Two and a half factors to assess growth investments.
This post will cover the following topics:
- The importance of being in the right market at the right time
- How hiring and people management is the true source of whether a tech business thrives
- Why number-crunching alone never tells you the story
Sequoia Capital, debatably the most prestigious and best-performing venture capital and growth equity firm on the planet, regularly realizes 10–12 fold returns for the funds. Most venture funds run over approximately 8–12 years. Doing the math, this accounts to 25–40% annual ROI. You can now object Sequoia does not operate in public markets, has an extensive network to get connected to the best opportunities & entrepreneurs and has some of the smartest minds working for them. Yes, all true.
However, in today’s world, retail investors can leverage Sequoia’s strategy and mindset. The internet provides public access to information the best investors would have died for a few years ago. It is easier than ever to connect to like-minded people all around the globe. They are just a creative tweet out of your reach. Today’s retail investment infrastructure allows us to put single dollars into public markets within seconds. A lot of successful VC-funded companies like Apple, Google, Facebook or Paypal acquired a significant proportion of their value in public markets. Consequently, except for being too lazy to put in the effort, you run out of excuses to apply a similar approach.
I by no means claim to have hacked the secret sauce of top tier venture capital and growth equity investors. But I have worked in the industry and I follow along industry leaders with massive track records for years. Nevertheless, the following lines will be biased by my experience and my view on the world. So please challenge everything and make the prove check for yourself. And always remember, these are methods/ learnings that worked in the past. While the past can be a good indicator for the future, it never is to a full extent. Circumstances and conditions change. Always prove check with first principle thinking. With that let’s jump right into the first of my two and a half buckets for successful growth equity investing.
I always start by matching top-down technology advancements with bottom-up basic human needs and desires. I outlined this approach and depicted my current view on the two perspectives in my last article. My investments always need to significantly better serve a basic human need compared to the currently available solutions. My categories of basic human needs are health, wealth, status, freedom or short-term satisfaction. For the technological top-down perspective, the investments need to leverage technological progression that generates economical value within the next 3–5 years. My six themes for technological progress are energy storage, robotics, artificial intelligence, blockchain, DNA sequencing or the web 3.0.
Next the investment has to qualify as a potential dominant platform that can significantly change an existing industry or leverage technology adoption to hundreds of millions of people. In my world, a dominant platform is a business that provides services and products for other companies or individuals that would not be able to operate without this platform. Uber is a great example of a dominant platform. Hundred thousands of drivers would not be able to generate income without Uber. Apple’s app store is another one, millions of developers rely on the App store to sell their products. From a basic human need perspective, Uber provide frictionless transportation. The service is cheaper, more convenient, safer and saves time compared to traditional taxi services (wealth and freedom). The same goes for the app store with its millions of diverse services offered to billions of people (touches every dimension of basic human needs).
On top of being a dominant platform, I want the businesses to be defensible in some form. Network effects are the strongest defensibility mechanism. Network effects provide additional value to existing customers with each new, additional customer using the product or service. Coming back to the example of Uber, the more people are using the app, the more drivers will be incentivised to be around. As a consequence, the faster I will get my ride. Additional side effects will be the continuous improvement of the platform and the user experience. Network effects make it very hard for similar products to coexist. A business with a larger user base will always automatically provide the better experience and service for its customers. Additional factors to make a business defensible can be economies of scale, regulation, technology or brand. Obviously, one of these criteria can be given while the other is not. Often these criteria even contradict each other. Perfect defensibility is an illusion. Consequently, there is no black and white answer to defensibility.
Lastly, in the market bucket, I take a look at the business from a direct customer perspective. There are three initial questions I ask myself from the customer perspective. Does the product or service serve a need that humans have that is not perfectly satisfied yet? Does it solve a current customer pain point? Does it make the experience for an existing technology, product or service significantly better? The answer to at least one of these questions has to be a highly convinced yes, otherwise I pass. In case this is given, I subsequently ask myself whether it will be relatively easy to roll out this product or service to a large customer base. In case this is also given, I ask myself will the customer be willing to pay for this service or provide a basis for monetization. Again, of course there are no black and white answers to these questions. In fact, they are super hard to answer objectively and without having a biased view.
To summarise the market bucket, I am looking for companies operating at the intersection of current technological advancement and better meeting basic human needs, businesses that have the potential to become dominant, defensible platforms and that provide a unique customer experience. Again, as straightforward as these points sound, they are not. Market dynamics are on the constant move and change. 10 years ago, who would have guessed that a company like AirBnB can generate 5 billion dollars revenue by selling services to people renting out part of their houses to strangers. Such a market did not even exist back then. To anticipate how human needs can be served with new technology is hard. Hence, foreseeing the rise of a dominant platform is hard. To guess whether the platform will be defensible, will ever become profitable and provides a unique user experience, even at a small scale, is very hard. That’s why Sequoia earns and deserves such kind of returns. The good thing is retail growth investors do not invest in the very early stage. We can rely on more information and better tracking possibilities for our assumptions. We will make good returns if we find better answers than the market to only a few of the dimensions above.
