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The Investor's Podcast (We Study Billionaires) - The Investor’s Podcast Network
TIP801: Value Investing Meets Venture Capital w/ Kyle Grieve
01:04:02
Kyle Grieve discusses lessons from venture capital that long-term value investors can apply to improve decision-making.
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You're listening to TIP.
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Let's imagine for a second that you made 100 investments over your lifetime. Now imagine that only three of those investments generated more than half of your total returns. That might sound crazy at first, because most investors think about returns like a bell curve. We imagine a few winners, a few losers, and a large number of outcomes in between. But that's not really how investing works. In reality, investing tends to follow something called a power law, in which a small number of outcomes drive the vast majority of results. And interestingly enough, there's one corner of the investing world that has developed a very deep insight into this dynamic venture capital. Now, if you're a value investor, venture capital might seem like the last place that you'd look for lessons on how to improve your investing. After all, venture capital firms primarily invest in early stage companies where most investments not only fail to make money, but often go to zero. But when you look a little deeper, venture capital has developed some incredibly powerful frameworks for thinking about asymmetric returns, risk management, position sizing, and long term decision making. And many of these frameworks translate surprisingly well to investors operating in public markets. Over the past few years, I found that some of the most valuable lessons that have improved my own investing have come directly from studying how venture capitalists think about their portfolios. Venture capitalists are forced to think differently simply because their investments are largely illiquid. They cannot easily just go and sell their positions. And that constraint leads to a powerful realization. One great investment can carry an entire portfolio, even when the majority of investments fall flat on their face. This way of thinking encourages investors to focus deeply on how businesses scale, how network effects can create extraordinary compounders, and how to add to winners rather than selling them too early. Venture capitalists also have fascinating frameworks around de risking investments, identifying key inflection points, and investing with an extremely long time horizon. When you begin applying some of these ideas to public markets, you start to see investing in a completely different light. You'll even notice that many legendary public investors arrived at similar conclusions despite never describing their approach as venture style investing. In today's episode, we're going to explore several lessons from venture capital that long term investors can apply to their own portfolios. So if you're interested in improving your skills as a longtime investor just thinking more clearly about outsized winners, understanding asymmetric opportunities better, and improving portfolio construction, I think you're going to find this episode especially valuable. So let's dive right into this week's episode on what investors can learn from the world of venture capital
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since 2014 and through more than 190 million downloads, we break down the principles of value investing and sit down with some of the world's best asset managers. We uncover potential opportunities in the market and explore the intersection between money, happiness and the art of living a good life. This show is not investment advice. It's intended for informational and entertainment purposes only. All opinions expressed by hosts and guests are solely their own and they may have investments in the securities discussed now for your host, Kyle Grieve,
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Welcome to the Investors Podcast. I'm your host Kyle Grieve and today we're going to discuss lessons from the world of venture capital that long term investors can utilize in their own investing strategy to improve their own decision making. Now you may be thinking that VC is a very strange place for value investors to look for insights. Don't VC businesses primarily invest in story stocks where 90% of them or more go to zero? And I can't argue with you on that point. Yes, VC invests in a very specific way, but as I learned more and more about the deep details of cloning from my co host William Green, we can clone just the parts that we find useful and disregard the rest. While VC does a lot of things that I don't think value investors really need to bother themselves with, they are also masters at leveraging the power law. When most people think about the world, they think in more linear terms. Let's say we are thinking about the average return on investments across the broader investing universe. If you looked at, let's say, 100 investments, there would be some that do very, very well, there would be some that don't do so well, and there'd be a bunch in the middle of that. If you looked at a graph, most of these stocks would cluster around an average return of, let's say, 8%. You can imagine this on a bell curve, but investing, especially in vc, doesn't follow a bell curve. They work with power laws in which a tiny number of outcomes drive most of the results. A VC business was outlined in the introduction to Scott Malaby's book the Power Law. The business was called Horsley Bridge. It operated from 1985 until about 2014, and during that time they backed a large number of startups over 7,000. The fascinating part about Horsley Bridge was that 60% of the returns that they generated over their time in operation was only from 5% of their capital deployed. Now, to give you some context, in 2018 the S&P 500 derived a 9% return from the top 5% performing sub industries. I think this number today is probably a lot higher due to the Mag 7, but I think you get the point. In VC you must utilize power laws. Otherwise you will never be able to offset the large number of losers that you're going to find yourself holding with