Want To Generate More Alpha? Try These VC Strategies

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Includes: AAPL, AMZN, APPF, AYX, BABA, BIDU, EB, ESTC, FB, GOOG, GOOGL, HUBS, HUYA, LYFT, MDB, MOMO, MTCH, NFLX, NKE, OKTA, PAYC, PINS, SHOP, SQ, TCEHY, TDOC, TTD, ZUO
by: App Economy Insights
Summary

As an investor, you want to be able to fight a wide range of counter-intuitive anxieties that can damage your long-term performance.

You can avoid many of the most common investing mistakes with a simple method: Approach your portfolio like a VC.

Since I started this strategy in 2014, I achieved 27% annualized IRR.

I break down here 10 key tenets of VC thinking applied to public markets.

Investors want to "buy low, sell high" or "be fearful when others are greedy and greedy when others are fearful" as Warren Buffett likes to put it.

The real problem is that people fail to properly execute on these principles because these principles are too broad and too vague. Just when they think they are doing it right, most investors are still doing it wrong.

We are hardwired to add to our losers to be breakeven faster and sell our winners to secure our gains. I wrote before about some of the counter-intuitive anxieties that can wipe the vast majority of your portfolio gains and how to monitor them.

Today, I want to illustrate the method to my madness via a simple analogy: Silicon Valley Venture Capital funds.

80% of my returns come from less than 20% of my investments. This kind of distribution, also know as power-law or Pareto, is usually seen in successful VC funds. And I believe there's a good explanation for that. My investing methodology is intrinsically similar to the approach of investors who seek private equity stakes.

As of this writing, my own portfolio includes 52 public equities:

  • 73% are winners (positive returns).
  • 19% are multibaggers (100%+ returns).

I'm grateful to have achieved 27% annualized IRR since 2014 as a result.

I believe approaching a public equity portfolio like a VC is a sustainable and repeatable way to generate alpha.

Here are what I consider the 10 tenets of this investing approach.

1) Understand the power-law distribution

Source

In his book Zero to One, Peter Thiel explains:

The biggest secret in venture capital is that the best investment in a successful fund equals or outperforms the entire rest of the fund combined.

Most people are familiar with the bell curve, also known as the normal distribution. The data has less of a tendency to produce unusually extreme values (also called outliers) as compared to other distributions.

A good example of a bell curve is the roll of two dice. The distribution is centered around the number seven and the probability decreases fast as you move away from the center (standard deviation).

On the other hand, as explained by The Quantified VC on Medium:

The power-law distribution involves small outcomes are very likely while larger ones are less likely. In other words, a small number of inputs account for a large percentage of outputs. Power laws also exhibit “fat tails,” compared to the area under a normal distribution curve which falls off much faster as you move farther along the x-axis.

You may have heard of it under many different names, such as the 80-20 rule or Pareto Principle. What really matters here is that it should set your expectations for your own portfolio performance.

This tenet is immensely important, because once you recognize that the top 20% of your investments are likely to represent 80% of your returns, you will start looking at your losers and average performers in a different light, and you will cherish your winners and be more likely to hold on to them.

2) Only invest in companies that have the potential to beat all of your other investments combined

Peter Thiel concurs that we live under a power-law. And it has ramifications when applied to the expected returns of a VC investment portfolio:

This implies two very strange rules for VCs. First, only invest in companies that have the potential to return the value of the entire fund. … This leads to rule number two: Because rule number one is so restrictive, there can’t be any other rules.

How can we apply this to a public equity portfolio strategy?

By setting the expectation that your next pick needs to have the potential to beat the performance of all your other investments combined, you are setting the bar at extremely high and you are challenging your own goal.

Indeed, with such a mindset, would you invest in a stock simply because it is 25% undervalued based on your DCF calculation? At best, this rationale would put such an investment in the fat tail of the power-law distribution.

There never is a guarantee that an investment will deliver outstanding returns. But if your goal is only to achieve a small gain due to a temporary inefficiency to begin with, you are already breaking rule number one.

The mindset required to set extremely high goals and seek an outstanding performance from all of your investments is likely to make you to flip the script and be driven by the right motivation.

This implies a strategy that tilts heavily toward growth rather than value. One of the flaws of an investment strategy tilting toward value is that investors can be really intrigued by companies simply because they appear "cheap."

