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Lessons from high-growth investors

Even in times of heightened risk, the value of innovation doesn’t go away
Lessons from high-growth investors

This feels like an odd time to expound the virtues of venture capital.

Recent venture-backed IPO debutants have been among the worst stock market performers, according to data provider Pitchbook. Many of the paper gains of the last few years have been incinerated by inflation and higher interest rates. SoftBank’s Vision Fund, famed for both its size and its increasingly wild stakes, posted a loss of $27bn (£22bn) in 2021. The world of cryptocurrencies, into which early-stage investors have ploughed billions of dollars, is imploding.

The listings market has gone deathly quiet, as has fundraising activity for early-stage funds. If there is a corner of the economy in the ascendency right now – and even that is doubtful given mounting recession fears – it is the old world of lumbering resource extraction.

Anyone who took from the pandemic a new purpose to invest in a brighter, more innovative, and cleaner future – in short, to think like a blue-sky venture capitalist – can be forgiven for wondering whether markets have returned to the 19th century. Thinking long term, or optimistically, has gotten a lot harder.

But even in times of plenty, why would a usually sober magazine for private investors entreat its readers to think like venture capitalists? And does Silicon Valley, home to many of the most successful venture investments and funds in recent years, offer any lessons for the portfolios of mere mortals?

For a start, there is the question of access. Start-up funds chase 100- or 1,000-fold returns not by betting on listed companies, but by getting in at the birth of an idea, sometimes before there are cash flows or even a business model. It’s a world in which knowing the scientists, technologists and entrepreneurs behind tomorrow’s best ideas is of critical importance.

Academic research backs this up, and suggests it is often the status and connections of early-stage fund founders, rather than their methodology, which determines success. Being a critical node in a network matters. “Silicon Valley is gripped by the cult of the individual,” the US-based British venture capital investor Matt Clifford once wrote. “But those individuals represent the triumph of the network.”

And networks mean those individuals aren't the everyday kind of private investor.

Then there is risk. Venture capital operates at a very high failure rate and is long term in nature. Huge risks combined with illiquidity is many investors’ idea of a bad deal, but that’s not all: many venture investments start with small stakes, and then require repeated rounds of funding before an idea is commercially proven.

This means taking a constantly evolving view of a company and a marketplace, all the while knowing it will (probably) end in defeat. Innovation-focused investing requires both skill and imagination to whittle down ideas, and contrition to realise when an idea is no longer viable.

But while venture capital might look like an exclusive game of sink-or-swim from the outside, there are lessons and routes in for the humble retail investor. Below are four of the most important.


Innovation > incrementalism

Seen from above, the slow march (and occasional slump) of economies and financial markets is all about incrementalism. At the national level, swathes of media and political attention is given over to single-digit annual changes in gross domestic product, and how this stacks up on the world stage. In finance, we obsess over the relative returns of a few asset classes.

This momentum is the product of billions of steps at the corporate and individual level. But it also masks the kind of ground-breaking change which propels everything forward in leaps. We know this to be true from the work of Hendrik Bessembinder. In 2018, the Arizona State University finance professor published a paper which showed a mere 4 per cent of stocks accounted for all the US market’s wealth creation in the previous eight decades.

By contrast, more than half of the 25,000 stocks Bessembinder looked at underperformed 10-year US government bonds. Outside the US, the results are even more skewed.

In the UK, Bessembinder might be best known to followers of the fund management team at Baillie Gifford, which has hired the professor as a consultant and taken his research as evidence for their approach to ‘moonshot’ investing. Although Bailie Gifford is having a tough 2022, its approach has won it plenty of fans over the years. Backing companies trying to shake up or reinvent industries, rather than simply competing in them, is a good starting point for any stock portfolio.

After all, over the long term all companies must embrace change or go extinct.

And while marketing power and good corporate execution can create a lot of shareholder value, innovation creates new growth markets. Apple (US:AAPL), Microsoft (US:MSFT), General Electric (US:GE), IBM (US:IBM), and ExxonMobil (US:XOM), which accounted for about a tenth of those 80-year gains, are all now mature firms. But together, this group has changed the worlds of work, computing, engineering, fuel, chemistry, entertainment, and communications. In three out of the five, venture funding was also critical to their early growth.

So how do private investors capture this innovation? To some minds, a long-term over-allocation to technology companies is the most reliable proxy, regardless of the sometimes-dramatic fluctuations in valuation and price. Another method is to look for companies with a higher rate of small-scale acquisitions outside its core product line. We can also lean on a few metrics, such as research and development spending to sales, or the rate of investment in intangible assets.

Above all might be an entrepreneurial culture, and executives who talk and think about the future as much as this year’s earnings outlook.

The most fertile ground for game-changing ideas may be outside of large corporate bureaucracies (see boxout), but management teams hungry to find and create new markets – rather than merely earning a rent off existing ones – can help to escape the tendency towards incrementalism.


Forecasts have limits

There’s a good reason why investors place a lot of emphasis on numbers. Without a clear idea of the size, sales, profit and possible growth of a company or market, the already tricky tasks of price discovery and fundamental analysis become a lot harder.

But venture investors are much more agnostic. According to a 2021 survey by the Harvard Business Review, almost a third of early-stage venture funds do not forecast company financials when making an investment, and valuation was only the fifth-most cited factor in determining what deals to pursue. For those which did set a projected rate of return, market risks were barely considered.

