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Venture Capital – There is Something Strange in the Neighbourhood

Investing into Venture Capital could not be further away from the focus of this blog. We are aiming to squeeze out returns from unloved and obscure companies that are trading substantially below their liquidation value and do not require growth or other forms of significant outperformance versus their current status quo to drive our return. If we were writing a blog about venture capital investing we would be looking for the next hot ticket and making investments on the basis of blue sky visions often with no expectation of profitable operations in the near or medium term.

Neither strategy is better (in our opinion) and there are some fantastically successful venture capital investors whose track records rival those of great value investors both in terms of returns but also longevity and consistency of performance. So whilst we would be absolutely awful deploying our capital in VC investments there have been a couple of interesting things we have recently been reading around the VC space that we wanted to highlight and discuss.

1. Andreessen Horowitz Presentation on US Tech Funding

Andreessen Horowitz – US Tech Funding.pdf

Whilst Andreessen Horowitz was only founded in 2009 its cofounders Marc Andreessen and Ben Horowitz were very well known VC investors in their own right prior to joining forces and founding this firm. Today it manages $4bn of capital and is known for playing in the mature end of the market at one point owning four of the highest valued privately held social media companies at the time (Facebook, Groupon, Twitter and Zynga).

This is a great thought provoking presentation whose central argument is that all the recent activity and investor interest in technology companies is not comparable to the tech bubble that occurred in the early 2000s. Core to their argument are the following points:

  1. Whilst tech indices are growing in value this is being driven by earnings and not multiple expansion
  2. You have not seen anywhere near the public market listing frenzy that we experienced in the early 2000s
  3. There has been a step change in the size of the market that tech companies are addressing (internet usage and smart phones). To highlight this they provide an interesting metric of tech funding by person online (this does remind us of the Wall Street research analyst folly during the 2000s bubble of inventing new valuation metrics such as “number of eye ball valuation metrics.”)
  4. US ecommerce and online advertising has increased 15x since 1999 and represents a significant addressable market from an economic standpoint
  5. We have not seen the same surge in VC funding that you saw in the 2000s bubble (lower funding also as a % of US tech GDP vs the previous bubble)
  6. The large fundraising rounds get a lot of focus but the majority of the capital deployed is in smaller companies where it has gotten cheaper to start a new venture

Away from the core theme the presenters also focus on trying to explain the “unicorn” phenomenon in VC (a unicorn is a private company with valuation in excess of $1bn). They make an interesting point that the time to IPO for successful tech start-ups is now substantially longer than in the early 2000s. The presentation also makes a compelling case that today tech IPOs have been delayed or even replaced by private funding rounds and imply that the risk of a bubble is lower as these funding rounds are focused on later stage companies. The big gap in the presentation is that they do not prove that there is not a bubble in the privately funded VC companies as they make their argument for why there has been a shift from the public to private market capital as a source of VC funding.

The biggest question the presentation left us with is whether a bubble has occurred in the private capital markets focused solely on the large capital rounds as institutional, sovereign and corporate investors struggle to deploy enough capital into “attractive” opportunities in this low inflation environment. There are two pages that sum up the key part that is missing in their defence of a tech bubble: (i) “Yes there is more funding for larger deals” (p22), and; (ii) “But this is just a rebalancing from IPOs” (p23). The problem with their arguments about tech contribution being flat as a % of GDP and other metrics about the step change in size of the industry is illustrated on p60 where they show that only $212bn out of a total market value of $3,085bn is represented by unicorns, just 6.9%. It is not inconceivable that irrational exuberance has crept into this part of the market.

The one metric we would love to see that would go a long way to evaluating whether we are in fact seeing a bubble in the unicorn VC deals is a comparison of p/e multiples by funding round to the p/e of the listed companies during the early 2000s bubble similar to what is shown on p7 (our guess is this is difficult to compile due to the private nature of all of these unicorns)

This is probably unfair given the quality of presentation and the thought behind it but after reading it we could not help but be reminded of one of our favourite investing quotes:

When people are saying: “this time it is different” grab your wallet and walk carefully toward the door. History never precisely repeats, but it does rhyme.”

