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.”
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 approach is Value Investing, a strategy which “seeks to maximize returns by finding stocks that are undervalued by the market. If there is a significant margin of safety between the [stock’s intrinsic] 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.
I summarize Momentum vs. Value here:
|Low Price/value||High Price/Value|
|Many VCs interested||Attractive but rare; if the CEO is competent, shouldn’t he negotiate better terms?||Momentum Investment|
|Few VCs interested||Value Investment||Probably 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 Momentum model is very attractive and tempting for four reasons:
- Immediate positive feedback. When you invest in a Momentum company, everyone congratulates you on your wisdom, sales skill, and success.
- 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.
- Low career risk. Few colleagues will criticize you for investing in a known Momentum company.
- Requires less analysis. Christian Mundigo, founder, Ackert Hook Holdings, observed that it’s easy to get positive (or negative) feedback when making a Momentum investment.
But the Momentum model also has some significant challenges for the investor:
- 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.
- Weaker negotiating posture. The “rock star management team” you invested in will wisely use their leverage to negotiate preferential terms, which can hurt the investor’s outcomes.
- 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. Haghani observed based on this research, “Since investors in private companies inherently lack liquidity, the Value model makes far more sense to me in venture capital and private equity.”
- The Momentum model’s perceived success is impacted heavily by survivorship bias. Many Momentum investors defend their investments on the grounds of:
- A tiny number of winners drive VC returns.
- It doesn’t really matter what valuation you pay for the big winners, because the returns are so high in the megacorns.
- Therefore, we don’t need to be valuation-sensitive.
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:
- Most obviously, investing at a more-reasonable valuation implies much more upside when/if a company continues on to greater success.
- 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.
That said, the disadvantages of Value Investing include:
- Psychologically challenging. Seth Masters, former CIO of AllianceBernstein, observeed that well-researched Value investments tend to deliver better returns but make you feel queasy when you invest.
- 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 out of favor. If the Founder continues to be weak at follow-on financing, that “value trap” can hinder their continued growth.
- Costly. Running your own analytics and sourcing process has real financial costs.
- 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.