The latter point might sound surprising to investors in public companies, given how much time is given over to imponderables such as inflation, interest rates, geopolitics and economic sentiment. But it makes sense when you consider start-ups' own focus. “Public companies are valued on a whole raft of short-term aspects,” notes Martin Davis, chief executive of listed venture capital fund Molten Ventures (GROW). “But even if the UK economy went into decline in April, it won’t affect the value of a company growing at 50 to 100 per cent a year.”

In his brilliant history of the venture capital industry, The Power Law, writer Sebastian Mallaby opens with the story of Patrick Brown, an American geneticist who wanted to mimic the taste of meat in plant-based food. Based on little more than a hunch about iron levels in clover root, a rough PowerPoint presentation and a burning desire to upend modern food production, Brown raised $3mn from the serial venture capitalist Vinod Khosla, without a forecast in sight.

While Khosla could point to Brown’s zeal and excellent scientific credentials, he would have known his initial 2011 investment came with a high chance of failure. But it was in keeping with his view that “the future cannot be predicted; it can only be invented”. Cheesy corporate-coffee-mug philosophy? Maybe, but it also carries an important reminder of our tendency to view time and trends as linear, and explain the future through the lens of our recent past.

Back in 2011, very few people would have thought Impossible Foods, the company which Khosla backed, might be worth $10bn – the group’s mooted valuation before market volatility forced a delay to its IPO. Only now is the company having to think about systematic risks.


The future might look odd

It's easy to feel doubtful about burgeoning technology. 

Energy storing bricks, robotic bees, and enzyme-based recycling – all of which are real inventions that have pulled in venture capital in recent years – sound like jokes as much as viable concepts. And in a decade’s time, we may look back on each of these innovations as unfulfilled Tomorrow's World pipedreams. But it also helps to be humble about the future's inherent unpredictability, and the limits of your own outlook.

Asked for his reaction to the iPhone after its launch in 2007, the then-Microsoft chief executive Steve Ballmer dismissed it as a “$500 subsidized item” and said the product had “no chance” of taking significant market share. “They may make a lot of money, but if you actually take a look at the 1.3 billion phones that get sold, I'd prefer to have our software in 60 or 70 or 80 per cent of them, than I would to have 2 or 3 per cent, which is what Apple might get.”

Ballmer delivered huge value for Microsoft and its shareholders in the 14 years he led the company. But he is remembered as much for his dim initial view on the importance of hardware in the nascent smartphone market – and what this all said about his character and understanding of emerging trends. As a competitor, Ballmer could only see an expensive second-rate business phone, rather than the must-have consumer product of the century so far.

Anyone who has watched corporate promotions for the metaverse – or the ballooning YouTube genre of ‘VR fails’ in which wearers of augmented reality headsets panic or fall over – might have felt a similar reaction. I’ll freely admit to thinking 'it’s not going to happen', although it hardly helps when a product is synonymous with Meta (US:META) chief Mark Zuckerberg, whose own visionary credentials have taken plenty of knocks in recent years.

Then again, plenty of converging trends point towards the metaverse’s broad adoption. We increasingly live, play and work online. Our shopping habits place ever lower values on physical retail, and higher values on personalisation. The hardware and software which virtual reality runs on are continuously improving. And like the app ecosystem which only evolved after smartphones were introduced, people will find ways to make it useful.

Backing improbable ideas, where the full use case is just out of sight, is what venture capital is about. The metaverse is just one example of the way innovations may – or may not – shake up the world and current industries.

Each of us carries biases and a tendency toward herd-like thinking, whether we are a Silicon Valley power broker or a self-directed stock picker. But an eclectic, thoughtful and above all open-minded approach to due diligence can help us move past this, and is something from which all investors can benefit.


Walk the tightrope

From the outside, early-stage investing often looks like a high-stakes form of gambling.

Shikhar Ghosh, a professor of management practice at Harvard Business School, has estimated that up to 40 per cent of start-ups lose most or all the money invested in the company, up to 80 per cent miss their estimated return on investment, and all but 5 per cent fall short of their declared projection.

For it all to be worthwhile, venture capital needs to see a handsome return on the minority of bets that do work out. Doing this requires walking the tightrope walk between conviction, contrarianism, and the possibility of failure – often over long periods. Davis puts the average Molten investment at between “five and ten years”.

The way venture firms make this work in practice is to start small, with a ‘seed’ like investment. A retail investing equivalent might be to commit an amount of cash you would be comfortable losing – given the all-too-real event that the stake goes to zero. From there, it’s useful to make further investments (also known as ‘series funding’ in the trade) contingent on the company passing certain milestones.

This also means dealing with hype. Any investor focused on big-promise Aim stocks, for example, should know that private money will likely have passed over the opportunity already. This doesn’t mean disruptive and high-growth companies on the junior market don’t exist. They do, and the fact they are listed normally offers a degree of downside protection, as well as market liquidity – a feature which some venture capital trust (VCT) funds lack, even if these are typically the best option for venture-inclined UK investors.

But even if venture investing feels too much like frontier territory, with its uncertain payoffs, and accelerated corporate Darwinism, its discipline has much to commend it to investors in even the stodgiest of mature sectors.

Sooner or later, even today's ascendant old economy stocks will have to embrace the next big thing.