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In Venture Capital, Should You Be a Momentum or a Value Investor?

 

As a venture capitalist, should you be a Momentum or a Value investor?

To simplify, there are two classic approaches to public markets investing.  The first is Momentum Investing, “a strategy to capitalize on the continuance of an existing market trend”, which usually meaning that the price has been rising in the recent past.  In VC, this means you source companies by talking with other VCs and tracking the investment patterns and new Linkedin connections of other VCs.  You identify the “hot” companies; network into them; and sell them on the value of accepting your capital. Likely signs of a Momentum investment: the round is oversubscribed and the entrepreneur has more negotiating leverage than VCs during the closing process.  

The second strategy is Value Investing, a strategy which “seeks to maximize returns by finding stocks that are undervalued by the market…Investors assess a stock’s intrinsic value…and compare that value with the stock price. If there is a significant margin of safety between the value and the price … the value investor will buy the stock.”  In VC, this means you identify companies that are not yet highly visible to the VC community; analyze them; persuade the company to sell you on the privilege of accepting your capital; then work to make them Momentum. You source companies by talking with industry executives in your target sector and reading industry-specific publications.  Likely signs of a Value investment: the company has challenges in filling out the round; the investors have more negotiating leverage than the founders during the closing process; the company has significantly better metrics (e.g. LTV / CAC, revenue growth, etc.) than comparable companies in the same sector that raised at a higher valuation.  However, Abe Othman, Partner at Indicator Fund and Head of Data Science at AngelList, observes, “Those companies don’t have a “margin of safety” though, in the traditional Seth Klarman sense of the word. If they don’t execute well, you’re screwed. “

I summarize Momentum vs. Value in this table:

Low Price/value

High Price/Value

Many VCs interestedAttractive but rare; if the CEO is competent, shouldn’t he negotiate better terms?Momentum Investment
Few VCs interestedValue InvestmentProbably a bad investment

Fintech investor Guillaume Amblard points out that Momentum and Value are never static classifications. “You could argue that when they were [raising] oversubscribed [VC rounds], Facebook, Google, Amazon, etc., were clearly Momentum, but [in hindsight] they were also Value.”  The reverse also holds: a Value investment can become Momentum, and then follow with a down round. VCs will almost always say that a given investment is “Value” at point of entry, because it’s sometimes uncomfortable to admit that they’re relying in part on Momentum thinking.

Today, some Momentum-centric venture capital investors have high paper returns.  Simple reason: most of them have known only a rising market in their careers, and in such a market the companies that are already hot can usually raise more capital and force growth.  But I don’t recommend confusing their luck (starting their career in VC at a good point in the cycle) with skill.  

The Momentum model is very attractive and tempting for four reasons:

  1. Immediate positive feedback.  When you invest in a Momentum company, everyone immediately congratulates you on your wisdom, sales skill, and success.   
  2. Sense of victory.  Investors tend to be competitive personalities, and investing in a Momentum company usually means that you “beat the competition”, which feels good.  However, my economics professors would say this sounds like you are about to suffer the winner’s curse.
  3. Low career risk.  Few colleagues will criticize you for investing in a known Momentum company.  But when you invest in a set of Value companies, inevitably some will fail before some succeed, and then you will typically be criticized and/or fired.
  4. Requires less analysis.  Christian Mundigo, Founder, Ackert Hook Holdings, observes that it’s easy to get positive (or negative) feedback when making a Momentum investment.  By contrast, properly valuing a company takes effort, and is particularly difficult in the opaque private markets.  

But the Momentum model also has some significant challenges for the investor:

