Here's the second half of last week's post:
Now, let's get back to one of my favorite topics: disregard for convention. A wise man once told me that most investors follow a set of rules that typically make them middle-of-road, B-level investors, but in breaking their rules they can become either A-level investors (rarely), or (more frequently) C-minus investors. And indeed, I've always been a bit insouciantly petulant about rules, but as far as guidelines go, but I've got to give James Montier from GMO a tip of the cap for The Seven Immutable Rules of Investing:
1. Always insist on a margin of safety
2. This time is never different
3. Be patient and wait for the fat pitch
4. Be contrarian
5. Risk is the permanent loss of capital, never a number
6. Be leery of leverage
7. Never invest in something you don't understand
And, generally, those are pretty darn good rules. The value investor in me swoons. But the Californian in me wonders if these rules are little more than a wind-break against the perennial gales of creative destruction? In this zip code, after all, those rules are more honored in the breach than in the observance. And surely, if investors had followed those rules exclusively all along, we'd still be communicating via horse-mounted couriers as we farmed the Appalachian Watershed with oxen, oppressed by the inexorable tyranny of the seasons and the immutable fright of nightfall. Instead, we live, work, and play in ways that are scarcely recognizable to our parents and would've been unimaginable to our forebears. Much of that progress was financed by the investors who broke their rules; some made mints while most didn't.
Now, I don't mean to critique value-oriented investing, as assets need an anchor around which to contextualize their valuation. But if the last century, with its optimists triumphant, suggested anything to us, maybe it's that the value of businesses isn't really the discounted value of their dividends? Perhaps businesses are better thought of as portfolios of options, some of which are very long-dated and way out-of-the-money. And maybe the central wonder of the American economy, with California as its exemplar, is that it offers the best framework for capturing the random forward lurch of progress? After all, the US economy, more so than that of any other nation, seems geared around exercising profitable options while letting unprofitable ones expire, often (and hopefully) cheaply. This asymmetry is getting even more acute as value chains continue to fragment and the cost of hatching and nurturing an idea continues to drop. The resulting left- and right-tail opportunities may be hard to differentiate from each other, but those who are unafraid of being wrong and alone will give themselves the electric opportunity of being right and alone.
I love working on a street thick with start-ups and it's been fun to watch these companies strive and stumble and pivot and grow. I love visiting them when engineers are piled up on top of each other in a too-cramped space; its a visceral and sensory experience when a startup finds its cadence. The old east coast value investor in me wonders aloud, "who would invest in this stuff? It's bananas! These guys are violating at least four of The Seven Rules!"
But the west coast Chris hears an echo of Steinbeck's description of Cannery Row: "[Silicon Valley] in California is a poem, a stink, a grating noise, a quality of light, a tone, a habit, a nostalgia, a dream."
Having walked on all sides of the investment line (I’ve been an analyst, a long short equity fund manager, a distressed debt hedge fund guy of various stripes, and a VC) it is interesting to see an analysis like this.
I would argue that the venture world is not as different as you might think in terms of what people invest in:
1. Margin of Safety – the definition of margin of safety is generally buying things at a large discount to what you think they are worth. Because VC’s go for large scale wins – 10X and above returns, by definition, they are including a large margin of safety in their investments (yes the risk of permanent loss of capital is far higher – but so is the margin of safety if things work out)
2. This time is never different – I have yet to meet an investor who does not use his or her own past investment experience – and that of his or her firm as a touchstone when looking at new investments. when it comes to certain technological innovation – this time is different. In 1992 – you couldn’t have youtube – simply not enough bandwidth – today it is a given.
3. Be patient and wait for the fat pitch – I’m not sure what the statistics are – but the average venture firm has about 25-30 investments in a fund over a 10 year span. My guess is that they review 100X that many plans – if not more.
4.Be contrarian – actually here is where I think VC’s are probably more like any other investors. VC’s tend to run in investment packs (how many group texting applications have been started in the past year? how many Groupon knock offs?), as do public market investors, and buyers of Hollywood scripts (Dante’s Peak and Volcano in the same year – really!)you need the be mentally able to be alone and wrong to produce superior results.
5. Risk is the permanent loss of capital – absolutely. and for VC’s this is why they structure investments not as equity but as preferred. A small margin of safety in an otherwise risky asset class.
6. Leverage – Tech doesn’t use it.
7. Stick to your circle of competence – I think VC’s fall down here. Too many don’t properly apply this filter – trading positions across a portfolio with the thinking – well if I give in on that biotech deal to one partner, he’ll vote for my group texting deal. Too little knowledge gathered in too few heads.
Here’s where I think it all comes down to:
1. Capital is now a commodity. Used to be that getting a call from KP or Sequoia was like visitng the pope – now you can get capital from anybody and have an equal chance of success.
2. Technology is largely fungible. Used to be that tech was hard (it still is for me). But for people developing web apps – everything is coded upon a fairly standardized set of tools.
3. Ideas are important but not paramount. As soon as an idea is validated with funding or n open beta – it can be knocked off – remember no tech barriers.
4. It is all about execution and strategy – and this is where VC’s need to focus.
So if you go back through your list and try and apply all of that to a new VC investment – what you really are asking yourself is the following question: is my knowledge of and strategic input into a company good enough that I can essentially derisk the investment and put it on an accelerated growth path which will lead others to realize the value of the idea and thus validate my heretofore imagined margin of safety?
If the answer is yes – then go right ahead – you very well may be alone and wrong – but chances are you will soon have a lot of company and be rolling in it!
Your comments are always spot on!
That should be a post of its own . . .