VC funds don't invest in companies just because they look undervalued. They invest in companies because they have tremendous potential, optionality, the capacity to disrupt an industry, and grow and compound over the years.

VC funds benefit from another significant advantage. Their investments are for the most part illiquid, and remain so for years. While it may sound like a constraint at first glance, it's actually a huge advantage to avoid common mistakes such as pulling the money out too soon or trading too much in and out of a position and creating unnecessary tax inefficiencies.

This led me to a very strong tilt in my portfolio strategy: Growth focused, with a long time horizon (five years at a minimum, ideally decades).

3) Invest in people and businesses, not stock tickers

If you put yourself in the shoes of a VC, you are more likely to look at stock tickers for what they really are: Partial ownership of a business.

What if, instead of being excited for a stock simply because it just went down or up, you were starting to focus on what a VC would be looking for in private markets:

  • Strong culture with a long-term focused management team (like Jason Randall and his management team at AppFolio (APPF))
  • Inspiring Founder-CEO (like Jeff Green at The Trade Desk (TTD))
  • Ability to create products and services that feed customer demand (like Shopify (SHOP) or MongoDB (MDB))
  • Exceptional competitive advantage (like Amazon (AMZN))
  • Optionality and geographic expansion (like Match Group (MTCH))

This all might sound obvious to many investors, but don't forget that a wide range of people on Wall Street trade solely based on price fluctuations, momentum, arbitrary short-term valuation targets, penny stocks and more.

Many actively managed public equity funds work solely on quantitative criteria, an area where individual investors have limited chance to have an edge and generate alpha. The good news is that none of this matters if you are approaching an investment with a VC mindset - looking first for qualitative elements, and only then looking at the price.

If you want to put yourself in the shoes of a VC, you'd want to think about how they interview start-ups. Here's an example of a checklist adapted for the CEO of a public company:

  1. Engineering: Was the company able to create breakthrough technology?
  2. Timing: Is now the right time for this business to thrive?
  3. Monopoly: Is the company a top dog in its category?
  4. People: Do they have the right teams? The right management?
  5. Distribution: Is the company efficiently delivering its product/service?
  6. Durability: Is the market position still defensible 10 or 20 years from now?
  7. Secret: Have they identified a unique opportunity that others don't see?

Any great business plan should have addressed all the points above long before a company becomes public. But even years later, without good answers to the questions above, chances are there will be roadblocks and hurdles preventing the business from succeeding over the long term.

Being able to answer most or all the questions above with a yes is what will truly matter in finding the investments that generate huge alpha.

4) Don't let a deal slip away: Start your position!

Over your life as an investor, as long as you maintain a balanced and diversified approach, taking into account market, sector and company risk, the biggest risk you are exposed to is the one of missing a significant opportunity.

Scared money doesn't make money, and once a VC fund manager has found a company that fits their criteria, there's no waiting around looking at a ticker and waiting for it to hit an arbitrary price target.

Here are typical ways public investors suffer before starting a position:

  • “The stock has run too much”
  • “The company is overvalued at this price”
  • “I'll buy if it drops back down to $40 or lower”

Here’s the thing. If you have a long-term view, past performance and arbitrary price targets are two terrible reasons to buy a stock. But they are even worse reasons not to buy a stock.

That’s why if you have identified a company that you want to invest in, the best action is likely to start a position now.

Many investors have achieved a fantastic performance over the last decade thanks to FAANG stocks: Facebook (FB) Apple (AAPL) Amazon, Netflix (NFLX) and Alphabet (GOOG) (GOOGL). But how many investors have watched these companies (or the broad market) from the sideline? They like the businesses, the products, they believe these companies have great leadership and strong potential for the years to come, yet they refuse to start a position in them because they irrationally think these stocks will crater as soon as they join the bandwagon.

Risk aversion is too often making people miss on some of the biggest opportunities of our time. People claim they want to buy low and therefore they avoid buying altogether, even though there is no way to know for sure whether the current market capitalization of a company will turn out to be lower or higher in a few years.

Nobody's going to press that buy button for you. In this example, approaching investing like a VC involves that you don't let a deal slip through your fingers if you think it's a good one.

5) Build up your position slowly over time

How would a VC approach an investment in a start-up? There are usually many steps involved before a company becomes public:

  • Seed (usually starting phase)
  • Series A (usually optimization phase)
  • Series B (usually building phase)
  • Series C (usually scaling phase)
  • and so on...

