Forget Facebook: Small Caps Beat Startups

Includes: FB, IJR, RZV, SCHA
by: Stocks & Shares

Peter Thiel is launching Blue Seed, a cruise ship which will serve as floating, international incubator for new startups. By remaining 12 miles off the coast of Northern California, the ship will remain in international waters to avoid Visa issues for its tenants. Over 181 startups expressed interest in leasing space on the floating campus, which could house as many as 1000 entrepreneurs at a $1200 per month pricetag. This concept is intriguing and might attract more capital to venture capital investments.

Unfortunately, there are many reasons to stay on dry land, away from the entire venture capital asset class. It seems like the army of well-paid entrepreneurs, investment managers, consultants, and attorneys enjoy spending venture capital while investors suffer low, often negative returns. My impression of venture capital comes from experience writing business plans, helping run a business plan competition, and listening to scores of talks by venture capitalists. I can honestly say that despite all my experience, none of my concerns have been assuaged.

Worse yet, my anecdotally-inspired fears have been confirmed by the extensive experience of thoughtful pension fund managers. The Kauffman Foundation reviewed venture capital fund performance and found that VC funds underperformed the stock market since the mid-nineties. After considerable study of their 20 years of data, Kauffman's Chief Investment Officer, Harold Bradley is highly skeptical of VC. He rejects the notion that pension funds should have any required allocation to startups. In a Bloomberg interview, he suggested that institutional investors should only invest in the top 10 VC funds and avoid the vast majority of other funds. He said, "If you can't be with those 10, the only way to win is not to play."

Many Ways to Lose in the Startup Investing Game

Investment in IPOs. Jumping in when the company goes public is a bad idea that underperforms buying shares in existing companies because the IPO markets are over-hyped and over-priced. For example, shares in Facebook are oversubscribed even though the valuation of Facebook is regarded as too high by 79% of investors. The company may even revise its filing to increase the price of Facebook shares. You are better off buying shares in existing, publicly traded companies in the secondary market than you are buying from an investment banker.

Angel investing. Angel investors give entrepreneurs money directly. This is a nondiversified, often unproven black box investment and I couldn't recommend it. You would be relying on the character of the entrepreneur for repayment and your own due diligence. You would be better off buying an index fund and slaking your appetite for new ventures by watching Shark Tank on television.

Crowdfunding is a reinvention of angel investing in projects that are posted online. If you cannot live another day without being an angel investor, consider these sites. They tend to have lower buy-ins, so you will lose less money. Spend as little as possible.

Venture capital funds. Individual investors band together by giving their money to venture capital fund managers (VCs). The VCs find new ventures to invest in, and presumably know what they are doing. (I have no evidence to support that they know what they are doing.) Many of the VCs are former entrepreneurs or have histories of selling firms at prior funds.

This experience is less useful than it sounds since much of success is luck and even the most experienced serial entrepreneurs only have a small number of successes under their belts. Taking a company from launch to IPO or acquisition takes many years and many failures. As such, even legends like Steve Jobs only racked up a few big wins. As human beings we do not live long enough to create track records of enough successfully launched and sold companies to distinguish luck from skill.

Small Cap Stocks: The Savvy Investor's Venture Capital

The Kauffman Foundation's report on the past 20 years of venture capital returns notes that small cap stocks have outperformed venture capital. That's right, boring small caps. In fact, Kauffman found that only four out of thirty venture funds in their portfolio beat a small cap index. Their venture investments delivered lower returns with more risks like liquidity risk, less diversification (firm-specific risk), and the risk of higher fees (legal, etc.) which are sometimes incurred when liquidating a private investment.

Instead of VC, it would be prudent to invest in small caps. One attractive small cap value fund is the Rydex ETF Trust S&P Small Cap 600 Pure Value (NYSEARCA:RZV) ETF which features a low average price-to-book ratio, low fees, and a low average market capitalization in its holdings. Small cap core exposure can be achieved with the iShares S&P Small Cap 600 (NYSEARCA:IJR) Index or the Schwab U.S. Small Cap (NYSEARCA:SCHA) ETF, each of which provides investors with a solid portfolio while charging low fees.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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