity 145% 187% 197%

Cash 21.7 11.9 3.4
Receivables 0.9 0.6 0.3
Prepaid & other 0.2 0.3 0.0
Current
……………………………………………
assets ………………………………………………………………………….
22.8 12.8 3.7
Property, plant & equipment, net 8.2 0.6 0.1
Investments 3.4 1.4 0.7
Other 0.5 0.0 0.0
Total
……………………………………………
assets ………………………………………………
34.9 14.8 4.6

Payables 0.5 0.6 0.2

Accrued & other 7.5 3.5 0.6
Current
……………………………………………
liabilities ……………………………………………
8.0 4.1 0.9
Long-term liabilities 0.8 0.3 0.0
Equity 26.0 10.4 3.6
Total
……………………………………………
liabilities & equity ………………………………………………………….
34.9 14.8 4.6

 What about the valuation? Megastudy planned on selling shares at 19,000 to 30,000 won, but the IPO priced at
18,500. They have 6.3 million shares outstanding and 50 billion won in cash (post-IPO). You can translate won to
dollars at a 1,000 to 1 ratio by replacing the ‘billion’ with ‘million’. So the market capitalization is $120 million—
or $70 million after netting out the cash.

How much money did they make the previous year?

[Student: 3,234 won per share…]

I don’t want per-share figures. Remember the first rule of value investing: A stock represents partial ownership in a
business—it’s not just a piece of paper. Don’t think in ‘per-share’ terms. Give me the overall results.

[Student: 15 billion won.]

Megastudy has a $120 million market value, $50 million in net cash and earnings of $15 million. That’s 8 times
earnings or 4 times earnings net of cash. Remember, the $15 million in earnings was from 2003—almost a year
ago. They’re growing 100% a year, but I’m not even looking at forward earnings.

MEGASTUDY CO.
KRW billions; USD millions at 1,000:1 fx rate

Share price at IPO -- 12/21/2004 KRW 18,500

Shares outstanding -- post-IPO 6.3
Market
…………………………………………………………..
capitalization …………………………………………………. 117
Cash at IPO date -- estimate 30
Cash from IPO -- estimate 20
Debt -
Net cash
…………………………………………………………..
……………………………………………………………………. 50
Market capitalization, net of cash 67
P / E ……………………………………………………………………
………………………………………………………….. 7.7
P / E --
…………………………………………………………..
net of cash ……………………………………………………………………
4.4

What’s wrong? Why is the company so cheap?

[Student: The government released a free online tutoring service.]

When was it released?

[Student: April 2004]

In April 2004, the government released a service like Megastudy’s that students can use for free. Megastudy had
been growing by over 100% per year. How did this new free service affect Megastudy’s business?

[Student: In the second quarter 2004, online revenues fell 7%. Then they fell 28% in the third quarter.]

 MEGASTUDY CO.
KRW billions; USD millions at 1,000:1 fx rate
2004
Q3 Q2 Q1
Online lectures 11.1 6.8 11.5
Offline lectures 2.4 1.9 2.4
Supplies & other 2.1 1.2 2.3
Total revenues………………………………..
…………………………………… 15.6 9.9 16.2
year-over-year - total -24% 6% 89%
year-over-year - online lectures -28% -7% 76%

Gross profit …………………………………………………….

……………………………….. 10.1 6.2 10.7
gross margin 65% 63% 66%

Operating profit………………………………..
……………………………………. 7.0 3.2 7.6
operating margin 45% 33% 47%

We’ve discovered Mr. Market’s opposing view: Megastudy’s fee-based business model may not be viable in a
market where the government offers a competing free service. Is that a realistic point of view? Yes. A thoughtful
person could make a good argument, supported by the company’s recent results, that students won’t pay for online
tutors when they can get them for free. And if that’s the case, Megastudy isn’t a bargain.

Let’s talk more about Megastudy’s business model. How do they pay their teachers?

[Student: They charge students a fee and give the teachers a 23% commission on all the fees they generate.]

The government, on the other hand, pays teachers a fixed salary. It may make sense for an average teacher to
switch to the government’s service. But what about the top teachers? Top teachers attract nearly all the students,
and they get 23% of everything these students spend on Megastudy. Are they going to give that up for a fixed
government salary?