very little ability to exit these investments. So why am I harping here on power laws? The longer that I invest and the more I research investing legends, the more I realize just how prevalent power laws are in the portfolios of even value investors. I think about this a lot and I enjoy looking at data on this. Unfortunately, most investors do not allow access to this information, so even if I wanted I wouldn't be able to get it. But I can access my own. So I'll be coming up on about six years investing in stocks by the time you're listening to this episode, and in that time my own returns have followed power laws. The best stats that I can show off here are that only two positions that I picked have contributed 45% of my investing returns since inception. The reason for this is simply power laws. If I looked at my portfolio as a bell curve, it's pretty clear that the model just doesn't work. These two options would be the fat tails that caused the curve to look drastically different. So what takeaways did this teach me that helped me learn more Great lessons from vc? There are a few. First off, a tiny number of winners completely dominate. Knowing this going in means that I should try to keep finding these winners, but it probably won't happen very often. In my equity investing career, I've made approximately 40 investments and only two of those have really produced outsized gains, meaning only 5% of my decisions are producing these incredible results. With that in mind, I have a constant fear inside of me and that's that I will erroneously sell positions that could follow this power law inside of my own portfolio. And I do follow my sold positions to see what's happening and try to find out if there's any data that I can take away from that. So I have two positions that have been multi baggers since I sold them. One of them is a micro cap called Gatekeeper Systems, but the other business is probably one that many of our listeners here are going to be a lot more familiar with, which is Micron. So this was a business that I think I was a little bit early on and had I known that AI would have become much more prevalent and discussed like it was today, I definitely would not have sold any of my shares unfortunately for me, I bought my Micron shares at a cost basis of about $45 and I ended up selling them at about $53. I held them for a little over two years, so my returns on this were very far from seller at around 9%. But I just checked the share price today, which I try to avoid because it's so painful and today Micron shares are $420. So I would have had a 9x on this one had I held onto my shares. Whoops. Luckily for me, my investing strategy has shifted over the years and my goal is to find businesses that are continuing to improve and as a result are increasing their cash flow. As long as that's happening, I won't sell the business unless prices get into bubble like territory. That's worked very well on my top two, which are still in my portfolio and I believe are continuing to improve and will probably produce ever increasing cash flows over the next few years. Now, the second rule I learned from this exercise is that I will have a handful of investments that contribute very modestly. So positions 3 through 10 all contributed about 1 to 4%. These are solid contributions, sure, but I have to strategize properly, just like a VC would do. The nice part about VC is that they're locked into positions for a long duration. So if I borrowed that thought pattern from them, these modest contributors might eventually show a massive winner. It's just going to take some time to develop. Now, the modest contributors are great to have because yes, you are still making a return and you have a lot of future upside if they turn into these kind of power law winners. This will rarely happen, but if you're a long term investor, you put yourself into a great position to take advantage of power laws simply by nurturing these modest contributors rather than just selling them for a small gain. This is a framework that I should have paid much more attention to regarding Micron. The final lesson here is regarding detractors. Of course, having these businesses that are contributing massively is a great feeling and I want more of those over the following decade. But the key, as I highlighted by discussing Horsley Bridge, is that there is a price to pay. You simply will not get a 25% contributor without having some losers. And that might mean a company that you know contributes minus 5%. The way I think about losses isn't as a sign of incompetence. Look at Buffett. He sold hundreds of companies. Each of those sales could be an admission of error, but I think Buffett understands that success comes at a cost and that's the cost of being wrong. And if you want to be right and get these long tail gains, you have to accept that you'll eventually lose. And probably quite often on that journey, VC understands that hit rate is just not that important. Their hit rate is actually quite low, as I've already shown you. It might be, you know, 10%, maybe even less. The beauty of investing in equities is that you can buy businesses that have much better protected downsides in vc. These are usually very illiquid investments where if things don't work out, you pretty much have no way of exiting your investment. Meaning you have a very good chance of losing everything that you invested in equities. If you have some value investor blood in you, you can try and find businesses where if you lose, you don't lose your entire investment. So I've had a number of losers, but none that have gone to zero. This gives me more capital to recycle back into my big winners or to my moderate winners. In the very early days of vc, there was a public company that was basically a VC investing vehicle. It was named American Research and Development, or ard. It was led by a French professor named Georges Doriot. One of the very early investments was in a business called Digital Equipment, which specialized in transistors. Ard provided a $70,000 investment and a $30,000 loan. This ended up giving Ard about a 77% stake in Digital. They ended up holding this business for 20 years, had produced 80% of all of ARD's gains as a public company. Classic power law. Let's transition here to