Weekly Thoughts: Venture Math, Explaining Trump, and Indexing
Here are three things that caught our eye this week:
We have written many times about our long term investment horizon. We enthusiastically embrace the notion that steady cash flow generation, incremental growth, and patience can result in significant rewards over time. That said, we also understand opportunity cost and competition, so we feel it is important to maintain a solid understanding of both relative and absolute investment performance. It was in this context that we spent time reading about venture capital and the expected distribution of outcomes.
While the exact breakdown may vary, most VC investors begin with the Pareto Principle concept that most (if not all) of the fund level returns will be driven by a small minority of the investments. As noted venture capitalist Fred Wilson framed it:
“I’ve said many times on this blog that our target batting average is ‘1/3, 1/3, 1/3’ which means that we expect to lose our entire investment on 1/3 of our investments, we expect to get our money back (or maybe make a small return) on 1/3 of our investments, and we expect to generate the bulk of our returns on 1/3 of our investments.”
Research from the Small Business Administration and other venture capital firms indicates that the failure rate for new ventures is closer to 50%, if not higher. As a result, when a venture deal succeeds, the magnitude of that success must be truly extraordinary to make up for the other less fruitful investments so that the overall fund can deliver profits back to the LP’s and eventually the GP as well. This explains the desire on the part of the venture investor to identify world changing opportunities that have the potential to produce 30x+ returns on capital. As Steve Blank recently noted:
“Some quick VC math: If a VC invests in ten early stage startups, on average, five will fail, three will return capital, and one or two will be ‘winners’ and make most of the money for the VC fund. A minimum ‘respectable’ return for a VC fund is 20% per year, so a ten-year VC fund needs to return six times (6x) their investment. This means that those two winner investments have to make a 30x return to provide the venture capital fund a 20% compound return – and that’s just to generate a minimum respectable return.”
The same principle that drives the portfolio-level return estimate can be applied to an individual deal to arrive at a theoretical expectancy. Every time the investor commits capital there is some probability of failure (~50% in the VC case), some chance of breaking even (~30%) and some potential for wild success. We can perform the same exercise for our own investments albeit with a different set of probabilities. When we partner with established operating businesses, we do so anticipating that our failure rate will be lower than that of the VC industry. The trade off is that any success we have is likely to be more muted. If we assume the aggregate expectancy is similar in both cases, the distribution of potential outcomes might be comparable to the tables below:
For us, the crucial takeaway from this analysis isn’t that we now know the return figure we want to hit but instead that we understand the bet we are making. We can promise with absolute certainty that our returns won’t rival the Chris Sacca’s of the world, but we can also predict with a reasonable degree of confidence that our business will still exist five to ten years hence. Time will tell whether these estimates are reflective of reality. The best part about owning an established, cash-flowing business is that we get paid while we wait to find out.
In the last year, we have written about filter bubbles, the rise of craft beer, and N of 1 trials. All of these concepts relate to the broader theme of personalization and this week we have been reading about the sam phenomenon applied to politics. Like the rest of the country, we have been fascinated by the evolution of the presidential primary season on both sides of the aisle. Bernie Sanders has been a constant thorn in Hillary Clinton’s side, and of course Donald Trump’s ubiquity has been, well, “huuuge.” Regardless of political affiliation, the main question continues to be: why is this happening?
Part of the answer is that we don’t understand the voting public’s perspective as well as statistics suggest we do. In the same way that someone can drown in a lake that is six inches deep on average, polls that indicate someone as moderate when looking at their policy views on average can obscure a diversity of extreme views with both liberal and conservative orientations. From a recent Vox article:
“The way it works is that a pollster will ask people for their position on a wide range of issues: marijuana legalization, the war in Iraq, universal health care, gay marriage, taxes, climate change, and so on. The answers will then be coded as to whether they’re left or right. People who have a mix of answers on the left and the right average out to the middle — and so they’re labeled as moderate.
But when you drill down into those individual answers you find a lot of opinions that are well out of the political mainstream. ‘A lot of people say we should have a universal health-care system run by the state like the British,’ Broockman said in July 2014. ‘A lot of people say we should deport all undocumented immigrants immediately with no due process…These people look like moderates but they’re actually quite extreme.'”
