Value Investment Strategy in Venture Capital

Why succeed in every investment (or the majority of them) is more important than depending on the statistical model of “Spray and Pray”.

Starting a business is not easy. One has to invest a lot of effort, time, and brain in order to introduce an idea that can stand out and is of value to others. Every individual is naturally inclined toward investing in a startup with better prospects than a start-up that would not generate any value and likely to fail in the future. Every investor would want to see his investment a complete success, whether it be an investment in a single stock or a bucket full of stocks. Same is the case with Venture Capitalists; they wish every investment to be successful, and for the same reason, prefer to use value investment strategy over the statistical model of spray and pray.

Although, spray and pray has got a lot of media attention in the past few years, and the face behind it is none other than Dave McClure, the founder of 500 startups, yet, you cannot deny the fact that it is important to reasonably manage your risk.

Nurturing the Idea is as Important as Making Money Out of it

Nurturing the idea is as important as making money out of it and this is exactly what value investors believe in, because you won’t be able to make money out of it if it doesn’t grow well. Manu Kumar, the founder of K9 Ventures, said that most companies do not turn out to be a failure because of their investors, but despite their investors. This is why he doesn’t want the startups, he has invested in, to fail, and wants a reasonable success rate in his investments. He keeps an average of four or five companies in his portfolio and he wants each one of them to be a success. This is why he is very selective and prefer to go for the one with good prospects. He keeps his investment between $100k and $200k and screen companies down while expecting a much higher rate of success. He looks for appropriately priced deals and doesn’t touch anything that is five or higher.

Value Investing Strategy – Bridging the Gap between Investors’ Mindset and Founders’ Perception

Another famous name among the Venture Capitalists, Thomas Korte, said that they do everything in a scaled way, because the majority of the founders tend to take the funds they are offered in the seed stage. There are very few in the market who believe that their investors would take them through Series B and Series C, and their apprehensions are true to a certain extent. At one point, McClure said, “it is not that their portfolio has a high death rate, it’s just that there is a higher death rate out there.” Instead of aligning himself with the founder and an acquirer, he prefers to align with an investor and acquirer. So, if a company has a scalable impact, he makes a deal as soon as possible. It is not easy to bridge the gap between investors’ mindset and this commonly held belief of startups. However, Value investing strategy can contribute towards changing this mindset and bringing harmonization to achieve common goals.

Benefits of Value Investing

Potential to Make High Profits – As opposed to spray and pray strategy, value investing has a potential to make high profits, because value investors tend to invest in companies that are being offered at a discount price and sell them well above their intrinsic value by bringing their true value to light through solid research on a value stock, its peers, and the sector.

Avoid Exposure to High Risk – Investing in a few companies with good future prospects will not only enable the investor to focus on materializing the potential value, but also keep the overall cost to a minimum. The investor will not be dependent to succeed on that only company that make the revenue beside all the others have already failed.

 

Yes, there might be a lot of effort and hard work involved the value investment strategy to be implemented while choosing the startups for investments, but it is important to note that short term price fluctuations are not always a true depiction of the true value of an asset.

As Benjamin Graham, the founder of value investing and mentor of Warren Buffet, once said, “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.”

Value Investing or Spray and Pray

In my last article I wrote about the value investment strategy, now I will compare it with the “Spray and Pray” method.

Value investing and Spray and Pray are two of the widely talked about strategies in the world of venture capital. Some of them view value investing as a reasonable approach, because it is concentrated toward investing in companies that are undervalued and have a strong business model with good future prospects. While others consider spray and pray method to be a wise approach as they believe it gives rise to diversification and enables investors to generate maximum return out of a few startups that reach a unicorn status. Before going into detail about which strategy is better, let’s take a look at what value investing and spray and pray strategies actually are.

Value Investing

It is a commonly used venture capital strategy, where investors seek the companies that have a potential to produce large profits for an extended period of time. It is a concentrated investment approach that allows VCs to identify good startups after keeping in mind certain factors, including the cash flow position of a company, profit generation from its key operations, and its potential to grow in future.