  1. When the market cycle turns, Momentum investing has a high risk of blowing up.  As booms progress, more and more investors adopt a Momentum model.  But VC is historically and consistently cyclical. The Momentum model depends in part on more and more venture capital being readily available.  In 2000, LPs invested $104b into 638 funds, but by 2003, LPs’ commitment rate had dropped to just $11b into 161 funds. VC returns for that era were consequently poor.  “What has happened before will happen again…There is nothing new in the whole world.
  2. Weaker negotiating posture.  Momentum investors almost always argue that they’re investing in a “rock star management team”.  But if they’re so competent, aren’t they going to negotiate up the valuation to take advantage of their known status, up to the highest possible point?  Why, yes, they are. And then you have the winner’s curse.
  3. Momentum investing can be an effective strategy in the public markets, but it requires liquidity, which the VC market inherently lacks.  Victor Haghani, Founder and CIO, Elm Partners, published a research paper showing the superiority of trend following to return chasing.  He defines return chasers as following a model, ‘When the past 1-year return has been good, buy some stocks, and when it’s been bad, sell some.’  Paraphrasing: The key difference between trend following and return chasing behavior is that return chasing behavior is a flow with a lag, which continues as long as returns are either good or bad, while trend followers buy as soon as the return has been good and hold until the return becomes bad, and then they sell, and don’t do anything until the return has been good again, and then they buy and hold again, etc.  In other words, the trend follower adjusts his buying behavior much more rapidly, which requires liquidity. Haghani observed, “Since investors in private companies inherently lack liquidity, the Value model makes far more sense to me in venture capital and private equity.”
  4. The Momentum model’s perceived success is driven by survivorship bias.  Many Momentum investors defend their investments on the grounds of: 
    1. A tiny number of winners drive VC returns.  True; see AngelList’s data on power law returns in VC.
    2. It doesn’t really matter what valuation you pay for the big winners, because the returns are so high in the megacorns.  Sort of true; obviously your returns are lower with a higher valuation, but even the people who put money into Facebook at a perceived-high valuation did well post facto.
    3. THEREFORE: we don’t need to be valuation-sensitive..

That’s where the logic falls down.  It’s true that the VCs who invested in Facebook/Google did really well, but all the VCs who invested in other once-Momentum companies which flamed out did not do well.  But the media only focuses on the winners.  

The advantages of Value investing include:

  1. Most obviously, investing at a more-reasonable valuation implies much more upside when/if a company continues on to greater success. Most Mosteiro, a hedge fund investor, argues, “the psychology of Momentum is not nearly as reliable as Value – especially in the long run, which is the name of the VC game.”
  2. Lower-visibility companies and categories tend to attract fewer well-funded competitors.  In a Momentum investment, all of the spurned VCs were clearly excited about the space, so they end up funding some of the other players.  Seth Masters observes that the modal reason why certain investments become Momentum is because they’re part of a trending category (crypto, cannabis, AI, subscription commerce, etc.).  Likely one or two of the companies in a given category will be winners, but the problem is that for each winner in a hot category there are usually many losers, and it’s not easy to forecast which companies fall into which category.  

That said, the disadvantages of Value Investing include:

  1. Psychologically challenging.  Seth Masters, former CIO of AB, observes that well-researched Value investments tend to deliver better returns but make you feel queasy when you invest.  I’d add that public market investors don’t have as much of a problem with this psychological challenge, since they’re operating in a much more efficient market.  
  2. If a company needs future investors, they may not be interested in the sector or the company.  Some Value companies are in that position because the founder was not well-networked and/or not very good at fundraising, as opposed to the founder just being in a sector that’s not in favor.  If the Founder continues to be weak at follow-on financing, that “value trap” can hinder their continued growth.  
  3. Costly.  Running your own analytics and sourcing process has real financial costs.
  4. A Value research process doesn’t always lead to a Value investment.  Sometimes a Value framework might lead a VC to a company that is “hot” and running a Momentum round.  In that case, you just proved you did effective research; you’ve learned that other smart VCs agree with you on the market opportunity you identified.  If you start just by filtering for what are the Momentum companies, you’re likely putting the cart before the horse.  

Many years ago, Gus Levy, then head of Goldman Sachs , encouraged his colleagues to be “long-term greedy”.   From the founder’s point of view, it almost always feels better to run an oversubscribed, high valuation round and be perceived as high-Momentum.  But I suggest that in many ways a founder is much better off running a Value round rather than a Momentum round, for three reasons:

  1. Keeping the preference stack reasonable.  When your capital-raise and valuation runs ahead of your realistically deliverable potential, you run a material risk of disappointed investors and, far more important, getting nothing for your efforts.  For example, the founders and common shareholders of FanDuel got nothing from their sale for $465m.  
  2. Attracting and motivating competitors.  If many, many investors are chasing you down and viewing your data, that implies your concept is easily understood and widely appreciated.  Your spurned VCs are likely to invest in one of the other players in your space that they uncovered in diligence. Remember how they all said they wouldn’t sign an NDA?
  3. Time allocation.  An oversubscribed round can imply that you overoptimized for marketing to investors and the press, as opposed to potential clients.

I have looked but not found a formal academic analysis of the returns for Momentum vs. Value investors in venture capital.  This is an excellent topic for a graduate student research paper; please contact me if you pursue this.  

(I published a short version of this at PE Hub.)

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