According to researchers, 71.3% of self-described moderates hold at least one policy view outside the political mainstream. This statistic matters because it means moderate candidates who promote centrist policy prescriptions with an eye toward bipartisan agreement may have a hard time connecting with their supposed constituents. As Vox explains, “the answer, Ahler and Brookman realize, is simple: these voters don’t want moderate candidates because these voters aren’t actually moderates.”
The result is a trend toward more individualized policy frameworks at the same time the internet has drastically improved access to a range of political information. Whereas newspapers and TV stations previously curated content in a process that would naturally guide viewers from both sides to the center, it is now possible to create a Facebook news feed that essentially caters exclusively to one’s own particular set of views. From a recent article on Ben Thompson’s Stratechery blog:
“…there is no one dominant force when it comes to the dispersal of political information, and that includes the parties described in the previous section. Remember, in a Facebook world, information suppliers are modularized and commoditized as most people get their news from their feed. This has two implications:  All news sources are competing on an equal footing; those controlled or bought by a party are not inherently privileged,  The likelihood any particular message will ‘break out’ is based not on who is propagating said message but on how many users are receptive to hearing it. The power has shifted from the supply side to the demand side.”
Clearly Bernie and Donald have tapped into a voter message that resonates deeply with their respective supporters. Without getting into their particular agendas, the key point is that in 2016, access and receptivity to alternative views go a long way toward explaining the staying power of both candidates. Moreover, to us the larger business takeaway is that the individual — the customer, the user, the voter — has never been more important, and if you aren’t proactively engaging with people who could be receptive to your product, service, or policy platform, you’ll lose to someone who is.
As asset managers we are very aware of the long standing and constant debate between active and passive investing. Rather than get into the intricacies of that conversation here — we have written about the advantages to both previously — we were interested to read an article in The New Yorker about the rise of passive investing and its effect on market prices. Titled Is Passive Investment Actually Hurting the Economy, the article focuses on a relatively simple question: what happens as passive investment strategies grow as a percent of total investments?
Although we had never considered this question, the absolute extreme result is quite obvious. In a world where all investment is passive, market prices will not reflect intrinsic value, but rather whatever rules govern the passive strategy. The New Yorker explains:
“One way to think about this is to imagine that investment decisions are increasingly on autopilot: more and more money will pour into a set of firms largely independent of the considerations that have traditionally guided investors, such as supply, demand, management performance, growth potential, or broader economic factors.”
Thanks to the simplicity and cost advantages of index funds, passive investing has been on the rise and now accounts for an estimated 20% of stock ownership, up fivefold from 2000. Compounding the potential effect on market dynamics is that fact that most indexing is allocated in largely the same way: by market capitalization. This ensures that indexed dollars follow one another into the same (large) companies. Timothy O’Neill, Global Co-Head of Goldman Sachs’ investment management division explains that this “guarantees that the most valuable company stays the most valuable, and gets more valuable and keeps going up. There’s no valuation or other parameters around that decision.”
The unidimensional nature of indexing also ends up increasing the prevalence of a tangentially related issue known as horizontal shareholding. In short, when the same shareholders own significant portions of companies within an industry, it introduces anti-competitive incentives that distort normal free-market forces. Horizontal shareholding is present in almost every major sector, but it is most striking in airlines, where one study concluded that airfare is 3-10% higher because of this phenomenon. From a Harvard Law Review essay on the magnitude of horizontal shareholding:
“For example, from 2013 to 2015, seven shareholders who controlled 60.0% of United Airlines also controlled big chunks of United’s major rivals, including 27.5% of Delta Airlines, 27.3% of JetBlue Airlines, and 23.3% of Southwest Airlines. More generally, institutional investors held 77.0% of the stock of all airlines operating in the average flight route from 2001 to 2013.”
To be fair, the negative consequences of horizontal shareholding are tied mainly to institutional ownership, which now accounts for about 80% of the S&P 500, but one could argue that its sharp rise from just 65% a decade ago has been largely driven by index fund growth.
Regardless of the magnitude of market distortions currently in effect, it is clear that the environment for them to exist is present and intensifying. Of course, there are obvious fixes — indexing based on factors other than market capitalization being one — but for us the takeaway is more about unintended consequences. A frustration with under-performance from active investing, especially net of fees, gave rise to the popularity of passive index funds. There can come a point, however, where that popularity will be the reason for its own under-performance. It seems Newton knew something about markets in addition to physics when he created his third law of motion.
Have a great week,
Your Chenmark Capital Team