Spray and Pray Method

Spray and pray method is a more diversified approach and is considered aggressive by some investors. A well-known name in the world of venture capital, Dave McClure, founder of 500 start-ups, is usually known as a spray and pray venture capitalist. However, he detests the idea of being characterized as such. A few years ago, he participated in a panel discussion of angel investors, where he said that he puts a lot of thought into his investment strategies, so it is not fair to call it spray and pray method; it is diversification with a thorough working behind it.

More Concentrated Approach or Diversified Approach – Which is Better?

When it comes to choosing between value investing and spray-and-pray strategies, mixed reviews are received from the market. For example, in an interview with McClure, he argued that a high volume and diversified investment strategies, like spray and pray, provide consistently stronger cash on cash returns than in the case of more concentrated scenario. He supported the idea by explaining his portfolio of 500 startups that around 60 to 80 percent of his investments do not reach any return less than 1x invested, whereas, 15 to 20 percent do provide 3 to 5 times the original investment. Moreover, 5 to 10 percent reach exceed the value of $100 million, but the actual return is generated from 1 to 2 percent of the startups that reach a unicorn status and provide 50 times or more of the originally invested funds.

When we talk about multi-party seed round, investors are compelled to earn their right to participate in the next phase due to the increased level of competition. It not only provides greater value to venture capitalists, but also turns out to be beneficial for entrepreneurs. According to McClure, using spray and pray at the seed level, collecting insight and optionality on early stage startups, and then doubling the bet on the successful investments, can actually break the perception of considering the concentrated portfolio strategy as industry best practice.

Flagship ventures, on the other hand, carefully select later stage value investments. They actively evaluate and fund the companies that are at an advanced stage in a product development, yet, these firms require additional funds and strategic involvement to reach their full potential. In a panel discussion of angel investors, Jed Katz from Javelin Ventures said that they invest as little as a few hundred grands to $2.5 million in the companies and dedicatedly invest the time and energy to expand their scalability. Another venture capitalist, Manu Kumar from K9 Ventures, said that he prefers all his companies to be a success, and this is the reason why he is very cautious about where he should invest. He further said that there are various strategies at a seed level, however, it doesn’t mean that one strategy is right and the other is wrong; they are just suitable at different levels.

Value Investment

Value investment strategy is one of the strategies used in the stock market, where investors look for the companies that have the ability to generate returns at a reasonable level during a sustained holding period. In other words, a value investor tries to find a company that is undervalued by the market, but it has a potential to show an increase in its share value once the market rectifies the error of valuing that firm. So, it allows an investor to buy a well performing share at a cheaper price.

How to Screen for a Value Stock?

Value investors are not concerned with the factors that usually cause price fluctuation in the market. For them, the factors that would impact a stock price are oil prices, inflation reports, wars, and hikes in the Federal rates. This is the reason why they look for stocks with strong dividends, earnings, cash flow, and book value, because value investing is not just about purchasing an undervalued stock, it is about purchasing a good stock that is undervalued. However, just having the strong fundamentals doesn’t necessarily mean it will be a value stock investment opportunity, because a company with strong and consistent earnings growth, attractive cash-flows, decent dividends, and a minimal amount of debt might represent a growth investment, and so, value investors won’t be interested in it.

An investor must keep three questions in mind when he seeks a high value stock:

  • How is the cash-flow position of a company?
  • If the company is generating profit from its key operations?
  • What are the future prospects in terms of growth potential?

Quantitative Aspects

How to assess a good value stock? (Just some RATIOS)

  • High Dividend Yield – The stock with an ability to generate high dividend yield, is considered a good value stock. However, a comparison should be made in the same industry.
  • Low P/E Ratio – It is a comparison between a share price and the earnings generated by each share. Paying less for more profit will be a good indication of a good value stock.
  • Low Price to Book Ratio – The lower this ratio is, the better it would be, as it shows how much will be left after the liquidation.
  • PEG Ratio – Value investing doesn’t simply means investing in low Price to earning stocks. Another largely accepted metric for finding out the intrinsic value of a company is PEG ratio, which is calculated by dividing the P/E ratio of a stock with its projected earnings growth rate over the years. It measures how cheap a stock can be while keeping in mind the growth of its earnings. Therefore, a PEG ratio of less than 1 means a company is undervalued.
  • Net-Net Method – According to this method, if a company trades at 67 percent of its current assets, an investor doesn’t have to adopt any other measure of worth, because it depicts that a buyer is getting all the non-current and intangible assets free of cost. But, there are only a few companies that are trading this low.