Jesse Livermore

2. The Increasingly Crowded Unicorn Club

The Increasingly Crowded Unicorn Club

Not much to say here (particularly as we do not know over half these companies) other that as always a picture tells a thousand words.

3. The Square IPO

Deal Book – Square, Facing a Chilly Market, Persists in Pursuing I.P.O

In the context of the thought process that the Horowitz piece began we thought this article and process was very interesting for two reasons.

First you are seeing the public markets require a 35% valuation discount to the last private market capital raise valuation in order to get the IPO away.

Second there is another hidden source of losses / potential excess valuation in private VC funding which is the existence of different economic rights for later stage investors such as shares with liquidation preferences or in the case of the square anti-dilution ratchets.

Now a disciple would say that point two is fine as these rights are typically only given to late stage investors and even if there is dilution of early stage investors on a monetisation event they will be making out like bandits regardless. However, given the furious pace of funding rounds we wonder whether there will be some late stage investors who subscribed at similar valuations but get disproportionally hurt in a downdraft as they find themselves sitting on the wrong chair from an anti-dilution perspective when the music stops.

Conclusion

To be clear we are not advocating for the existence of a bubble in late stage / unicorn VC deals, our knowledge and data is simply too skin deep to make any conclusions either way. However, it is always useful to take a critical look at other investment classes as well as your own and ask which offers the best value and risk/return.

Would be great to hear other people’s opinion on VC and any good data they have come across on valuations.

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12 Things We Have Learned From Reading The 25iq Blog

If you have not read Tren Griffin’s 25iq Blog we would highly highly recommend it. The highlight of the 25iq Blog is a series of articles entitled “A Dozen Things I’ve Learned from …” which covers a whole host of value and VC investors as well as some leading entrepreneurs past and present.

Having read the blog cover to cover we thought it would be good to highlight the twelve things we have learned (or at least have had reinforced) from great men and women in a chapeau to a great blog. Thanks Tren

[the lessons below are in no particular order of importance and should be viewed in the round]

 

1. Keep Things Simple!

“Listen, business is easy. If you’ve got a low downside and a big upside, you go do it. If you’ve got a big downside and a small upside, you run away. The only time you have any work to do is when you have a big downside and a big upside.” Sam Zell

This is an absolutely brilliant quote. Drawing on our limited experience since starting this blog the securities we have spent most of our time agonising over have been related to Sam’s third category (e.g. Unitech Corporate Parks). We are continuously left with the feeling that a good investor really needs to size their best longs aggressively given good ideas are so rare.

 

2. Don’t agonise over forecasts and recognise the limitations you are working with

“We deal in probabilities, not predictions.” Marty Whitman

“In both economic forecasting and investment management, it’s worth noting that there’s usually someone who gets it exactly right… but it’s rarely the same person twice. The most successful investors get things ‘about right’ most of the time, and that’s much better than the rest.” Howard Marks

Investing is a probabilistic exercise where the frequency of an investor’s correctness should not be the focus but rather the magnitude of correctness. We all need to recognise that there is risk, uncertainty and ignorance involved in investing and diligently focus in on an approach that minimises the risk inherent in uncertainty.

 

3. Investing is physiologically though, the temptation to lapse into bad habits is ever present

“The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.” Howard Marks

Psychological mistakes are at the same time the biggest source of danger for an investor and the biggest source of opportunity when other people succumb to those mistakes. Staying apart from the maddening crowds, having stable capital and a long term outlook will put you in a very small club that can exploit the psychological flaws of others.

25iq has an absolutely fantastic post about the 12 most common human psychological flaws. We would encourage everyone to read it and identify past examples of your biases (link

 

4. Stay within your “Circle of Competence”

People seem more comfortable investing in something about which they are entirely ignorant.” Peter Lynch
We have found it particularly hard not to fall into this trap when we are looking at seemly attractive value opportunities in either technology or financial companies which are both areas where we lack a great deal of knowledge compared to “real world” industries. It is likely that we will post an investment memo in the coming weeks about a financial company that looks incredibly cheap but the biggest risk is that we are not 100% on top of their business model and think it is difficult to be as an amateur investor.

