Venture Capital / Start ups: Why should you give a s*** as Value Investor ?

Disclaimer: It might easily be that If I look back at this post in 10 years and that this marks the peak of the current Venture Capital boom but who knows ?

Let’s start with a quick reflection on how to distinguish Value Investing vs. Venture Capital:

What is Value Investing ?
There are many opinions on what Value Investing actually is. There is “Graham” or “Klarmann” style value investing where one tries to buy existing assets at a discount, or ” Buffett style” where one tries to buy great and “moaty” companies at a discount to future earnings. My personal interpretation is to buy good companies at decent prices (something like a GARP strategy) or misunderstood companies. What all those approaches have in common that one tries to protect the downside by getting a “discount” on some perceived value. With regard to portfolio management, full diversification is rather the exception. In its more extreme version, concentrated value investors concentrate on mostly making sure that they don’t have losers in their portfolio and transact very infrequently.

Relatively young companies are rarely considered value investments unless the underlying assets have moaty characteristics . True value investors like to read 10 years or more of financial statements because most value investors implicitly assume that a long operating history with a proven business model lowers the risk of sudden bad outcomes. Many value investors (including myself) are also very “Numbers driven”, with some strategies exclusively focusing on screening tools (“Quant Value”). “Buffett style” value requires more thoughts on future business prospects and management, but still, the numbers and the history play a big role.

Venture Capital/Investing
Venture Capital is clearly on the exact opposite side on the investment spectrum compared to a typical value investment. There is no history, no earnings track record and usually no assets to speak of. The business model has yet to be proven and risks are abundant. Business plans are just pieces of paper where everyone should know that this is wishful thinking at best. Failure is quite common and returns a made via a few spectacular investment whereas the majority of investments fail one way or the other.

Therefor in Venture Capital common knowledge is that the most important aspects to analyze are the people (founders) and the question if the problem that they are trying to solve is actually a relevant problem and if this could turn into a business model at some distant point in the future.

Really concentrated investing is considered suicide in Venture Investing. Most VCs try to spread their investments broadly in order to gain exposure to the one or two potential “next Ubera” or “Next AirBnBs”.

Does it make sense to spend time with Venture Investing / and or young companies from a Value Investor perspective ?

Up until a few years ago I completely ignored young companies or even Venture Investments. I considered it “too risky” and completely uninteresting. Almost any other day you read about the most prominent failures such as “Juicero” or “Theranos” which for many Value Investors are proof that there is a huge bubble that could explode any second. Implicitly these scandals reinforce the believe that it is not worth the time to look at new companies at all.

On the other hand, sector after sector gets into structural problems mostly caused by changes in technology and new business models. Retail and especially clothing chains are clearly the most prominent examples of how once very profitable businesses can go out of fashion pretty quickly. Happily I never liked retail stocks but I am not sure if I would have seen this coming quickly enough. Or think about media companies, newspapers or travel agencies.

I cannot prove it but I think those current structural changes which seem to impact each and every industry are one of the reasons why the “buy cheap stocks” strategy didn’t work very well over the past years.

Another important factor in my opinion is the following: In the past, for many young companies, missing access to capital was the biggest issue. In Phil Knight’s (Nike) memoir “Shoe Dog” one can read how Nike was in constant danger to fail with each shipment as funding was mostly not available for young companies back then. Nike was lucky, but many others failed. Access to capital in the past was the privilege of old and large established companies, giving them a huge competitive advantage against newcomers. These days however, this advantage seems to have gone away almost completely with the huge pools of private money available for new and young companies.

So even as a value investor, one really should have some idea which new companies are attacking the existing players and if current issues at a company or sector are really only cyclical or rather structural.

My personal experience with Venture Capital

In my professional life for various reasons I had some first and second-hand experiences with (Corporate) Venture Investing for quite some time now. And no, it was no coincidence that I did 2 Venture Capital book reviews almost exactly 1 year ago.

My involvement in this area went from being somehow involved in a couple of small stake venture investments into (more or less) promising tech start-ups, to being on the board of a startup/spin-off for a few years  and now even directly helping (and negotiating) with founders to start and launch their start-up companies.

Being a passionate Value Investor privately it sounds odd but I enjoyed working in this Venture Capital environment a lot and I think I already learned some very important lessons. As elsewhere in life, the best lessons come from failures:

In one occasion for instance, the start-up addressed a potential gigantic market. The issue however was that in order to get the first “MVP” (Minimum viable product), a lot of money had to be spent on tech. Then, they found out that although the product addressed a problem, the potential clients were not willing to pay for it. The whole project was further complicated by the fact that in the beginning. paid consultants were building the product and the company and a real “entrepreneur” with “skin in the game” came in only a later stage.

The second failure was a company with a great product but involved a founder who had a huge personal issue with his main customer. Additionally, the B2B sales cycle for new customers took a lot longer than expected. Combined with the ongoing disputes  with the main existing customer led to the firing of the founder and somehow the company lost its edge pretty quickly.

In both cases, personal issues played a big role and a good proof that what I mentioned above about venture investing is clearly relevant: people are really important.

One other interesting observation I made is the following: As people expect a lot of failures in a Venture investment portfolio, clever sounding but actually really stupid ideas have a relatively high chance to get an investment if they are sold well.

