Why it is a good idea to invest in “Unsexy Startups” & a bad idea to invest in “Trends”?

This article was first published on Yourstory.in. The original article can be found here

Over the last year or so, one interesting philosophy evolved at TM:

  • Almost everyone around was busy either in investing in e-commerce / group deals (ECGD) or starting an ECGD venture themselves (Bollywood celebrities included)
  • Specially e-commerce ventures where you setup a website to sell stuff which is easily available from offline shops (commodity e-commerce services)
  • We have an investment in Jumadi (commodity e-commerce) & have closely looked at a quite a few companies in ECGD domain
  • The topic of ECGD has been beaten to death at a number of heated discussions at TM-gang meet-ups
  • Based on our experiences we formed a strong hypothesis that lead us to believe that very few of these will turn out be real winners & most of these deals will end up losing money
  • We could also see that it will take 2-3 years before people involved will realise & accept this hypothesis
  • This rush towards a couple of sectors meant that most other sectors will get very little attention & money from investors
  • But still a number of good founders will start companies to solve problems they are passionate about without bothering about the ECGD madness
  • For TM the philosophy was, “While everyone & there mom is busy doing ECGD, we would like to aggressively go out, find teams of good founders working on so called ‘un-trendy / unsexy problems’, & capture all of that”
  • Following this philosophy, we did 24 deals in last two batches: Batch 6 & 7, as compared to 11 which we did in two batches before : Batch 4 & 5
  • None of these companies conformed to ongoing trends of their time
  • In Batch 6 we have two companies in e-commerce domain but they are far away from the general trend (www.engrave.inwww.zepo.in)

 

This was not a philosophy that we created by sitting around a table & nor did we make a conscious decision to follow it. As a team we always pay attention to our subconscious instincts & act on them. This was also one of those things that happened as we followed our instincts. Even we were not completely aware of the reasons behind our actions.  The questions we wanted to find answers for:

 

  • Why is everyone doing this?
  • Why are we not doing this same thing?

In last couple of months, we got the time to reflect on our decisions & have been able to understand them better. This post is an attempt to share what we have found & understood. Would love to get contributions from readers, please do share your thoughts.

 

Best investors “invest” in “highly undervalued” assets 

  • There is one common theme in the investments of great investors like Ben Graham, Warren Buffet, Charlie Munger, George Soros, Peter Theil, Paul Graham, Vinod Khosla & many more such folks
  • They were able to identify assets which were highly undervalued by the market in the prevailing market conditions
  • But as per their judgement & assessment, once unlocked, the real value of these assets would be much higher than the current market value
  • They reached these conclusions very early on without availability of a lot of data or market proof etc
  • Most of these realisations were very subconscious in nature, just based on their judgement of people, life experiences or unique theories etc
  • On top of the ability to spot these assets they also had the chutzpah to “pull the trigger” & make investments in these assets
  • Also, while investing in these assets, they were either able to spot some underlying trends which would lead to markets realising the real value of these assets (George Soros belongs to this category)
  • Or they themselves played a critical role in “unlocking” the value of these assets  (Warren Buffet & Paul Graham belong to this category)
  • After making the investments they either worked with people who managed these assets (exec management of the companies) or just waited for markets to correct themselves based on the underlying trends
  • In most cases, over time the value of these undervalued assets got unlocked & they ended up creating a lot of value for their shareholders & for themselves

Most investors invest in trends 

As we know most investors invest in trends (ECGD has been the recent trend among startup investors in India). For any sector to become a “trend” amongst the “startup investors of India” some or all of the following should happen:

  • There is initial activity in an undervalued sector, a set of founders take the initiative, work hard to build a business
  • A set of investors who spot them & take bets on these undervalued assets
  • This also happens to be the sector that has generated a lot of investor wealth / investment activities in bigger economies like US & China
  • Lots of folks start watching the developments closely
  • There are visible signs of success & activity starts to pick up (most of these are false signs like GroupOn going IPO or some company valuation going thru the roof)
  • More founders start companies in this sector & more investors starting actively scouting for deals
  • Startup media takes notice & starts writing actively about this sector, which is soon followed by the traditional media
  • The deal tracking firms start highlighting these sectors in the private reports they send to investors
  • Investment firms now have dedicated analysts tracking these sectors & sending their finding on daily basis to the Partners
  • Media continues to write about these sectors
  • As a result of all this, partners at firms hear the same thing from every direction : Media / Deal reports / Internal analysts / Partners at other firms / Founders pitching to them & more
  • Soon it becomes a self full filling prophecy
  • Now investors start believing that this is a huge market opportunity which is backed by “data / trends / media reports & many more things” & they should catch this wave at any cost
  • Same data & hype now leads to formation of founder teams with impressive back grounds on paper (name of colleges, names of companies they were at etc)
  • These are exactly the wrong type of founders who would only start a company when there is a lot of data to back their decision & as per them the chances of getting funded are more than 100%
  • Many such founding teams are formed
  • All these teams will start talking to angels / VCs , who have also seen the same data backing a huge market opportunity
  • A certain percentage of these founders get funded by investors eager to jump into the trend
  • This reinforces the same trend & leads to more activity of similar kind
  • The “hotness” factor of the sector continues to increase, the valuations surge across the board
  • New firms jump into the market & start investing aggressively into these sectors
  • Series B / C rounds are now 20-40 million / couple of companies are valued at Billion dollars
  • Seed rounds are ranging between 1 – 5 million