[Student: No.]

What about the students? Why would students pay for Megastudy when they can use the government’s service for
free?

[Student: Exams are zero-sum, so what matters is how well you do relative to other test-takers. Koreans paid high-
priced tutors for an edge in the past. They shouldn’t have a problem paying a small fee to Megastudy for that same
edge in the future.]

What about new competition? What if someone started a competing service using the same commission-based
model? What if someone offered teachers a higher commission? This business has 40% operating margins and
doesn’t need capital—there’s lots of room to pay teachers more. Competitors could, for instance, offer teachers
33% commissions. Would that be enough to persuade the best teachers to leave Megastudy?

[Student: Teachers go where they make the most money. If Megastudy offers a lower commission but has more
students, teachers will still make more money on their platform.]

Correct. 33% of a small number isn’t the same as 23% of a large number. And if that’s the case, Megastudy will
still attract the best teachers because they have more students.

Does that mean Megastudy has a network effect? Consider the dynamics:

…as more students use Megastudy, the tutors earn higher fees; as the tutors earn
higher fees, they will continue to produce material for Megastudy; as they continue
to produce material for Megastudy, more students will use Megastudy…

If Megastudy has a network effect, how should they compete? Network-effect businesses compete in winner-take-
all markets. We need to answer the question: Who will be the winner?

[Student: eBay won in the online marketplace by having the most buyers and sellers? Perhaps Megastudy can win
in their market by having the most students and teachers.]

They need to provide a platform where (a) teachers earn the most money and (b) students earn the highest exam
scores. That’s the feedback loop. If they do this, pricing becomes less of an issue.

What about first-mover advantage? In a network-effect business, the first to market has an advantage over
everyone else. Is Megastudy the first mover in online education?

[Student: Yes. The founder of Megastudy was one of the best exam teachers in the country. He knew all the other
top teachers, and he offered them equity. He signed up the best teachers in every subject.]

Let’s go back to our investment decision. It’s the day of Megastudy’s IPO, and you’ve reached the following
conclusion about the company: they deliver an essential service; they’re the leader in a winner-take-all network-
effect business; they’re growing more than 100% a year, have 40% operating margins and don’t need capital to
grow; and they’re trading at 8 times earnings or 4 times earnings net of cash. But we’re still faced with one big
unanswered question: Is Megastudy’s fee-based model viable when the government offers a competing free
service?

Do you invest in December at the offering price of 18,500 or not?

Say you decided to invest. What happens after the IPO? What happens in the fourth quarter 2004?

[Student: Online revenues increased by 15% and total revenues increased by 14%.]

This is an improvement. Maybe we’re right that Megastudy won’t be affected by the government’s free service. Or
maybe Megastudy dressed up the results to help sell the December IPO. Both are possible.

Let’s move on to 2005. What happened in the first quarter?

[Student: Online revenues were down 12% and total revenues were up 3%.]

So what do you do? Are you wrong about Megastudy? Online revenues fell 7% and 28% in the second and third
quarters, respectively. Things improved in the fourth quarter, but that could have been due to the IPO. Now
revenues are down another 12%. If you believe Megastudy’s business will be unaffected by the government’s free
service, how can you explain these results?

 You need to ask yourself: Do I know enough to be entitled to an opinion? Those who haven’t done the work will
look at these results and think, “Maybe Mr. Market is right.” But if you’ve done the work, if you know more about
the company than anyone else, if you’ve earned the right to hold an opinion, then times like these present an
opportunity to act. It’s one of the defining qualities of a good investor: When the time is right, you must act.
[Note: Li Lu bought more]

What happened next? What happened in the second quarter 2005?

[Student: Online revenues were up 22% and total revenues were up 45%.]

This was an important quarter. Students are getting serious about preparing for the exam, which takes place in
November. Perhaps students tried the government’s new service in the first quarter when there was still lots of
time, but now it appears they’re returning to Megastudy. If that’s the case, we could be right about the viability of
their business model.

Let’s move on. What happened in the third quarter 2005?

