Over the past few days, I’ve described a unique investment technique that if performed right just once, can allow you to never worry about money again.
I’m talking about venture capital-style investing.
As I’ve covered, venture capitalists are the grand slam home run hitters of the investment world. They back small companies in their early stages. Venture capitalists don’t look to make 300% returns… they look to make 3,000%… even 30,000% returns.
Venture capitalists have funded nearly every mega-hit technology company you know today: Google (now Alphabet), Facebook, Twitter, Uber, Airbnb, Pinterest, and the list goes on and on.These companies weren’t always household names. Venture capital investors backed them in their early days… and in many cases, made more than 100 times their money as the start-up firms grew large.
Make just one great venture capital-style investment and you may never have to work or worry about money again.
When it comes to evaluating early-stage companies – which are often technology firms – I use a “five factor” analytical model. You see, in my experience, the biggest early-stage stock winners tend to have five key qualities that define their businesses.
While not every single winner has all five qualities, most do. And the more of these qualities you see in an early-stage company, the greater your chances of investment success.
I like to frame our model as a series of five questions. Every company we risk our hard earned capital on must answer the questions to our satisfaction… or have a clear path to producing good answers:
Question #1: Are You Hunting Elephants or Mice?
Every company – no matter what industry it is in – has a critical choice to make.
Will it try to conquer a giant market, a medium market, or a small, niche market?
For example, Amazon, Google, and Facebook all went after giant markets. Amazon went after books and then retail. Google went after the search market. Facebook went after the broad-use social media market.
In contrast, a company that sells software to the legal industry is in a niche market. That kind of “niche” market is dwarfed by the markets I described above.
Although niche market companies can do well, as early stage “venture capital” investors, we’re much more interested in owning companies that are going after massive or potentially massive markets. We want to hunt elephants, not mice.
It often takes the same amount of planning… the same amount of creative thinking… the same amount of man hours… the same amount of back office expense… and the same amount of marketing creativity to prosper in a $100 billion market as it does a $1 billion market.
You might as well do all of that work in the pursuit of a huge prize instead of a small prize.
This is why we are on the hunt for companies that are going after giant or potentially giant markets.
Don’t get me wrong. We will occasionally invest in small companies going after smaller markets. Many small companies have struck it rich in smaller markets and delivered 1,000%+ returns to investors (we see this happen most often in the biotech industry). But typically, I prefer to invest in companies going after giant markets.
Question #2: Is the company’s technology CLEARLY better or MUCH cheaper than its competitors’ technology?
Almost everybody has lived through a “systems change” horror story sometime in their professional lives.
Most of these horror stories go like this: A company someone works for or owns decides to switch to a different software system, different phone system, different website, or a different payroll system, etc. Although the company selling the new system promises everyone that the change will be quick and easy, it turns out to be a miserable slog that causes tons of problems.
Since so many people have lived through a “systems change” horror story – and since people are naturally resistant to change – any new way of doing anything must be CLEARLY better or MUCH cheaper than the current (aka, “old”) way of doing things.
That’s why as early-stage investors, we can’t risk our capital on companies with products and services that are “just a bit better” or “just a little cheaper” than products and services already on the market and in use. Those companies are very unlikely to change the behavior of potential customers… and very unlikely to succeed.
Instead, we want to own innovative companies with new products and services that are CLEARLY better or MUCH cheaper than what is already out there. It’s often said that a new technology must be 10 times better or just 10% of the cost of existing technologies in order to get people to change.
Remember. People hate change. That’s why any company we back with our capital must be doing something that is CLEARLY better or offering a similar product or service that is MUCH cheaper than its competitors.
Question #3: Is the business scalable?
It’s one of the most repeated words in Silicon Valley for good reason.
A business must have scalability in order to grow large in a short time (aka, “Make you lots of money quickly”).
Scalability is the ability of a business to massively grow revenues while minimally growing the costs associated with producing those revenues.
For example, a lawn mowing business is not scalable. If you own a lawn mowing business and want to double in size, you’ll have to buy twice as many lawn mowers as you have now and you’ll have to hire twice as many lawn mower operators as you have now. Because of this, your revenue cannot soar far beyond your costs.
