The Education of an Aspiring Angel Investor
Learning to Ask the Two Questions that Matter
Remember your goal in investing isn’t to earn average returns; you want to do better than average. Thus your thinking has to be better than that of others — both more powerful and at a higher level. — Howard Marks
You’ve just been given $100,000 to invest in startups. How do you spend it?
If you’re like most investors, your thinking goes something like this:
I want to pick startups that will be successful. Successful startups usually have easy-to-use products, a great team, media attention, and are in a hot market. So, I need to find startups that have these features.
This is how most investors think and, like Howard Marks says, will probably earn average investment returns.
If average thinking leads to average returns, what’s the above-average thinking needed for above average returns? That’s what we’ll figure out together.
Price, Value, and Investment Profit
Investing is paying a price today to get value in the future with the goal of making a profit — getting back more than you paid.
The value of an investment (in a company) is all of the profit that company will earn in its lifetime:
But it’s impossible to predict exactly how much profit a company will make in the future. The best we can do is estimate. Every investor has their own estimated value of a company, and averaged together these estimates become the market’s price.
Our goal is to invest when the market’s price is less than a company’s eventual value. In other words, we need to be right when everyone else is wrong. The difference between the future value and the market’s price will be our investment profit.
This idea is illustrated below. To make a profit, we need to invest in companies whose value will be green but the market expects will be blue:
Our investment strategy is not to pick great companies, it’s to pick companies that the majority of investors have underestimated.
Great investment opportunities like this don’t happen often. Most of the time, the market’s price is a more accurate prediction of a company’s future value than any one investor, including us. As James Surowiecki explains in The Wisdom of Crowds: “a diverse collection of independently deciding individuals is likely to make certain types of decisions and predictions better than individuals or even experts.”
But, these opportunities do happen. Investors sometimes make huge mistakes when valuing young companies. The key to making profitable investments is understanding what these big mistakes are, why they happen, and how to spot them when they do.
How Investors Underestimate the Height of the Value Curve
The height of a company’s value curve — the Y-axis — measures how much profit it makes in a year. It’s roughly the product of three factors: the number of customers it has, its average revenue per customer (ARPU), and its profit margin.
ARPU and profit margin aren’t very elastic — they don’t change much from year to year. Big valuation mistakes, like the kind we’re looking for, won’t be caused by underestimating how much a company’s ARPU or margins will change.
Customer growth, on the other hand, is the key growth driver of annual profit. When a company’s profit increases by 10 times in a year, it’s usually by adding huge numbers of new customers.
Underestimating customer growth potential leads to big valuation mistakes. Let’s look at two of its common causes: underestimating new markets and fragmented markets.
Underestimating Value in New Markets
Investors frequently underestimate how valuable a new market will become. New markets often start in small niches. People tend to assume these markets will stay small — using the past and present as a predictor of the future — instead of imagining the new market becoming mainstream.
Amazon is a great example of investors undervaluing a new market. Amazon’s niche, selling books online, was considered too small to be interesting by investors and competitors. The company steadily expanded into adjacent product categories, growing to become “The Everything Store” with 250M customers. Investors who failed to imagine how selling books would expand to selling everything severely undervalued Amazon.
Underestimating Value in Fragmented Markets
Investors often undervalue companies entering huge but fragmented markets. In their present state, fragmented markets are fiercely competitive with companies unable to grow their customer base or create value. However, any company that manages to consolidate one of these huge markets will become extremely valuable.
In 1998, online search was a huge but fragmented market. Twenty companies including Yahoo, MSN, and AOL competed fiercly — but futilely — for customers. Google joined and, within five years, used its superior technology to consolidate 60% of the market. Most investors, tricked by the fragmented history of the market, underestimated how much value any one company like Google could capture.
Avoid the first big valuation mistake — underestimating profit from customer growth — by asking:
Have investors underestimated the company’s value because it's in a new or fragmented market?
How Investors Underestimate the Length of the Value Curve
The length of a company’s value curve — the X-axis — measures how many profitable years it will have. This is determined by one thing: competition.
The goal of every company is to establish a monopoly — to be the only supplier of the solution to a customer problem. A company with a monopoly can live for as long the problem exists and can charge as much as customers can afford.
But profitable companies attract competitors like moths to a light, forcing everyone to compete on price. Companies may survive, but profits are driven to zero.
Sustainable competitive advantages — what Warren Buffett calls a “moat”— help companies establish and protect monopolies. These advantages greatly extend the profitable life of the company. There are four — and only four — kinds of moat that a company can create:
- Demand-Side Economies of Scale (Networks, platforms)
- Supply-Side Economies of scale (Cost advantages)
- Intangible Assets (Regulations, intellectual property, or brand)
- High switching costs
A strong team, great product, or large market share are not sustainable competitive advantages — none of them will prevent other companies from solving the same customer problem.
Investors often undervalue companies with monopolies because their moats are hard to see. Some moats, like network effects or cost advantages, don’t become obvious until the company has reached a certain scale.
Avoid the second big valuation mistake — underestimating profitable lifetime — by asking:
Have investors underestimated the company’s value because they’ve overlooked a monopoly with a moat?
You’ve just been given $100,000 to invest in startups. How do you spend it?
Our answer is to look for monopolies in huge markets that other investors have underpriced.
You might be thinking “This sounds too obvious to work. What’s the catch?”
The catch is that it’s obvious, but it’s not easy. It’s hard to identify the moat of a young company or the growth potential of a new market. That difficulty is what creates the huge investment opportunities we’re looking for. Like Howard Marks said: above average returns require above average thinking.
The first half of this required thinking is focus. The most valuable companies all have a monopoly in a huge market, yet investors often focus on industry trends, management, and other distractions when valuing startups. Our questions keep us focused on the two features that create the most value.
The second half of this required thinking is having the right mindset. We need to be what Phillip Tetlock calls a Superforecaster: open-minded, objective, probabilistic, humble, and hard working. A Superforecaster mindset improves the accuracy of our predictions and help us recognize — and capitalize on — the big mistakes the market occasionally makes.
Thanks for reading.
It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent. — Charlie Munger
Say hi on Twitter :)