Qualitative Aspects

Value stocks can be found in any industry, including finance, energy, and even TECHNOLOGY. Yet, they are mostly commonly located in industries that have recently been hit by a difficult time, for example, the cyclical nature of auto industry give rise to a period of undervaluation of companies like General Motors and Ford.

Warren Buffett, one of the most astute investors of all time, learned the art of trading from Benjamin Graham, who was the father of value investing. Buffett has always emphasized that buying a good company at a fair price is far better than buying a fair company at a good price, which is true. Value investing is not about purchasing stocks at a bargain price and hoping for the best, nor is it about making quick money on a market trend. The main idea behind it is to invest in companies with strong business models.

It is important to have a long term strategy with value investing. The investors shouldn’t get faltered by short term market features, such as volatility or daily price fluctuations, because a good firm will not lose its worth even on a bad day. Although, value investment strategy is dependent on a stern screening process, yet, it has a potential to generate reasonable returns in the long run.

Basic Investment Strategies

Deciding on a suitable strategy to fuel your investment plan is based on various factors, including the risk appetite, the time span of an investment, and financial goals. Some investors stick to one particular strategy, while others use several strategies over a period of time. Although, investors usually have their own style that forms the basis of their decisions, yet, there are some basic investment strategies that can be employed to achieve your financial objectives.

Define Your Goals – Defining a goal is the first thing every investor should do. You cannot go about investing in the market haphazardly without having any plan in mind, or else you would end up losing all your money. Always devise a sound trading plan and define your financial goals. It allows you to identify which financial instrument is most suitable for you and enables you to take timely decisions.

Diversify – Investing is a broad term that can be intimidating for newbies as it involves a wide variety of investment vehicles and hundreds of strategies. However, it can be managed if you devise a flexible and effective plan. Today, investors have more investment options than were available to an average investor ten years ago. Having a few stocks in your portfolio might cost you more in the beginning, but it will be beneficial in the long run, because one of your investments might only generate 5 percent profit, while the other one gives you a 100 percent return five years later.

Monitor Your Investments – Investing in the same stock forever is never a wise option. Even the blue chip companies can turn out to be a failure, because the old perception of buying and holding the stock forever doesn’t work in today’s world with such an effervescent economy. Therefore, monitor your investments and take timely decisions to avoid losses.

Start Investing Early – The sooner you start, the better. This is certainly true when it comes to investing in the financial market. If you keep your money invested for a longer period of time, it will have more potential to grow. Patience is the key! If only you learn to practice patience and adhere to a long term investing strategy, you would definitely experience financial success and secure reasonable returns.

Turn Discretionary Income into Your Investment – It is important for you to not confuse your needs with wants. The president of the U.S. Retirement Strategy for Transamerica Retirement Solutions, Stig Nybo, once said that phone bills, cable TV packages, and other automatic services eventually become necessities, which doesn’t let the would-be investor jump out of it. He further said that you should question the things that have become the norm, but they might not be necessities.

Adhere to a Cash-flow Plan – It is an essential element that should become a part of your investment plan. Reinvest your money every month during your employment years and stick to a strict cash-flow plan, while making reevaluations as life progresses. This will definitely help you go a long way and enable you to achieve your financial goals.

Separate Emotions from Financial Decisions – Emotions play a major role in your investment decisions. But, it is very important to separate emotions from your short as well as long term financial objectives. Emotional involvement tampers with your judgment and performance. Just because everyone is talking about hot stocks, doesn’t necessarily mean it is going to be a good investment. Always analyze the trends and pay close attention to market news and events, as it allows you to take rational decisions in the long run.

Assess Your Tolerance for Risk – Whenever you invest in the market, ask yourself one simple question, “How much can I take and sleep at night if the value of my investment drops by 10 percent or 50 percent?” If a huge decline is going to hit you hard, you should consider investing the major portion of your funds in safe investments, such as, bonds or utilities.

However, bear in mind that it takes some time to be able to understand the gist of these strategies. Being a newbie, you might initially experience a high risk of loss if you follow one of these strategies. Therefore, observe patience and perseverance, because you will eventually get there.