 

5. The key determinant of a business value is current and future cash generation

“If you don‘t have the free cash flow, you don‘t have anything.” Leon Cooperman

The only unforgivable sin is to run out of cash. At HIPS when we screen for deep value opportunities positive operating free cash flow (or in a few cases a very small burn rate vs the margin of safety) is an absolute must.

Away from investing our other hobby is collecting art and friends often ask if we are doing it is an investment to which the answer is always no. Art’s only inherent value is what at least one person is willing to pay for it. We have picked up cracking pieces at auction because we were the only buyer, similarly we have paid over the odds for rare items because there was one other buyer in the room. Compare this to cash which is globally fungible and can be used to buy anything, particularly other assets that generate more cash. As a value investor should always be looking to acquire the asset that generates the most cash over a long period of time at the lowest risk which is selling for the cheapest price. As usual Warren Buffet put it best in his excellent article extolling the dangers of investing in gold particularly this quote: “if you own an ounce of gold for an eternity, you will still own an ounce at its end.”

 

6. Spend as much time learning from your mistakes as your successes

“It is fine to celebrate success, but it is more important to heed the lessons of failure.” and “There are many lessons about the dangers of success, and Henry [Ford] is one of them.” Bill Gates

Failure is an opportunity to learn. The more you learn in life the more you learn that there is even more you don’t know and that some things are unknowable.  What you may attribute to success may be luck and vice versa.  Success in one domain does not equate to success in all domains.  Success may cause you to succumb to “man with a hammer syndrome (everything looks like a nail).”

 

7. Nothing good or bad goes on forever. Don’t extrapolate something indefinitely

“Rule No. 1:  Most things will prove to be cyclical. – Rule No. 2:  Some of the greatest opportunities for gain and loss come when other people forget Rule No. 1.” Howard Marks

“Whatever happens in the stock market today has happened before and will happen again.” Jesse Livermore

When people are saying: “this time it is different” grab your wallet and walk carefully toward the door. History never precisely repeats, but it does rhyme.” That markets will fluctuate in cycles is inevitable; predicting the timing and extent of the cycles is impossible.  Value investing is about putting yourself in position to benefit when the inevitable happens.  Price, don’t predict!

 

8. “Unless you’re running scared all the time, you’re gone”

“Unless you’re running scared all the time, you’re gone.” Bill Gates

“A steel company might think it is competing with other steel companies. But we are competing with all other companies.” Henry Singleton 

In our opinion Bill’s quote applies to life away from investing. Being paranoid, self-reflective and constantly in search of improvement is the hallmark of the most successful people we have encountered. Given we are apt to buying business that are mispriced due to a structural change in their market Henry Singleton’s quote resonates a lot with us. We have found it difficult to find a moat that we can really underwrite for 100years particularly in the age of disruptive technology. Businesses tend to fail not from a frontal attack, but when they are eclipsed or enveloped.

 

9. Don’t buy anything that doesn’t have a substantial margin of safety

Most investors are primarily oriented toward return, how much they can make and pay little attention to risk, how much they can lose.” Seth Klarman

“A lot of people talk about risk in the stock market as the risk of stock prices moving up and down every day.  We don’t think that’s the risk that you should be focused on.  The risk you should be focused on is if you invest in a business, what are the chances that you’re going to lose your money, that there is going to be a permanent loss.” “[The] key here is not just shooting for the fences, but avoiding losses.” Bill Ackman

As Buffett says Rule No.1 is “not to lose money,’ and Rule No. 2 is “not to forget Rule No. 1.” The second point to bear in mind is to only care about permanent capital loss and not market to market movements. Permeant loss of capital can only occur if your underwriting of a business was incorrect and something occurs that fundamentally and permanently changes the cash flow generation profile of the assets (think yellow pages when google thundered onto the scene). We are also constantly reminded that the volatility of a stock, known as beta, has absolutely no bearing on the securities inherent risk of a security and anyone trying to tell you otherwise should be rounded ignored.

