A VC, A Value Investor and a Quant Walk Into A Bar

One minute, you are dancing in the clubs until three, waking up at midday without a care in the world. The next minute, you’re worrying about EBITDA. Life comes at you fast. And so it is that here we find ourselves talking about investing. That youthful hedonism seems a long time ago. 

But all is not lost, because if you can make a shit tonne of money, then you can have some middle aged or elderly hedonism too. I don’t know if it’ll be as good, but hedonism is hedonism!

There are only really two ways to make money through stock investing. The first and best way is by value investing. The principles are really very simple. You identify stocks that are priced below their intrinsic value, which is based on discounted future cash flows. Every so often, the opportunity arises to invest and you go in big. The most famous name in the history of investing, Warren Buffett, is a value investor. But there are other names, too, such as Seth Klarman.

The second way is through quantitative trading. Most of the time, you are not taking a long or short position but are instead taking a neutral position and trading on volatility. This is what most hedge funds and investment banks do.

Both are appealing, so let’s do a comparison that an MBB consultancy would charge you a few hundred thousand pounds for.

Value investing has the advantage that it works. If you can stay true to being hyper rational, valuing a stock accurately, and not getting swept up in bubbles or stock market crazes, you will make money. Not only that but if you do it well, you make a small number of decisions a year that will provide returns for decades ahead, as compounding works its magic. Whatever you do, don’t get in the way of compounding. The negatives, well, you have to be comfortable with being wrong. Through value investing you can outperform the market over time, but you’ll lag the market about one of every three years. You’ve got to be comfortable with someone shilling a crypto coin and ignoring them.

Quant trading has the advantage that you can make a lot of money very, very quickly. But it has the disadvantage that you need a few PhDs, a lot of compute, quite a few machine learning algorithms, and a good internet connection. The disadvantage is that because you are holding stocks for milliseconds, you are constantly at work. Personally, I’d prefer to buy and hold and then go do something else - like reclaiming my youthful hedonism.

Actually, there is a third way to make money from stocks: channel your inner Bernie Madoff and commit fraud. LOL. We’ll move on quickly.

Of course, you are thinking that there are more ways than this to get rich. And, hurray, there are! You can invest in gold or classic cars, but that’s just vibes. You don’t know if you’ll make money. I don’t know if you’ll make money. No one does.

Right now, you’re probably looking at your iPhone screaming, “macro investing, you idiot.” True, there have been some notable winners through macro investing: Ray Dalio and Bridgewater Associates had a fabulous multi-decade run and George Soros bet against the pound in 1992. But, the record of macro investing isn’t great because as fascinating as macroeconomics is, and it is fascinating, it’s hard to make money through it, which is why you don’t see many rich economists. Macroeconomics is an extraordinary science, but there’s still so much for us to learn. For example, the Phillips Curve, the relationship between inflation and unemployment held, and then it didn’t. So macro’s out.

There’s private equity, but it’s hard to truly evaluate the returns against the stock market, and most funds do not beat the market. So you pay a lot of fees for the pleasure of not beating the market. And anyway, private equity doesn’t build great companies, it destroys average ones. That’s not cool, bro.

“Okay, but what about VC?” Well, this is more interesting. Undoubtedly, VC has historically good returns: Peter Thiel’s initial angel investment in Facebook was $500,000. It’s reported that when he sold, those shares were worth over £1 billion. Andy Bechtolsheim invested $100,000 into Google. He sold his stock for a total of $31 million, a good return, no doubt, although that would now be worth billions. So we know people can make incredible returns from VC.

VC is not dissimilar from value investing in many ways. I know that sounds a little crazy, but VC, at its very best, invests in startups or people with the expectation or analysis that the value of the person or startup today will be minuscule compared to the value in the future. 

The difference is that in value investing you want to make a small number of investments because you’ll get losses through inclusion: investing in companies that do not generate good returns. But in VC, you’ll get losses through omission: by not investing in companies that do get returns because VC operates on a power law. 

However, at the moment, VC is highly concentrated in a small number of places - Silicon Valley being the primary one, and is overvalued. There are too many VC dollars chasing too few good opportunities, so funding rounds are crazy. It’s also increasingly speculative (see the pivot from crypto to the metaverse to AI) and attracts short-term moneymakers. Will VC make outsized returns in the future? Probably. The challenge will be identifying which VCs will make money in the future because the fundamental principles will always hold. If you are willing to invest and not make a return for 5 or 10 years but then make outsized returns, you can make good money in VC.

There’s also a second difference between value investing and VC: value investing is generally a buy and hold phenomenon because you think the business you’ve invested in will generate free cash flow and high returns on capital invested. The value of the business, and as such, the stock, will go up over time. Because you hold the stock of a company generating free cash flow, you don’t need any subsequent liquidity event. In VC, you invest in a start up, and then you need a liquidity event, either an IPO or a sale. 

This brings me to another point: regardless of what type of investing you do, fund fees are the absolute worst: it’s what makes Berkshire Hathaway so special. All of the investors in VC funds are paying high fees - so instead of letting compounding do its magic, you need a liquidity event to make a return so cash can be returned to the investors in the funds. Then you have to go and do it all again. In some big investments, like we saw with Facebook and Google above, the early investors would have been better never ever selling. The concept of the fund is suboptimal.

So VC is a good thing, but it can be improved, that’s for sure.

All of this has probably got you wondering where you can make money. You can start and build a company, which you should go do, right now.

But there’s a passive way: make more than you spend and invest in a low-cost index fund. Buy and hold. The longer you hold, the lower the probability of losses, and the higher the probability of equities beating other asset classes, like bonds.

Or just go and stick it all in red, whatever floats your boat.