Most, if not all, of these steps can involve the same investors, adding to an existing investment.

If you managed to identify an investment that fits your criteria, it would likely be a mistake to let greed take over and go “all-in."

A way to replicate the way a VC is likely to build up its position in a start-up is to stage your buys.

Dollar-cost averaging is a favorite practice of Benjamin Graham, Warren Buffett's mentor. It means investing a set dollar amount in the same investment at fixed intervals over time. This leads you to buy more shares when prices are low and fewer while prices are high.

Similarly, being patient and buying the dips when the opportunity occurs can lead you to buy more shares at lower prices.

That’s why – to replace the “buy low, sell high” adage – the real actionable mantra for long-term investors should be start your position now and stage your buys."

If you stage your buys, using dollar-cost averaging or buying on dips, you are more likely to get a lower cost over time or have a lower exposure to what ends up being a loser. You will have successfully built a position in your portfolio you are satisfied with. And you are less likely to perceive a drawdown in the stock price negatively, therefore overcoming the potential risk of panic selling.

6) Add to your winners, leave your losers alone

If we project our future returns in light of the power-law, we can easily see where Peter Lynch is coming from when he says:

Selling your winners and holding your losers is like cutting the flowers and watering the weeds.

That’s inherently a recipe for a losing performance because winners tend to keep on winning and losers tend to keep on losing.

  • If you trim your winners to add to your losers, you are guaranteed to eventually end up with a portfolio filled exclusively with losers.
  • If you focus on adding to companies that already are winning in your portfolio and eventually trim the ones that underperform, you are guaranteed to end up looking at a portfolio filled with winners.

Water the flowers, not the weeds. Simple, yet rarely executed properly.

This tenet should not be interpreted as an excuse to chase high flyers and ignore mean reversion. You should still focus on adding on dips - but again, only the dips of your winners - because they are great opportunities to accumulate positions in great businesses. Meanwhile, forget about "doubling down" on your losers, because this is typically how you will throw good money after bad.

7) Cap your single company exposure on a cost-basis

Any VC would define the maximum amount they are willing to allocate to a company ahead of time. Are you?

The vast majority of financial literature will tell you to diversify. Yet, there's a persisting belief that concentrating your portfolio only on your few highest convictions can help dramatically your performance. After all, that’s how Warren Buffett achieved 21% compound annualized return over his career. In his 20s, he put all his money into Geico.

Firm conviction can be the enemy of truth. Even some of the best investors in the world have made mistakes, concentrating too much into only a few bets. A good read on some of them is the book Big Mistakes: The Best Investors and Their Worst Investments (Bloomberg) by Michael Batnick.

One of the easiest ways to avoid being carried away by your own convictions is to cap your maximum exposure to a single company from a cost-basis perspective.

VC funds look at an investment from a cost-basis perspective, evaluating how much of their LP money was allocated to a given company. The current value can be misguiding because it relies on a volatile estimate that could be easily disrupted at the next round of money raised.

There are many opinions out there about what that maximum basis exposure to a single company should be in a healthy portfolio. It all comes down to your risk profile, time horizon and goals. What matters is to have it defined ahead of time, before you are in the heat of the action.

Overall, if you don’t want to let one single company put your overall portfolio performance at risk, a cap from 5% (at least 20 balanced companies in your portfolio) to 10% (at least 10 balanced companies) is reasonable.

I have found my personal preference slightly toward the risky end of the spectrum with no less than 12 balanced companies in a portfolio, i.e., an 8% maximum exposure to a single company on a cost-basis (100/12).

If you focus on your investment risk allocation from a cost-basis perspective rather than your current value, you will benefit from two leverages:

  • It will prevent you from adding too much to your losers.
  • It will encourage you to add to your winners, even if they have run a lot.

8) Let your portfolio concentrate for you

Imagine you decide to invest $120,000 today and invest it equally in 12 companies, resulting in 12 individual investments of $10,000, each representing at most 8% of your cost basis (10,000/120,000).

Now, a year later, let’s say one of your investment is up 200%, two companies went bankrupt and all nine other companies are unchanged.

Here is how your portfolio would look like:https://static.seekingalpha.com/uploads/2018/8/27/47516905-15354133444378965.png

As you can see:

  • From a cost-basis perspective, you have allocated only 8% of your portfolio to company A.
  • From a current value perspective, your portfolio is 25% allocated to company A.

