Wednesday, December 20, 2006

Unlikely Experts

Venture capitalists (VCs) are investors who make high-risk investments in young, start-up businesses. Because such start-ups have little, if any, operating and financial history, VCs are often forced to make investment decisions with poor information—and are therefore anxious to get their hands on any bits of information they can. A recent New York Times article reports that many VCs are turning toward an unlikely source for information: their kids.

The article suggests that VCs believe young people are better able to assess new technology and trends than are older people like themselves. There may be merit to this argument, as many new products are designed for the younger generation—for example, social networking sites and mobile gadgets. The article goes on to describe a shift in VC investing research away from strict business and engineering analysis and toward consumer testing. Of course, the extraordinary part is using children's "expertise" to test products and perform business plan and market analysis.

While this notion may be new to the VC industry, it is hardly new in the investment world. Peter Lynch, former manager of Fidelity's Magellan Fund, has touted a similar investing approach in what has become known as the "Invest in What You Know" strategy, or sometimes as "common sense investing." Lynch argues that ordinary people possess keen insight on various products, companies, and industries--insight that can be leveraged. In economic parlance, he suggests that ordinary people possess valuable "local knowledge" that can supplant sophisticated quantitative analysis and help them identify undervalued stocks. A new mother will know more about which diapers are most reliable and which baby food infants like the most, just as a teenager will know more about what features a portable game player needs and how easy and fun a social networking site is to use.

Opinions on the efficacy of common sense investing are mixed, but it's hard to argue with Lynch in light of Magellan's performance under his management. Magellan had only $18 million in assets when Lynch took the reins in 1977, but grew to more than $14 billion in assets by the time he resigned as fund manager in 1990. Under Lynch's direction, Magellan averaged a 29.2% annual return and only underperformed the S&P 500 twice during his 13-year stewardship. There's no way of knowing how much of that is attributable to "common sense" as opposed to conventional research, but it's worth noting that Lynch credits much of his success to being able to "think like an amateur."

Discussion Questions

1. Do you think there is merit to the "Invest in What You Know" philosophy? Should this supplant fundamental analysis and valuation?

2. Lynch touted common sense investing for casual investors in a large, liquid, and relatively efficient market. How applicable do you think this attitude is to VC investing?

3. Magellan consistently outperformed the S&P 500 during Lynch's tenure. However, Magellan had significant exposure to international stocks, while the S&P 500 is a domestic stock index. Is the S&P 500 the appropriate benchmark? If not, what sort of benchmark should be used?

4. Do you think Lynch's success was due more to great skill or luck?

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  • At 3:41 AM, December 22, 2006, Anonymous Anonymous said…

    Isn't Warren Buffett also famous for not investing in businesses that he knows nothing about. For example, during the late nineties dot com boom, he steadfastly refused to invest in them because, as he put it, he didn't understand how they worked. As I recall, he was ridiculed during those days for being so utterly clueless!

    I do realize, of course, this comment has nothing at all to do with the 'amateur advantage'! But it does go with Peter Lynch's strategy of 'Invest in What You Know'.

  • At 10:46 AM, December 22, 2006, Blogger Chris Buzzard said…

    Buffett tends to follow a value investing approach by identifying companies with distinct comparative advantages, strong brands (or the potential for a strong brand), and good, honest management. The Graham-Buffet approach to investing focuses on a firm's intrinsic value and invests in firms that are undervalued relative to their intrinsic value. Intrinsic, or fundamental, valuation techniques rely on the present value of the free cash flow firms are expected to generate in the future.

    During the Internet boom, it did seem that many investors abandoned fundamental valuation in favor of relative valuation, in which a firm's multiples (P/E, P/CF, P/Sales) are measured against comparable firms. Some fundamental valuation proponents were critical of the Internet boom, because they didn't believe these firms possessed sound business models and because investors were using non-value-based analysis to guide their decisions.

    At the height of the boom, many investors (like Buffett) were criticized for missing the train on Internet stocks. Of course, soon after the bubble had burst and fundamental investors' portfolios didn't take nearly as big a hit as others did.


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