Let’s jump next to the microorganism of the investment. The two dimensions to consider here are the people and the product & it’s distribution. However, the first factor influences and therefore dominates the second by a mile. The company’s people are the determinant factor of who joins along their path, which problems in which way they tackle and how their products & it’s distribution look like. So let’s start with the people dimension.
The people, or more precisely the leadership of any growth company, are the determinant factor for success or failure. They need to figure out problems that have not previously been solved before. Subsequently, they need to design a process to solve these problems consistently and mostly independent of particular people and changing circumstances. Consequently, you want to invest in independent, first-principle-thinkers who can solve problems and make smart, informed decisions and bets consistently. For me, good decision-making in the following two categories make up for 80% of success or failure. The definition of the right north star & its measurement and the hiring of the right people & the establishment of the right systems to solve them. To get the right decisions for these two dimensions, leadership needs to be incentivized accordingly. The alignment of incentives is key. I cannot stress this enough. This is how nature works. A fast company, racing for winner-takes-it-all markets, cannot be operated by linearly thinking and paid bureaucrats, even smart ones. Let’s dive a bit deeper in what kind of human attributes are needed to succeed as a fast-driving company.
Honesty, open-mindedness, curiosity, logic & first principle thinking, flexibility, grit, vision and empathy are for me the most important attributes. Honesty is the very basic foundation. You don’t want to trust your money to a company where you have doubts about the integrity of its people. Secondly, when operating at full speed in new fields, circumstances will change. Open-mindedness and curiosity will help to find underlying changes in circumstances. Logic & first principle thinking paired with mental flexibility will shift someone’s thinking and allow them to subsequently find the right actions to adapt. Generally, growth paths are bumpy and full of unforeseeable roadblocks and obstacles. This doesn’t make the ride particularly comfortable. Grit is needed to pass through these storms on the way to destiny. Finally, nobody will succeed on this road alone. There is a need for attracting people with similar attributes or specific skills & knowledge. Vision and empathy must be part of the company’s playbook to get these people.
Getting information about company leadership fulfilling these traits is rather an art than a science. Listen to interviews with these leaders. Follow their earning calls, notice the difference between different styles of how they present themselves, how they structure their thoughts, how they communicate their vision or how they deal with critics. Read about their background and track record. Exchange thoughts & opinions or simply follow along like-minded people, domain experts or other passionate retail investors.
As a next step, a company needs to be able to convert its talent into building a great product and distribution system. My definition of a great product or service is very, very simple. The customers need to love it. And the process of arriving there is in theory also fairly simple. Start with a thesis, bring it to customers and then reiterate over and over until there is the famous product-market fit. As a retail growth investor, I barely touch stocks where I am not highly convinced of an almost perfect product-market fit. Exceptions may be huge technological shifts with highly promising teams. But I currently only have one, maybe two of these in my portfolios.
“Growth is not convoluted or magical. It is very simple: Measure, test and experiment.” Eric Ries
To figure whether product-market fit is reached, I test the products of companies I invest in whenever possible. Otherwise, I at least research customer reviews. Even better than positive customer reviews are companies that have a strong moat around them. Especially for direct consumer-facing businesses but increasingly also B2B, I love businesses with a base of die-hard customers or even better fans. On top of that, I also watch out for factors that could make it harder to build a successful product or make it hard to acquire or retain customers. This could be factors such as capital needs, operational complexity, physical or geographical obstacles, regulation or dependencies on third-party infrastructure or partnerships.
Data and Information
The last bucket, or half bucket to be more precise, are numbers and data crunching. The reason why I see it as half a bucket, numbers and data crunching does not add any new dimension of fundamental first principle information to the analysis. It is just the tracking and feedback mechanism whether you are right on the analysis you did on market and the micro perspective of the business.
The most obvious indicator for the tracking is revenue growth. Revenue growth tracks how fast a company is able to grow into their market. Comparing revenue growth to competitors is important, especially for winner-takes-it-all markets. Other important indicators to track are unique customer growth, customer acquisition costs, lifetime customer value, churn rate or depending on the growth stage of the business development the progress on achieving the target gross margin. Plus obviously the price. I personally track the progress by combining all these factors. In its simplest form, I use a discounted financial model with imaginary high future market share, a target profit margin and a conservative P/E ration. With this, I can double-check whether the company is on track, even for a rather bear scenario, and whether my assumptions on market and business are correct.
Another indicator I like to look at for growth stock is the traction from institutional investors, especially the one with remarkable track records. Institutional money obviously grows the stock value but also makes the stock less volatile. Furthermore, it confirms that professional analysts have similar theses and future expectations. Over the coming months, I will more concretely outline some of my investments and their underlying thesis with the above-described framework.