Your portfolio has concentrated into company A simply because it is the “biggest winner,” the investment that has performed the best over time.

If you were to invest additional funds to that portfolio, it would be perfectly fine to add more to our existing position into company A as long as it remains no more than 8% of the new funds invested in the portfolio.

The power-law applies to the indexes just as much as it applies to your portfolio. Outliers, massive multibaggers over the years, like Apple, Amazon, Netflix or Nike (NKE), are the very companies that are enabling the S&P 500 to grow at a 10% annualized return over the last century. They more than offset the other companies that perform far under the average.

Again, if you don’t let the few investments that are overperforming take a bigger piece of your portfolio over time, you will be left with average performers and a bunch of losers slowly overtaking your portfolio allocation.

Let your portfolio concentrate for you. If your top three investments become more than 50% of your portfolio, they got there themselves, not because you blindly invested in them in an unreasonable way. Keep track of your cost basis and try to maintain the cost allocation of every single individual stock of your portfolio below 8% (or whatever number works for you).

Let the current concentration of your portfolio be a result of its sheer performance, not a result of your firm convictions. Let the power law do its job.

9) Favor high-margin businesses

Silicon Valley VCs don't waist time with poor unit economics. If a business is unlikely to reach a healthy gross margin at scale, why bother?

If I get to choose the type of business I invest in, I'd rather go not only for significant addressable markets and large moats but also strong (projected) unit economics.

A favorite category of mine is Enterprise Software and the various cloud services that have emerged over the last decade. The winners in this category could become ubiquitous and their upside is humongous with high gross margins.

I covered some of my favorite ones under $10 billion market cap here.

They cover a wide range of industries and specialties:

  • Analytics (like Alteryx (AYX) or AppFolio)
  • Data management (MongoDB, Elastic (ESTC))
  • Security (like Okta (OKTA)
  • Marketing and Advertizing (like HubSpot (HUBS) and The Trade Desk)
  • Accounting/HR services (like Paycom (PAYC), Zuora (ZUO))

Image Source: App Economy Insights.

10) Invest in platforms benefiting from network effects

In his book Modern Monopolies: What It Takes to Dominate the 21st Century Economy, Alex Moazed explains that software is a commodity. The real value is in the ecosystem.

The advent of mobile computing and its ubiquitous connectivity have forever altered how we interact with each other, melding the digital and physical worlds and blurring distinctions between "offline" and "online." These platform giants are expanding their influence from the digital world to the whole economy. Yet, few people truly grasp the radical structural shifts of the last 10 years.

On modern digital platforms, the network of people uploading content and connecting with each other is the true value created. Think about products like LinkedIn, YouTube, Instagram or Tinder. Without its users, the software itself isn't creating value.

Most winners of the App Economy Portfolio are platforms: US companies that have gained an ubiquitous role internationally such as Apple, Google, Facebook, Amazon, Match Group, Shopify, Square (SQ), as well as Chinese leaders such as Tencent (OTCPK:TCEHY), Alibaba (BABA), Baidu (BIDU) or Momo (MOMO).

According to Feng Zhu and Nathan Furr on Harvard Business Review:

Products produce a single revenue stream, while platforms—which we define as intermediaries that connect two or more distinct groups of users and enable their direct interaction—can generate many. Indeed, a large number of the world’s most valuable companies by market capitalization in 2015 were platform companies, including five of the top 10 (Apple, Microsoft, Google, Amazon, and Facebook).

Platform businesses are not exclusively companies with more than $400 billion market caps. Several promising smaller companies are taking the platform strategy to new areas such as Huya (HUYA) in Esports, Teladoc (TDOC) in Healthcare or Eventbrite (EB) in event planning and organization.

This year is a fascinating year for platform-like models, with many recent IPOs such as Pinterest (PINS), Lyft (LYFT), and more to come very soon with Uber, Airbnb and DouYu or Slack.

I would not invest in all of them, and probably not before their respective lock-up period expires, but that's a topic for another article.

Bottom Line

If you can apply these 10 tenets that convey some of the fundamentals of private markets to your own public equities portfolio, I believe you will see your performance improve dramatically, and it might even make your search for alpha more fun in the process.

Disclosure: I am/we are long AAPL AMZN APPF BABA BIDU EB FB GOOG HUBS HUYA MDB MOMO MTCH NFLX PAYC SHOP SQ TCEHY TDOC TTD ZUO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.