 

10. Don’t let your first purchase price anchor your subsequent buying if Mr. Market presents more paper substantially lower

“Your profit is the difference between your average purchase price and your average selling price. Bernard Baruch [a great investor in the 1920s] said nobody buys at the bottom and sells at the top except liars. Your stock will go down after you buy it, and it will go up after you sell it. Being willing to lower your average cost [by buying more when a stock drops] is a great strategy. But it’s difficult.” Ben Miller

Every purchase we made in the HIPS portfolio (albeit we have not made many) has gone down after we purchased it. Probably our biggest asset allocation sin to date has not been adding to Caltagirone Editore when it was in the 0.80s despite the fact that the business had turned EBITDA positive compared to when we initiated the position at EUR 1.00. There are reasons for this and hindsight is always 20:20 but it illustrates Ben’s point. You should not be adding a position to your portfolio that you would not be comfortable buying if it was 50% down without any fundamental change in the facts driving value.

 

11. Hold a concentrated portfolio of high conviction stocks that represent your best ideas

“Owning stocks is like having children — don’t get involved with more than you can handle. The part-time stock picker probably has time to follow 8-12 companies.” Peter Lynch

“An investor is better off knowing a lot about a few investments than knowing only a little about each of a great many holdings…. you diversify most of the diversifiable risk away from a portfolio by owning 20 or 25 positions.” Seth Klarman

“…for an individual investor you want to own at least 10 and probably 15 and as many as 20 different securities.  Many people would consider that to be a relatively highly concentrated portfolio.  In our view you want to own the best 10 or 15 businesses you can find, and if you invest in low leverage / high quality companies, that’s a comfortable degree of diversification.” Bill Ackman

There are a lot of different opinions amongst proven value investors about diversification. Investors like Walter Schloss and Joel Greenblatt have high 10s to hundreds of securities in their portfolios whilst the giants quoted above are all comfortable with less than 20. Marty Whitman once argued that once your portfolio exceeds 40 names the risk of closet indexing is high. What is clear to us is that you need to find your own style as an investor and just because we gravitate to a concentrated high conviction strategy doesn’t mean you should.

 

12. Remember the importance of having an “edge”

“To make money, you must find something that nobody else knows, or do something that others won’t do because they have rigid mind-sets.” Peter Lynch

“[At a horse racing track people make] bets and the odds change based on what’s bet. That’s what happens in the stock market.” Charlie Munger

We debated whether to include this as having an information edge is very difficult for the amateur investor. The quote from Munger puts this best as it highlights that betting on a favourite or long shot may or may not be a good bet. What matters is whether it is “mispriced” in your favour because the market is missing something. We believe that the market is efficient most of the time and therefore you need wait for the right pitch and look in areas where market inefficiency is likely to occur more often.

We decided to include it as we believe the amateur can generate edge by digging in the illiquid, obscure backwaters of the stock market where the professional money manager doesn’t tread. When reading other investment websites where both amateur and professional investors pitch their top ideas we are always surprised to see that the majority of the recommendations are large cap stocks that are very well covered by the street research analysts, money managers and newswires. It seems to us that your statistical probability of finding something that gives you confidence that you will outperform on an absolute basis seems very remote compared to less well covered parts of the market. Remember it is mathematically certain that you can’t beat the market if you *are* the market.

 

We hope this was as helpful as the content on the 25iq blog; it is certainly no match for it. The only thing we did not add as we thought it was too obvious but is definitely something you need to focus on if you do not already is to remember that “A share of a stock is not a lottery ticket. It’s part ownership of a business.” Peter Lynch. The right thing for an investor to love is the process of investing, not the bet itself.  The right process for an investor is to understand the value generated by the underlying business.

Happy hunting

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