If you take off your 3D glasses, you can see the real picture behind any “hot investment trend” 

  • Valuations are sky high
  • Founder type is grossly wrong
  • At the peak of the trend lots of money gets invested at super high valuations in “low quality, opportunist teams”
  • The sector is over heated with competition & lot of excess money
  • No one cares about being capital efficient.
  • Rents paid are insanely high / salaries go thru the roof / selling prices are dropped to unviable levels in the name of building customer base
  • There is a mad rush to acquire customers & loads of money is pumped into marketing across media : Social Media / Searching Engines / TV Spots
  • The super capital inefficient scenario is surely bad for almost everyone who jumped in after this became a trend
  • Only folks who may end up benefiting are those who were in the game before it became a trend
  • Even they could get wiped out if they start thinking too much of this trend status of the sector & it goes to their heads
  • This could even lead to the whole sector getting wiped out, where none of the players succeed in building a long lasting business
  • As the founder of madhouse, I was part of a similar trend like this in the “DVD Rental” days (which was way smaller than what we are seeing today)
  • The players who survived had 20 million+ funding & today no one is doing the “DVD rental” business in India
  • The whole thing got wiped out, not because there was no demand – there are still so many customers with real need of watching good movies
  • These trends have nothing to do any particular sector (e-commerce / group deal / travel or DVD rentals) nor are these caused by fault of some particular individuals / firms
  • These things are part of how the human minds get affected by events happening around & the urge to do what others seem to be succeeding so easily at. Why should I miss it?
  • But each time a trend booms &  busts, the sequence of events is striking similar & results are also similar
  • Even if you invest in a company as part of a trend & that company achieves certain success, no big deal – you just rode the trend
  • And the returns certainly will be lower as compared to an well executed investment in an undervalued asset
  • The risks involved in trend investments are way higher even thought it feels other way around – it becomes kind of a lottery game
  • We used to get really puzzled when we saw some of the excellent investment minds in India investing in trends (or skipping good undervalued assets)
  • I am sure is that at the subconscious level they do realise the truth but they  are making these investments because the LPs (investors in funds) or the Senior US Partners who made money in the same sectors in US / China want them to do so
  • It is a combination of
    • Lack of complete self belief
    • Lack of authority

Who can be a good investor? 

  • Someone who has gained intense real life experience in startups
  • In the order of priority the following are the ways people get the intense experiences:
  • By starting & running their own startup once or more & going thru the whole cycle end to end
  • By working at one or more startups in the early stage, where they were close to real action, spent countless hours / days working & absorbed the whole thing
  • By investing in startups & working closely with them
  • Folks who go thru these intense experiences develop a certain level of subconscious capability to intuitively understand & analyse investment opportunities in startups
  • This allows them to recognise “investment opportunities in undervalued assets” which are away from current trends of the market
  • Alongside they also have complete self belief / chutzpah to pull the triggers & make the investments in undervalued assets which they believe will eventually rise in value
  • Startup investments are all about founders, they are only assets that one bets on
  • It requires a lot of courage to invest in just founders since the success might be huge (if it happens) but the probability of failure is higher – unproven entrepreneur treading on an unproven path
  • The hallmark of  a good startup investor is the amazing amount of trust they have in the founders’ ability
  • There is ZERO focus on ideas. They back the “founders” from whom the idea came out & not the founders working on the right idea
  • Also these investors need a lot of patience since these investments will typically have long gestation periods
  • And through this period they will need to put tremendous efforts in helping these companies stay course & overcome a slew of tough obstacles
  • Over time as these investors succeed with certain strategies, others will start to notice & start to follow a similar path without having the right reasons (for example even if there is a rumour that Warren Buffet is going to invest in a particular sector the stock prices shoot up)
  • Which would mean the buying price of assets which they were investing will no longer be “cheap”
  • At which point they need to have the ability to move on & find a new “class of undervalued assets” to invest in
  • Also, at this point a new cycle starts afresh again