Setting the scene
This topic matters simply because of the observed, data-driven notion that the key characteristic of venture capital is that returns follow a power-law distribution. In any given VC portfolio of 20–40 start-ups, it will be 2 or 3 outperformers that provide the economic performance that return the investment made into the fund and achieve the return expected of venture capital investors, known as limited partners. By reverse engineering what this requires, Marc Andreesen, famed venture capitalist explains that the basic math component is that any given rated VC firm will see about 3,000 inbound referred opportunities per year. This is narrowed down to a couple hundred that are taken particularly seriously and each firm can invest in about 20 each year. There are about 200 of these startups a year that are fundable by top VCs. … about 15 of those will generate 95% of all the economic returns for the entire Venture Capital sector. Even the top VCs write off half their deals. This generally means that, assuming a holding percentage of 10% by a VC firm at the time of exit, an investable company for a VC must have an outcome of above $1 billion in order to return a fund of around 100M$.
I like to explain to people new to venture capital that this is the industry of the less than 1%, because that is the proportion of opportunities considered that have the characteristics to outperform and achieve the sought after returns. This begs the question, how do VCs know what these outperformers look like? The short answer is that factually, nobody does know, even the best investors often resort to notions of “following gut instinct” and “luck” breaking their way when explaining their successful funds given the benefit of hindsight.
Yet, there are characteristics, patterns and mannerisms that allow VCs to operate and build the belief that such outperformance can be identified very early in the company lifecycle and unlocked as technology, cultural and regulatory inflection points emerge when combined with observing market and investor sentiment. This essay will explore the environment of uncertainty in which VCs must operate, the profiles of the people and the teams they assemble in order to improve their chances of success and critically the bravery and capabilities needed by investors to be RIGHT AND ALONE in their pursuit of outperformance.
Why this is relevant? Power Law dynamics in Venture Capital
- What are Asymmetric bets
Definitions: misconception of contrarianism
- Finding the mispriced value
What outperformance looks like when it works
A Framework for uncertainty
- Discipline in beliefs
- Truth seeking, not consensus
How to apply contrarian thinking into portfolio construction and firm culture
- Daring to have ideas
- Belief in a thesis
Misconception of Contrarianism
Successful contrarian investing isn’t about going against the grain per se, it’s about exploiting expectations gaps. The mass of investors aren’t wrong all the time, or wrong so dependably that it’s always right to do the opposite of what they do. There is a subtle yet incontrovertible distinction between being confrontational and being counterintuitive, between dismissing orthodoxy for the sake of it and meaningfully challenging it. It is a willingness to examine the consensus, recognise it as imperfect and demonstrate that a better answer lies elsewhere.
Kahneman summarises the problem in his seminal book “Thinking Fast and Slow”. He says: “if there are several ways of achieving the same goal, people will eventually gravitate to the least demanding course of action”. Laziness is built deep into our nature and causes the crowd to follow each other. Quite often “I decided in favor of x” is no more a representation of “i liked x”. We buy the cars we “like,” choose the jobs and houses we find “attractive,” and then justify these choices by various reasons.
From Steven Crist, chairman of the Daily Racing Forum: the issue is not which horse in the race is the most likely winner, but which horse or horses are offering odds that exceed their actual chances of victory . . . . there is no such thing as “liking” a horse to win a race, only an attractive discrepancy between chances and price
We know that the wisdom of the crowd is useful in deciding the value of an asset but we also know that crowds sometimes overreact. In investing, it is this overreaction aspect that matters. Daniel Kahneman won a Nobel Prize for showing that if you’re trying to mobilize people under conditions of uncertainty, notions of loss are psychologically more powerful than notions of gain. A second thing that happens when people are uncertain is that they don’t look inside themselves for answers — they look outside for sources of information that can reduce their uncertainty and provide comforting decisions by mimicking what others do. Quite frequently the crowd is mistaken because they are not acting on the basis of any superior information, they are unwilling or uncapable of doing the work it takes to arrive at the superior information.
The venture capital return profile dictates that you can’t take the same actions as everyone else and expect to outperform. In order to outperform, your thinking has to be different and better. You have to react differently and behave differently. How does my expectation differ from the consensus? Is the consensus psychology that’s incorporated in the price too bullish or bearish? “Because if the crowd takes something to an extreme, either on the bullish side or the bearish side, that should show up in your disconnect between fundamentals and expectations. And that is what allows you to make a good investment… Again, the goal is not to be a contrarian just to be a contrarian, but rather to feel comfortable betting against the crowd when the gap between fundamentals and expectations warrants it. This independence is difficult because the widest gap often coincides with the strongest urge to be part of the group.