[Student: Online revenues increased by 37% and total revenues increased by 57%.]

MEGASTUDY CO.
KRW billions; USD millions at 1,000:1 fx rate
2005 2004
Q3 Q2 Q1 Q4 Q3 Q2 Q1
Online lectures 15.2 8.3 10.1 6.2 11.1 6.8 11.5
Offline lectures 6.0 4.5 4.6 1.1 2.4 1.9 2.4
Supplies & other 3.1 1.6 1.9 1.2 2.1 1.2 2.3
Total revenues………………………………..
…………………………………… 24.4 14.4 16.7 8.6 15.6 9.9 16.2
year-over-year - total 57% 45% 3% 14% -24% 6% 89%
year-over-year - online lectures 37% 22% -12% 15% -28% -7% 76%

Gross profit …………………………………………………….

……………………………….. 15.4 8.8 10.3 5.1 10.1 6.2 10.7
gross margin 63% 61% 62% 60% 65% 63% 66%

Operating profit………………………………..
……………………………………. 10.6 4.8 5.0 1.9 7.0 3.2 7.6
operating margin 43% 34% 30% 22% 45% 33% 47%

It’s becoming clear that the government’s free service won’t have a lasting impact on Megastudy’s business. Now
the question becomes: Will Megastudy dominate the online-tutoring market?

[Student: It’s a winner-take-all business. Megastudy was the first mover and has a big lead. They have a good
chance of dominating their market.]

Over the next few years, Megastudy did indeed dominate Korea’s online-tutoring market: they overcame the threat
of both new entrants and the government’s free service; they reached 80% subscriber market share and had
revenues 6 times larger than their nearest competitor; and they grew 50% a year and maintained 35% operating
margins. No one else came close.

 MEGASTUDY CO.
KRW billions; USD millions at 1,000:1 fx rate
CAGR Year ended December 31,
(2007-2004) 2007 2006 2005 2004 2003 2002 2001
Online lectures 41% 99 59 44 36 35 16 4
Offline lectures 78% 44 31 19 8 4 1 -
Supplies & other 43% 20 12 9 7 7 3 1
Total revenues………………………………..
…………………………………… 48% 163 101 71 50 46 20 4
year-over-year 61% 43% 41% 9% 126% 376% 638%

Gross profit …………………………………………………….

……………………………….. 47% 102 63 44 32 30 14 3
gross margin 63% 62% 62% 64% 66% 67% 66%

Operating profit………………………………..
……………………………………. 43% 58 32 25 20 20 9 1
operating margin 36% 32% 35% 39% 45% 46% 30%

Net profit 46% 46 26 21 15 15 7 1

Shares outstanding 10% 6.3 6.3 6.1 4.8 4.7 4.7 4.7
Net profit per ………………………………..
share ……………………………………………….
33% 7,290 4,345 3,464 3,115 3,234 1,459 189

Dividends per share

………………………………..
…………………………………….
- 1,800 900 750 - - - -
payout ratio 25% 21% 22% - - - -

Return on beginning shareholders' equity 40% 29% 32% 57% 145% 187% 197%
Cash 63.0 60.7 50.6 52.7 21.7 11.9 3.4
Receivables 7.7 4.3 2.1 1.5 0.9 0.6 0.3
Prepaid & other 11.1 8.2 4.4 1.8 0.2 0.3 0.0
Current assets ………………………………………………………………………….
…………………………………………… 81.8 73.1 57.1 56.1 22.8 12.8 3.7
Property, plant & equipment, net 47.4 30.7 23.7 8.7 8.2 0.6 0.1
Investments 68.7 39.0 23.9 8.2 3.4 1.4 0.7
Other 8.1 0.7 0.5 0.6 0.5 0.0 0.0
Total assets ………………………………………………
…………………………………………… 206.0 143.4 105.2 73.6 34.9 14.8 4.6

Payables 3.4 1.7 1.1 0.6 0.5 0.6 0.2

Accrued & other 38.7 20.7 11.2 7.3 7.5 3.5 0.6
Current liabilities……………………………………………
…………………………………………… 42.2 22.4 12.3 7.9 8.0 4.1 0.9
Long-term liabilities 2.8 5.7 2.4 0.6 0.8 0.3 0.0
Equity 161.0 115.4 90.5 65.1 26.0 10.4 3.6
Total liabilities &……………………………………………
equity ………………………………………………………….
206.0 143.4 105.2 73.6 34.9 14.8 4.6

[Student: What about the stock price?]

