The thought of being a venture capitalist seems pretty exciting, doesn't it? You come across some bleeding-edge technology that's going to change the world. You're there before everyone else. You invest, and the next thing you know, a company with a high-growth stock and a great business model, like eBay (NASDAQ:EBAY), has helped you to a 10-bagger, and you're rich enough that you've got people to wipe the noses of the people who wipe your kids' noses.
It is a beautiful dream. And you know what? You're right to have it. The key measure of success in investing is your ability to turn small amounts of money into large ones. And let's face it -- someone out there invested in eBay many years ago. You might as well look for the next one, because you really do only need one.
Think about that -- investing is one of the few forums where you can get it right one time out of 10 and still be extremely successful. The one just has to be a monster win to make up for the little losses.
Where are the winners?
But there's a problem with this thought process, as glorious as it seems. Most people who invest that way, over their lifetimes, will never have enough gigantic wins to make up for scores of underperformers. It's easy to point at a tech innovator like eBay, or even Dell (NASDAQ:DELL) right after it first went public around 1990, and say, "All you need is that," but when it comes down to it, that's a pretty tall order.
Back in 2001, coming off of some really heady success in avoiding the worst of the tech bubble, I got into the venture-capital business. OK, not really, but I did think I was smart enough to get into a couple of companies that the market had simply destroyed -- namely, Openwave (NASDAQ:OPWV), which had lost almost half of its value after the bursting of the bubble, and Avanex (NASDAQ:AVNX), which lost even more. The result was predictably bad for me since these companies still had a long way to fall, though it wasn't as bad as it could have been.
The problems with my investing in these companies were manifold, but among the two biggest were these: I didn't have much of an information or knowledge advantage (that is to say, I didn't understand the technology), and neither one had ever made a penny in profit. Consequently, neither did I.
It was a lapse in judgment, but it was one that investors make every day: In looking for the big score, we forget about the little companies that do something well and make good money doing so. In our Motley FoolHidden Gems newsletter service, companies that do things as mundane as count coins, make RV components, and build ovens have been extraordinary winners for us, and it's not as if these were nano-coins, laser RVs, and satellite ovens, either.
The problem with trying to invest like a venture capitalist is that you aren't one. (Unless you are, in which case, thanks for reading.) Venture capitalists pick areas of specialization and establish stakes in many different companies, some that are little more than a gleam in an entrepreneur's eye. If one fails, there are 15 more potential winners. And even if they all fail this time, it's pretty rare that the VC's whole nest egg cracks up along with them. VCs don't structure themselves that way. They work the way they do because they're investing other people's money, with a high payoff for success and a low cost for each individual failure.
Buy in to proof of greatness
Look at the great investors of our time, and you'll notice a common theme: None of them tends to buy companies before those firms show any ability to earn profits. They recognize that as being a low-probability game, with Charlie Munger going so far as to describe growth investing as being nearly indistinguishable from insanity. It would be great if Munger weren't so inhibited.
Most people should invest in companies in their earliest stages only after undertaking an extraordinary amount of research. It's easy to point at the few companies that did great, but for each one, there are hundreds -- and hundreds of billions of dollars -- that evaporated as they failed to live up to the dreamers' expectations. Spotting the winners is not easy, and it can be extremely costly.
We have a simple ethos at Hidden Gems: We want our stock selections to be the equivalent of fish in a barrel -- great, profitable companies that we just have to reach down and pick up. Oh, sure, it might be a lot more exciting to hope that a wonder drug will cure ugliness than to buy in to a turnaround funeral-home operator such as Alderwoods (NASDAQ:AWGI), but focusing on profitable companies teases out a great deal of the risk.
To me, that's the most sensible way to invest in small caps. As Tim Hanson noted in his superb article "The Secret of Superior Stocks," the overwhelming majority of the biggest-gaining stock picks over the past decade -- massive gainers such as America's Car-Mart (NASDAQ:CRMT) and Thor Industries (NYSE:THO) -- were profitable companies beforehand. It's not so much to say that for every eBay there are dozens of wrecked investments like Cyberian Outpost and iTurf, because that's an obvious parallel. It is something to say that for every unprofitable company that goes on to be a moon-shot success there are dozens of companies in out-of-the-way industries that go on to provide overwhelmingly positive stock returns. If you ask me, that seems like a reasonable place to look for investments.
Alderwoods is a Hidden Gems recommendation, Openwave Systems is a Motley Fool Rule Breakers pick, and eBay is a Motley Fool Stock Advisor selection. Dell has been picked by both Stock Advisor andMotley Fool Inside Value.
Bill Mann's second least favorite sport is track. His least favorite sport is field. He owns no shares of the companies mentioned, and he invites you to join him as his guest for a 30-day free trial to the Hidden Gems newsletter. The Motley Fool has a disclosure policy.