The mass of investors take the positions they take for reasons they find convincing. Investors witness the same developments they do and are impacted by the same news. Yet, great investors realize that if they want to be above average, their reaction to those inputs — and thus their behavior — should in many instances be different from that of others. Regardless of the reasons, if millions of investors are doing A, it may be quite uncomfortable to do B. And if we do bring ourselves to do B, our action is unlikely to prove correct right away. As John Maynard Keynes said, “Markets can remain irrational longer than you can remain solvent.”
This is especially important in an investment context because a contrarian’s opinions must tally with market sentiment at some juncture if a strategy is to succeed. It is about having good ideas that turn out to be correct. It is about being right and, crucially, being shown to be right [eventually]. There’s a huge difference between high risk and high uncertainty. The key to great venture returns is not the courage to walk away but deep conviction and passion for the big winners.
In his infamous Berkshire letters, Warren Buffet shares that sometimes waves of social proof and other dysfunctional heuristics create a significant gap between price and value. This does not happen often in areas within a person’s circle of competence, but it does happen. For some investors, spotting a gap like this happens only once or twice a year and that is just fine with them. In those instances these investors bet big and the rest of the time they do nothing. The most effective way to get free of social proof when the time is right is to have done the homework in advance and stay within your circle of competence.
Being right may be a necessary condition for investment success, but it won’t be sufficient if your goal is to achieve outperformance. You have to be more right than others… which by definition means your thinking has to be different. Investors have to answer what should be a very basic question: Will you (a) strive to be above average, which costs money, is far from sure to work, and can result in your being below average, or (b) accept average performance — which helps you reduce costs but also means you’ll have to look on with envy as winners report mouth-watering successes.
Most great investments begin in discomfort. The things most people feel good about investments when the underlying premise is widely accepted, the recent performance has been positive, and the outlook is rosy — are unlikely to be available at bargain prices. Rather, true value is usually found among things that are controversial, that people are pessimistic about, and that have been performing badly of late. In early stage investing, true profit lies where uncertainty exists, where the outcome cannot be measured because it is simply unknowable.
But then, perhaps most importantly, it is moving from daring to be different to its natural corollary: daring to be wrong. Most investment books are about how to be right, not the possibility of being wrong. And yet, the would-be active investor must understand that every attempt at success by necessity carries with it the chance for failure. If you buy T-bills, you can’t have a negative return. If you invest in an index fund, you can’t underperform the index. People who use can’t-lose strategies by necessity surrender the possibility of winning.
The cautious seldom err or write great poetry — Confucius
The measure of outperformance lies in “how much money you make when you’re right and how much you lose when you’re wrong”. American hedge fund manager Stanley Druckenmiller, once claimed the art of investment management is not about being right or wrong per se. It is, he said, about “how much money you make when you’re right and how much you lose when you’re wrong” Given that the average person rather likes gains but absolutely hates to experience losses, a key aim of the process is to pinpoint investments that are likely to maximise “upside” potential while limiting exposure to “downside” surprises. The extent of this positive asymmetry — upside versus downside — is fundamental to the management of risk and, in turn, the generating of returns. It is the magnitude of success and not frequency of success that matters for an investor. All a venture capitalist can lose is 100% of what they invest in a startup and yet what they can potentially gain is potentially many multiples of that investment, this is what drives the power law returns of the venture capital asset class.
What outperformance looks like when it works
Founders are the dreamers that are thinking about the future in order to invent it. As an investor, you’re looking for an exceptional solution for acute pain. To be “exceptional,” a solution should be either the only solution out there, or it should be 10x better than anything out there. You want the MVP to solve a problem for a small group of users, but eventually, your product will expand and the lanes will get wider. Once you have identified a flock of opportunities from this novel solution, you will analyse that each one is different, and you try to find interestingly unique opportunities from the flock and not by taking a position in the entire flock. People like Edison did not build companies around single products and then forsake all they learned for some other technological field, they built many companies and many products based around a fundamental secular technological shift. As an investor, you should do the same, as inevitably the majority will fail, but the successes will be extra-ordinary. Your support of a company in the flock increases the value of the flock, including any other investments made in the flock. Furthermore, exceptional performance attracts new resources as well as rewards that facilitate continued high performance for the new market.
The knowledge you need to effectively invest in outperforming companies is all over-lapping: if you invest in one company in the sector you will be much more knowledgeable about other companies in the sector (even when they don’t compete); you will be much more able to help your investments with advice about their industry, their business, their competition, future fundraising, and potential exit opportunities; You will have a higher profile in that industry; and you will be much more likely to see promising entrepreneurs in that sector because you will be known to be interested in it. In addition, your support of any company in the sector will help the sector as a whole. The biggest challenge for any new sector is not competition from within the sector, it’s getting the sector itself taken seriously enough to compete with whatever it’s replacing.