On the other hand, you have businesses like Facebook and Twitter. These businesses are very scalable. It took a lot of work in the early days to create the technologies and businesses behind Facebook and Twitter, but once they were created, these two businesses could add new users and increase their advertising revenues much, much faster than they increased costs. Their market values exploded higher as a result.
Software companies are very scalable as well. A software company like Microsoft will spend money and time creating and developing software like Microsoft Office. But once it has the product created, it can produce and sell additional copies of the software at minimal cost. The revenues can rise much faster than costs.
Don’t get me wrong: owners of non-scalable businesses (like a lawn mowing business) can grow very wealthy. Many people have done so in the past. Many people will do so in the future.
But if your goal as an investor is to own shares of businesses that can make you a lot of money quickly, then you must focus your attention and capital on scalable businesses.
Question #4: How big is your moat? Do you have a meaningful and defensible competitive advantage?
The brilliant investor Warren Buffett has helped make the term “moat” one of the most popular words in the investment world.
And for good reason. You want every company in your portfolio to have as much moat as possible.
“Moat” is how resistant a company’s business model is to outside competition. The name comes from the time when a wide moat could keep people inside a castle safe from invaders.
Free market capitalism is survival of the fittest. As soon as one company is successful in one area, dozens of competitors will rise up to imitate it or decapitate it. Today’s big winner can be tomorrow’s road kill.
That’s why a critical part of our analysis process is studying a company’s competition. We study their products, services, patents, marketing strategies, people, and distribution networks. We always want to own companies that are several steps ahead of the competition.
These days, a key part of studying any technology business’s moat has to factor in the 800-pound gorillas of the industry. I’m talking about Amazon, Google, Facebook, Microsoft, Intel, and other giant businesses. These companies have incredible resources on hand at all times. They have the biggest research & development budgets. They have the most political power. They can pay top people the most money. They have the biggest distribution networks.
A giant like Facebook can allocate $2 billion toward a new project, which is more than your average small-cap company’s entire market value.
When one of the 800-pound gorillas decides to get into a particular industry, it’s always a major concern for the current smaller players.
Don’t get me wrong. David often beats Goliath in business. American history is full of stories of upstarts thriving despite attacks from larger companies. But no analytical process of early-stage companies would be worth its salt if it didn’t study the potential threats from the giants.
Question #5: How much are you worth?
Figuring out what an early-stage company is worth is one of the most difficult tasks in all of finance. This is because most early-stage companies earn little to zero profit.
For example, some small tech and biotech firms generate almost zero revenue because they are basically science projects. They’ve raised money from investors and are spending it on research and development. They hope their work will lead to a breakthrough and huge sales.
Of the early-stage companies that do generate sales, many of them plow the money into growing the business, leaving no profit at the end of the year.
Because of all this, using conventional valuation metrics like the price-to-book value or the price-to-earnings (P/E) ratio are often useless when it comes to valuing early stage businesses. This means that conventional stock screens are pretty much useless for uncovering potential early stage winners.
I believe this is a great thing for us. Most people prefer doing things the easy way. Since uncovering and valuing early-stage companies is harder than valuing conventional businesses with conventional earnings, less people do it.
So much of our analysis comes down to old-fashioned detective work. Instead of using cookie cutter valuation metrics, we base our valuations on how assets are being valued in specific industries, potential market sizes, and the quality of innovations.
I spend thousands of hours per year speaking with industry experts… attending conferences… personally testing products and services… evaluating business plans… pouring over balance sheets… and studying industry reports.
After all that work, I arrive at the valuations I place on companies… and of course look to buy them at discounts. It’s just as much art as science, and it will never fit inside a conventional stock screener.
One key thing here to know: Depending on conventional metrics like the price-to earnings ratio won’t help you with early-stage companies. Avoiding companies with high price-to-earnings ratios (or no earnings) will cause you to miss out on many early-stage winners. Just because a company looks expensive based on earnings doesn’t mean it can’t be a great investment.
As I mentioned at the start of this letter, if you make just one great venture capital-style investment, you may never have to work or worry about money again. The returns made in a small business that grows large can easily go over 100-fold.
By following the analytical framework I’ve described above, we can put ourselves in the best possible position to earn these kinds of big returns.
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