“Active management has to be seen as the search for mistakes.” Howard Marks

Venture capital and value investing share many different elements but each system is based on a different mispricing. This is a critically important point for an investor to understand. If an asset is not mispriced, market outperformance is not mathematically possible. It is also important to understand that investments can be mispriced for different reasons.

In venture capital the mispricing occurs because very few investors or asset owners understand optionality. This allows a VC to buy what are essentially long-dated, deeply-out-of-the-money call options from companies at prices which are a bargain. By purchasing a portfolio of these options, a VC who understands optionality and who has the right deal flow due to “cumulative advantage” can substantially outperform the market. The basic formula is simple for a top 5% VC with the requisite cumulative advantage and deal flow. A VC invests in ~30 companies per fund and the distribution of returns among those companies will reflect a power law. One to three of the companies in the VC’s portfolio will overwhelmingly drive financial returns and 50% of the companies will be a total or near total loss.

In value investing the mispricing occurs because the market is bipolar (i.e., neither always rational nor always efficient). This allows an investor to sometimes buy assets at a price which reflects a discount to intrinsic value (i.e., a bargain) and to wait for a good result rather than trying to “time” the market. Avoiding mistakes is a focus of the value investor. There is no trick to value investing other than being smart by avoiding stupidity.

Value investing and venture capital investing are not the only ways to invest, but they share many elements like fundamental analysis, circle of competence, rationality, margin of safety and most importantly a search for a mispriced asset. Both value investing and venture capital investing require unique skills and very few people have that skill. Almost everyone (~97% of people) should buy a portfolio of low fee index funds/ETFs.

Many successful value investors do not like to buy an asset which does not generate cash flow since the “intrinsic value” calculation requires cash flow. It is important to note that intrinsic value is a very specific type of value. Intrinsic value is not the only type of value. For example, gold has commodity value, but no intrinsic value. There is nothing wrong with commodity value per se, but for some value investors gold is not their “cup of tea” (i.e., it is not their preference to acquire that type of value). For example, if you want to give Warren Buffett gold he will be appreciative of the gift, but don’t ask him to buy it as an investment since to do so would be what he calls speculation.

Factor investing, a type of tweaked index investing is yet another way to invest, but it is not value investing. A value stock for a factor investor is not necessarily a stock a value investor would buy.

When different types of investors disagree the disagreement is often based on different taxonomies and their chosen investing thesis. Investors have more in common than they may imagine. What Leo Tolstoy should have said was:

“All successful investors are alike; each unhappy speculator is unhappy in their own way.”

Notes:

“not mathematically possible” Item #1 here: http://25iq.com/2013/09/28/a-dozen-things-ive-learned-from-john-bogle-about-investing/

“venture capital” http://25iq.com/2013/07/05/a-dozen-things-i-have-learned-about-venture-capital/

“optionality” http://25iq.com/2013/10/13/a-dozen-things-ive-learned-from-nassim-taleb-about-optionalityinvesting/

“cumulative advantage” http://25iq.com/2012/10/06/the-matthew-effect-and-vc-performance/

“value investing” http://25iq.com/2013/09/15/a-dozen-sentences-explaining-what-ive-learned-from-warren-buffett-about-investing/

‘intrinsic value” http://www.berkshirehathaway.com/owners.html

“speculation” http://25iq.com/2013/03/02/investment-vs-speculation/

“factor investing”: http://25iq.com/2014/03/16/ben-grahams-value-investing-%E2%89%A0-famafrenchs-factor-investing/

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