The stock went up more than 10 times. But a stock that rises like that presents a new set of issues. When
Megastudy went public, investors were paying $70 million for $15 million in earnings. Now investors are paying
$1.5 billion for $50 million in earnings. You need to ask yourself: Do I still have a margin of safety? Is this stock
still a bargain? Are there better uses for my capital?

365,000

315,000
Share Price (KRW)

265,000

215,000

165,000

115,000

65,000

15,000
12/31/2004 12/31/2005 12/31/2006 12/31/2007

[Student: What about saturation? Korea isn’t a big market, so how much longer can they grow 50% a year?]

That’s another question you need to ask. Megastudy started when online was 1% of the overall tutoring market.
You can grow a lot if you start from a low base—even in a small country. But what about when everyone uses
online tutors and you control 80% of the market? Will Korea’s tutoring market continue to grow? Will students
continue to move from offline to online? Will Megastudy continue to take market share? And do I know enough
about these things to pay 30 times earnings?

We don’t have time to answer these questions today. I’m focused on Megastudy’s IPO because I want you to see
that you can find bargains in all kinds of places, including IPOs. But I suggest you study what happened to
Megastudy and answer some of these questions for yourself. It’s another good case study.

Let’s move on to the second case study.

Second Case Study: Amorepacific Corp

The Megastudy case began in December 2004. The second case, Amorepacific Corp., takes place today. It’s a live
situation, which makes it more interesting because we don’t know the outcome.

You all have the Amorepacific handouts. Tell me about the company.

AMOREPACIFIC CORP.
KRW billions; USD millions at 1,000 to 1 fx rate
CAGR Year ended December 31,
(2011-2006) 2011 2010 2009 2008 2007 2006
Domestic 14% 2,248 2,004 1,720 1,493 1,331 1,169
International 24% 306 248 220 185 127 104
Sales …………………………………………………………………………
……………………………….. 15% 2,555 2,252 1,940 1,678 1,457 1,273
year-over-year 13% 16% 16% 15% 14% 9%

Gross profit …………………………………………………….

……………………………….. 15% 1,780 1,674 1,401 1,180 1,027 878
gross margin 70% 74% 72% 70% 70% 69%

Operating profit …………………………………….

……………………………….. 10% 373 356 309 246 234 231
operating margin 15% 16% 16% 15% 16% 18%

Net profit 15% 327 284 226 184 179 162

Shares outstanding 0% 6.9 6.9 6.9 6.9 6.9 6.9
Net profit per share………………………………..
……………………………………………….
15% 47,411 41,242 32,746 26,695 25,984 23,457
Dividends per share ………………………………..
……………………………………. 8% 6,500 6,000 5,500 5,000 5,000 4,500
payout ratio 14% 15% 17% 19% 19% 19%

Return on beginning shareholders' equity 21% 22% 20% 19% 22% 22%
Cash 343 326 302 197 203 203
Receivables 152 141 150 134 110 114
Inventories 226 204 160 173 136 106
Prepaid & other 32 39 24 23 38 29
Current assets ………………………………………………………………………….
…………………………………………… 754 711 636 527 488 453
Property, plant & equipment, net 1,771 1,186 967 858 726 642
Investments & other 291 128 151 153 123 85
Total assets ………………………………………………
…………………………………………… 2,815 2,024 1,754 1,538 1,337 1,180
Payables 78 81 71 54 43 46
Accrued & other 332 209 193 177 162 158
Current liabilities ……………………………………………
…………………………………………… 410 290 265 231 205 204
Postretirement & other 205 163 169 166 160 156
Debt, including short-term 61 13 20 25 19 22
Equity 2,138 1,558 1,300 1,115 953 798
Total liabilities & equity
……………………………………………
………………………………………………………….
2,815 2,024 1,754 1,538 1,337 1,180

[Student: It’s a Korean cosmetics and skincare company. They’re the market leader in both retail and direct sales.]