When looking into opportunities, there are two kinds of pitches; those that are clearly bad ideas, and those where it’s not clear at all if it’s a good idea or a bad idea. Investing in the former will lose you money. Investing in the latter might lose you money or might make you money. Skill is distinguishing between the two. Then luck comes into play. Most new ideas are not in response to new markets, they are the result of new technologies when new customers need something else. When incumbents are so motivated by the needs of their existing customers to increase capacity that they ignored nascent markets.
The very best companies will be those that have nailed a very specifIc pain point for a very specific type of person. They’ll have formed a novel acquisition method for bringing those customers as cheaply as possible, and they’ll have the product velocity and quality to keep those customers around for as long as possible. These companies develop “capabilities”, the intangible assets that you have developed as a business that enable you to operate more effectively and earn returns above others in the market — often referred to as “The Flywheel Effect”. Ultimately these are the engines of your competitive advantage, determining the persistence and scope of your moat.
“Most of the big breakthrough technologies/companies seem crazy at first: PCs, the internet, Bitcoin, Airbnb, Uber… It has to be a radical product. It has to be something where, when people look at it, at first they say, ‘I don’t get it, I don’t understand it. I think it’s too weird, I think it’s too unusual.’” ‘Non-consensus’ in practical terms translates to crazy. You are investing in things that look like they are just nuts.” “The entire art of venture capital is the big breakthrough for ideas. The nature of the big idea is that they are not that predictable.”
An operating system for uncertainty
If outperformance is the signature dish, how can venture capital firms develop a kitchen of chefs expert in this art?
Marc Andreesen says, “You must learn things others don’t, see things differently or do a better job of analyzing them — ideally all three.” Warren Buffett describes a portfolio of bets in his 1993 Chairman’s letter: “You may consciously purchase a risky investment — one that indeed has a significant possibility of causing loss or injury — if you believe that your gain, weighted for probabilities, considerably exceeds your loss, and if you can, commit to a number of similar, but unrelated opportunities (companies with optionality in the form of strong teams and research & development capability that can pivot into other markets)”.
It’s about finding the early inflection points, and being ready with a prepared mind to invest in the things that can most effectively ride those inflections. But how do you systematically find the things that most people don’t believe in, understand them better than anyone so that you can believe in them, and then invest in them? Doing this systemically requires a magical place. Understanding things better than anyone else so that you’re not caught up in the hype, and hyperbole, but can instead be focused on the honest take. The nature of the venture capital business is that financial returns come from the world of non-conformity. It is only in this quadrant that optionality will be substantially mis-priced and the type of bargains found that make a venture capital portfolio work financially.
Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom. VCs really shouldn’t care about the short term — after all, we’re investors, not traders. The possibility or even the fact that a negative event lies ahead isn’t in itself a reason to reduce risk. But there’s usually no way to know. Investors can profitably diverge from the pack by blocking out short-term concerns and maintaining a laser focus on long-term capital deployment. Appropriate investment procedures contribute significantly to investment success by allowing investors to pursue profitable long-term contrarian investment positions. By reducing pressures to produce in the short run, liberated managers gain the freedom to create portfolios positioned to take advantage of opportunities created by short-term players. By encouraging managers to make potentially embarrassing out-of-favor investments, fiduciaries increase the likelihood of investment success.
Legendary VC Fred Wilson notes that the time to buy is when there is blood in the streets, even if the blood is your own. The only uncorrelated asset out there is a team of smart people creating a company out of a good product that improves people’s way of doing things. Making the call about whether that opportunity resides in a great market sector is what separates good from great. The key difference is whether the VC is hesitant about the sector because the facts are against it or because the facts are unknown. With enough research and knowledge you will know all the VCs who become interested in the sector and separate these from the ones who are willing to make the bets that require some belief. When risk is measurable, rational expected value decisions can be made. Uncertainty is impossible to price. Overcoming uncertainty requires believing in an idea, an irrational act and, as such, one that is impossible to defend if it proves to be wrong. Unless the VC has really outstanding returns they need to defend their decision-making every time they raise a fund.
We noted earlier the importance in an investment context of contrarian thinking eventually squaring with market sentiment. This convergence — a deeply satisfying form of mean reversion — is essential to success. Forever ploughing a lone furrow can be an alienating and even detrimental experience. “If you want to have good ideas you must have many ideas. Most of them will be wrong, and what you have to learn is which ones to throw away.”. It is not totally accurate to say the majority will be “wrong” as such; yet it is right to say some will be more attractive than others at any given time. The process of deciding which should enter a portfolio is about only allowing the best ideas to endure. Meritocracy must rule. You must discard the good to arrive at the great.