What I think that I can apply to Value Investing

Should you now run out and look at or even invest into any new “hot” IPO ? Of course not.  However what I found interesting is that Venture Investing is much more “business like investing” than normal stock investing. Business like investing focuses much more on people and business models than what typical stock investors do.

People
It’s clear that in very large companies individuals play a smaller role despite all the Jeff Bezos and Steve Jobs stories. However in smaller companies, management clearly plays a bigger role. In the past, I tried to incorporate already some analysis of management into my investment cases, especially if interests of management and shareholders are aligned. In the future I will clearly need to look deeper into this and try to understand what makes those people “tick”. Majestic Wine for example is an investment where I weighted management quite high in my final judgement. I would not have bought this company just based on the numbers. I also made a private undisclosed investment into a tiny UK-based (listed) company where my case almost exclusively relies on the quality of the people involved in turning the company into a completely new direction.

Understanding business models
With established companies, there is often the tendency not to focus on how they actually earn their money but mostly on guessing how much they will earn in the future. Especially when there are fundamental changes like now, this can be quite dangerous. Yes, a lot of asset manager stocks look cheap but not understanding the impact of ETFs and Index funds will lead to some nasty surprises. I think that a good understanding of business models is key in order to avoid typical value traps. It also helps to hold good companies for longer. From my early investments for instance ,TFF Group was the company where I understood the business model best. That makes it easier for me to hold the stock despite the massive gains.

Time horizon & letting winners run
When you do a venture Investment, the time horizon is automatically a couple of years. It is mostly impossible to sell unless a strategic buyer shows up and wants in or, if you are really lucky an IPO will materialize. The good side of this is that if you have a winner, you will be forced to hold the stock for a long time and realize the big pay out. I am thinking hard about really implementing a minimum holding period for my “core” value investments like 3 years or so before I even think about selling them.

Summary:

This post is clearly not meant as a recommendation to start investing in one of the currently “hot” Tech companies or go out and act as “Business Angel”. However I do think that even as a hard-core Value Investor it makes a lot of sense to look more deeply into what is going on in Venture Investing and new technologies.

There are a lot of things to learn and especially how to think more about investing into business than investing in a piece of paper with a fluctuating stock prices.

As an added value there is also a good chance to spot structural changes which might turn a “great and cheap” company or sector into the typical value trap.

And don’t worry: I will still be doing “special situation” investments which are clearly pieces of papers that will go up and down in value 😉

 

 

 

 

 

 

 

12 comments

  • Not sure if you follow comments on old posts, but I came across this:
    https://ftalphaville-cdn.ft.com/wp-content/uploads/2017/11/27110627/FT-Request-EIF-Own-Resources-VC-portfolio.pdf

    It shows returns from the EIF’s European Venture portfolio – the EIF is a large institutional investor in most European VC funds, so this is a pretty good proxy for market returns. Doesn’t look that exciting does it?

  • Enjoyed reading your weekend links. Thanks!

  • I’ve recently read How Google works written by 2 insiders; one of them was Eric Schmidt. It summarized pretty well the functionning of a disruptive start-up, how they measure success, how they create and above all, maintain a technological edge in an ever changing world.

  • You forgot to mention odds. Doesn’t matter if it’s a vc, cigar butt, compounder, distressed debt, people-driven or numbers-driven investment, Howard marks and buffett would advise the same thing: what odds are being offered if you win and what’s the likelihood winning. Don’t invest if you can’t answer those 2 questions and if the spread between odds and probability isn’t massive enough (margin of safety). How you go about answering said questions is obviously up to the individual.

  • Then let me restate . what represents attractive value.

  • Excellent article!

    One related problem with venture investment to me seems the crowding effect: As soon as the first prominent investors start to invest in a startup many others follow. That hurts you also if you are invested before since you get diluted if you are not throwing more money after them. And it seems people are loosing all their judgment skills in such cases. Examples:

    Theranos: The business model and value proposition are great! And someone will successfully launch such a service in the next years. Was Theranos worth so much before falling in disgrace? Of course not. The technical risks have been still very high and they did not show any proof that they can do what they claim. No doubt, they could have succeeded if they would have had a few more years and better scientific control over their processes. But investors got carried away by the promise of them too quickly and the top VCs thought they have to be invested if their competitors are.

    Uber for me is in the same situation of investor crowding. Yes, they have brought innovation to the transportation market. But it has been know since years that they don’t treat their drivers well. Also, unlike e.g. Facebook or Amazon with their Prime services, the lock-in effect of a taxi app is very low and drivers are signed up for various companies also. Not to mention the particular personality of the ex-CEO. Uber will most likely stay around and become profitable one day. But I am not sure all investors from the last years will make money with it.

    In both examples there are signs that the big investments lead to unhealthy pressure for the companies to expand to quickly and take shortcuts.

    I am not the expert here but would say that this adds an additional level of risk to venture investing: Even if you find a future star you might get influenced by a hype emerging around the company which pushes them in the wrong direction and makes your investment worthless.

  • I guess this is the wrong blog for such a question. There are many others with “hot recommendations”.

  • Not to change the subject but what long would recommend here in terms of upside. Anything interesting in Europe. Thanks.

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