What else?

[Student: They own all the top domestic skincare brands and have three times the market share of their next-largest
competitor.]

What about the financial results? When you look at the results, what makes this business stand out?

[Student: They have a big international business.]

What else?

[Student: They’re growing and earning good returns on capital.]

We’re looking at a business with the following qualities: ownership of the leading brands; dominant market share;
strong multi-channel distribution capabilities; mid-teens growth with high returns on equity and no net debt; and an
international business that has succeeded in large markets—including China. Does that sound like an appealing
company? Of course it does. If you can’t recognize that, you’re in the wrong business.

What about the valuation? What makes Amorepacific a unique situation?

[Student: The common and the preferred trade at different prices.]

What prices do they trade at?

[Student: The common trades at 1,180,000 won per share and the preferred trades at 275,000 won per share.]

What about the market capitalization? What’s Amorepacific’s market capitalization based on the common stock
price?

[Student: $8.1 billion.]

They have 6.9 million shares outstanding—5.84 million common shares and 1.06 million preferred shares. At
1,180,000 won ($1,180), Amorepacific has a market capitalization of around $8 billion.

What about at the preferred price of 275,000 won ($275).

[Student: $1.9 billion.]

Right. 6.9 million shares times the 275,000 won preferred price gets you a market capitalization of around $2
billion.

How much did Amorepacific earn last year?

[Student: Their net income was $327 million.]

What about their shareholders’ equity?

 [Student: $2.2 billion.]

And do they pay a dividend?

[Student: Last year, they paid 6,500 won to the common and 6,550 won to the preferred.]

We have the same company with two different valuations:

- Common shares: 25 times earnings, 4 times book value and a 0.6% yield.
- Preferred shares: 6 times earnings, 1 times book value and a 2.4% yield.

AMOREPACIFIC CORP.

Common Preferred

Share price KRW 1,180,000 KRW 275,000

Shares outstanding 6.9 6.9
…........................................................................................................................
Market capitalization …...............................................................................................................
8,139 1,897

Cash (343) (343)

Investments (262) (262)
Debt 61 61
…........................................................................................................................
Net debt (cash) …...................................................................................................................................
(544) (544)

Market capitalization -- net of cash 7,595 1,353

…........................................................................................................................
P / E …..........................................................................................................................
24.9 5.8
…........................................................................................................................
P / E -- net of cash …..........................................................................................................................
23.2 4.1

…........................................................................................................................
P / B …..........................................................................................................................
3.8 0.9
…........................................................................................................................
Dividend yield …..........................................................................................................................
0.6% 2.4%

Why are the preferred shares cheaper? How are the preferred different from the common?

[Student: The preferred shares don’t have voting rights.]

What else?

[Student: The preferred pays a higher dividend.]

Yes. The preferred are entitled to 50 won per share more than the common.

Any other differences?

[No comments]

Can we agree that the preferred are equivalent to non-voting common that pays a higher dividend? If that’s the
case, why do the preferred trade at a discount? Are voting rights worth a 400% premium?

[Student: Voting rights aren’t worth a lot because the founding family controls the company.]

Right. The family controls a holding company, Amorepacific Group, and the holding company owns a majority
interest in Amorepacific Inc. Common shareholders have voting rights. Those rights, however, aren’t worth a lot if
insiders control the company.

Any other reasons for the discount?

[Student: Maybe it’s due to a lack of convertibility. Can you convert the preferred shares into common shares?]

You can’t convert the preferred into common. But that doesn’t, by itself, make them less valuable.

[Student: It could be due to a liquidity discount.]

The preferred are more illiquid. But should the liquidity discount be 75%? I don’t think so.

[Student: Maybe it’s due to the dividend rights. Can Amorepacific stop paying dividends to the preferred but still
pay them to the common?]

Korean companies must pay preferred dividends before they pay common dividends. Of course, the preferred are
noncumulative and don’t have a coupon, so Amorepacific could stop paying them. But then they would have to
stop paying common dividends as well.