Accordingly, only those opportunities that are able to satisfy the most persistent probing should be granted entry to a select portfolio. This being the case, conviction is in order. So, too, every so often, is a readiness to absorb pain, since the wait for vindication can sometimes give the impression that the herd’s putative wisdom is being reinforced. It is the discipline and rigour underpinning that sensitivity that enables an investor to hold those positions with warranted confidence rather than in blind faith. Overall, the attitude should not be one of speculation: it should be one of ownership.
Remember that true contrarianism is about redefining the consensus rather than unrelentingly opposing it. We want to be proved right, which means our decisions must stem from something disciplined and rigorous.
A focus on a small number of positions is required to define that these are the companies that comprehensive research and expert insight have distinguished as the cream of the crop — and these are the holdings in which we have the utmost long-term conviction.
John Maynard Keynes, famed economist said: “It’s not bringing in the new ideas that’s so hard. It’s getting rid of the old ones.” VC firms try to invest in unicorns. The easy way to do this is to have the expertise, the network, and the reputation to be the firm the founder chooses after it’s already obvious that they have a shot at the gold ring. In these cases the founders have their pick of VCs and they often pick the VCs who have backed unicorns before.
Being a constant student of the world around you is one of the most effective ways to identify opportunities for change. The most contrarian thing of all is not to oppose the crowd but to think for yourself. You need to say things no one else has realized yet. Independent-mindedness requires: (1) curiosity, (2) resistance to being told what to think, and (3) fastidiousness about truth. If you can observe in yourself tribalism, group-think, or blanket rejection of counter-points to your beliefs then you’re probably bought in to the current thing. Charlie Munger from Berkshire shared that if you can get really good at destroying your own wrong ideas, that is a great gift. He additionally said that he feels that “I’m not entitled to have an opinion unless I can state the arguments against my position better than the people who are in opposition “
“Strong opinions, weakly held.” To effectively adopt this antidote a person should do enough research so their opinions are strongly believed but be open to new disconfirming evidence. The process must be a quest for the best. To quote Plato’s Theaetetus: “Wisdom begins in wonder”.
“If your mind is empty, it is always ready for anything, it is open to everything. In the beginner’s mind there are many possibilities, but in the expert’s mind there are few.” — Shunru Suzuki:
Brilliant thinking is rare, but courage is in even shorter supply than genius. People should ask themselves more open “what do I believe? The question that needs to be answered is not what is the upcoming trend or how to buy into the current hype but most critically for a long term framework is to establish an educated thesis and develop a system of conviction surrounding such a thesis. The best founders in an emergent space will flock towards your thesis if it resonates with their vision of the future that they want to manifest through the companies they build.
Rollo May, the existential psychologist whose most renowned works include “The Courage to Create” summed up the intellectual desolation of this mentality when he warned: “If you do not express your own original ideas… you will have betrayed yourself.” The opposite of courage in our society is not cowardice. It is conformity. To reach outperformance you must break the meta.
As an individual you can dramatically increase your odds of understanding and taking advantage of all the exciting things getting built in our increasingly complex world by establishing a decentralized brain. Investing is an opportunity to evaluate what you believe. To gain conviction. And then to act on that conviction.
– A willingness to dispute conventional wisdom
– A capacity to demonstrate creativity
– A determination to reform the consensus
– A high-conviction focus on long-term objectives
Contrarianism is about redefining the consensus rather than unrelentingly opposing it. We want to be proved RIGHT, which means our decisions must stem from something disciplined and rigorous rather than from an unfocused desire to contradict for the sheer devilment of it. Socrates saw that the prevailing view and the right view are not invariably one and the same and that consensus should therefore not escape question. The qualities of contrarianism are a willingness to challenge and, ideally, disprove received wisdom. This is achieved thanks to a capacity to “see further” and exhibit creativity and ingenuity as well as a desire to identify inaccuracies and imprecisions in prevailing paradigms.
It also requires a firmness of conviction and the courage to develop a thesis that you ALONE believe in and act by. You must back it by conviction in those companies that manifest your vision of the future. Finally, your conviction requires a firm and sizeable investment that will outperform radically when benchmarked against the consensus or de-risked position of acting after uncertainty has been measurably overcome.
be rigorous in your search for truth in order to be RIGHT
be courageous in developing your thesis in order to be ALONE
Author profile: Adrian Galea is a professional in venture capital and portfolio management for early stage startup investors. He also manages a facebook group called Malta Startup Space that inspires startup culture in Malta. For more information: www.clutchplayadvisors.com