[Student: It seems like investors don’t think the preferred have a claim on the company’s earnings.]

Do we all agree that Mr. Market doesn’t think the preferred have the same rights to Amorepacific’s earnings as the
common?

[Students: Yes.]

How can we research what rights the preferred have?

[Student: We can look at the company’s financial statements.]

Let’s look at the financials. How does the company allocate their earnings in last year’s annual report?

[Student: They don’t allocate any profits to the preferred.]

Right. The company allocates all the profits to the common. But that’s not all. If you look at the footnotes, you’ll
notice that they also (a) exclude the preferred from the number of shares outstanding and (b) deduct the preferred
dividend from net profit like it’s an interest payment to a junior security.
Amorepacific 2010 Annual Report

Are there any other ways we can confirm the status of the preferred?

[Student: We can research the legal rights that preferred shares have in Korea.]

Anything else?

[Student: We can look at Amorepacific’s preferred offering documents in the securities filings.]

Anything else?

[Student: We can look at some other Korean companies that have issued preferred shares.]

What company should we look at? Think of a large Korean company—a company that sets the standard for
accounting best practices in the country.

[Student: Samsung Electronics.]

How does Samsung calculate earnings per share?

[Student: They allocate a pro-rata interest in their earnings to the preferred.]

Right. They allocate a pro-rata interest in their earnings to the preferred and divide by the number of preferred
shares. The result? Earnings per preferred share of 105,592 won, which is close to the earnings per common share
of 105,992.

Samsung Electronics 2010 Annual Report

Where does that leave us? Perhaps Amorepacific was wrong to exclude the preferred shares from earnings per
share? Perhaps the preferred shares do represent a claim on the company’s earnings? And if the preferred represent
a claim on the company’s earnings, then perhaps the market is wrong to discount them by 75%.

It reminds me of the debate over stock options. Until 2006, businesses didn’t have to account for stock options as
an expense. Executives argued that if options weren’t expensed for accounting purposes, then they must be free.
But that logic was flawed. Warren Buffett, in fact, wrote an article about it in 2002. Buffett asked three questions:

- If options aren’t a form of compensation, then what are they?

- If compensation isn’t an expense, then what is it? And
- If expenses shouldn’t go into the earnings calculations, then where should they go?

You should apply this same reasoning to the Korean preferred:

- If preferred shares aren’t a form of equity, then what are they?

- If equity isn’t a claim on earnings, then what is it? And
- If a claim on earnings shouldn’t go into the earnings per share calculations, then where should they go?

NOTE

Soon after Li Lu gave his lecture, Amorepacific published their 2011 annual report. The report included an updated
earnings per share footnote that allocated a pro-rata interest in the company’s earnings to the preferred shares.

Amorepacific 2011 Annual Report

Any questions?

[Student: Can you describe how to think about the control issue. Amorepacific is an emerging-market company,
and the family controls both management and the board of directors. The outside shareholders have no say in how
the company is run. How do you get comfortable with this?]

In most situations, either a majority shareholder or the management controls the company. So your question
applies to all publicly-traded businesses. You need to ask yourself: Do I want to be a passive minority shareholder
in this company? It’s a question that must be answered before you make any investment.

[Student: Do you invest in China? What are your thoughts on A shares, H shares and Chinese ADRs?]

I don’t focus on where the company is listed. Remember the three basic concepts of value investing:

(1) Stocks represent partial ownership in a business—they aren’t just pieces of paper;
(2) Investing demands a margin of safety; and
(3) The concept of Mr. Market.

When looking at a business, I focus on three things:

(1) Do I understand it?

(2) Is it a good business? And
(3) Is it available at a good price?

Those are the things you need to think about—not where the company is listed.

Concluding Remarks
Today we covered two of my investments—Megastudy and Amorepacific. Why choose these two investments?
Because I want you to know what it’s like to take the opposite view of Mr. Market. You must always remember
Charlie Munger’s advice: “I never allow myself to have an opinion on anything that I don’t know the other side’s
argument better than they do.” Those who don’t listen to his advice will be influenced by the market’s ups and
downs. Those who do listen, however, will have made a big step towards becoming a good investor.

Thank you all.