some of the important laws that VC discovered through the lens of business models now. So there were two major laws discovered inside of businesses that have produced some incredible winners of the last few decades and I will expect will probably continue to produce outperformers in the decades to come. So in 1965, Gordon Moore, who helped found intel, found something very, very interesting. Every year the number of transistors on integrated circuits was doubling. This was the beginning of the circuit when technology was advancing very rapidly. By 1975, he had to revise that to doubling just every two years instead of every one. Gordon's law is important and has very far reaching implications. Yes, it was originally intended to discuss just transistors and circuits, but I think it applies to all sorts of technologies when you really think about it. Look at the cost of TVs today versus 20 years ago when LCD TVs were first released. You know, they cost four or five thousand dollars now you can get them for a few hundred bucks. I think when viewing commoditized technology, this is where the law probably still stands. And I would simply say that as a technology becomes better and better, costs just tend to fall. You could see this on things like the cost of modems and computers as well. Now, around the same time that Moore's Law had been discovered, another technologist named Robert Metcalfe was busy inventing Ethernet. Ethernet is a simple way to connect computers in a local area network to each other. One of the problems that Metcalfe was running into was why on earth anybody would ever actually need to use the Ethernet. And what Metcalfe discovered was actually the precursor to network effects. If you have one computer on a network, its value isn't very high. But as you add more and more to the network, the value goes up exponentially. For instance, let's say you have one computer. Then clearly it's not that valuable because it doesn't have anyone to talk to. But let's say you have two computers. Okay, now it's getting a little bit better. You have one connection between those two computers. Now we'll say you have three computers. Now you get three possible connections. Values going up. Now you have four computers. You have six possible connections. When you have just 10 computers, you have 45 possible connections. So Metcalfe's law states that the value of a network grows approximately with the square of the number of users. So if you can find business models or platform companies that take advantage of this law, you can find some pretty incredible businesses. Businesses like Amazon, Meta, and Google all took advantage of this law many decades after Metcalfe had already discovered it. And I think many new businesses will continue to be built on the power of network effects. Now, the beauty of Metcalfe's law is that as a business scales, it often has fixed costs that don't increase as quickly as new users are onboarded. This means that the business can scale and improve margins simultaneously. And this is pretty much an investor's dream scenario. And to make things even better, it's very hard to displace a very strong network. For someone to knock off a business like, let's say, Meta, you need to get 3 billion monthly active users. Doing that is basically impossible. And that's part of the reason that Meta has been such a big beneficiary of Metcalfe's Law. In 1974, a rising venture capitalist named Don Valentine raised $5 million for the tech startup Atari. For listeners who are unfamiliar with Atari, it was essentially the first gaming console to gain widespread popularity. The problem with Atari was that it was run by engineers and not by business people. But Valentine had a lot of ideas. He thought that the business needed to do two things to succeed. The first was to modify the game for private use. So its first game was Pong, which I remember playing as a young kid, and it was almost like a game of digital ping pong. The original developers wanted the game to be played in places such as bars across the country. Now, Valentine realized that the business needed a much wider audience to succeed. And this is why Valentine invested in the business in the first place, because he believed that it could have a wider audience. Now, the second aspect it needed to focus on was in distribution. There was just no way to distribute consoles without having a partner who had a lot of customers to distribute them to. Valentine thought they should partner with a prestigious company, and they ended up partnering with Sears. Now, after Valentine visited Atari's hq, which he referred to more as a clubhouse, he came away not entirely sold. He wasn't willing to invest more into the business until it was very clear that Atari was becoming de risked. Now, in the power law, Malabi writes, he would risk his money, in other words, only when Atari had been at least partially de risked. That was a major lesson that I've already learned from my own investing experience, and it's one that I think is a very valuable tool. Now, a portion of my portfolio was invested in businesses that I consider quasi venture type bets that are publicly traded companies. Now, I'm lucky in that I don't have to be sold on a specific narrative. The businesses that I buy are actually generating cash and profits. It's a requirement. Now contrast that with vc. They may invest into just a person with an incredible idea. I don't take that route at all. But the framework of investing when a business becomes partially de risked, I think is a very, very good one. Let's look at arguably Warren Buffett's most successful investment in absolute terms. Apple. So Apple was founded all the way back in 1976. Apple had a number of incredible products. The iPod in 2001. The iPhone in 2007. The App Store in 2008. And yet Buffett didn't start buying Apple until 2016. Plenty of VC firms have made an absolute mint as early Apple investors. But it was clearly not a VC type bet. When Buffett started buying it in 2016, it wasn't, you know, this kind of scrappy startup that was struggling to find product market fit. It was already a highly cash Generative business with a deeply loyal customer base. It also had a dominant ecosystem and was generating recurring revenue through a multitude of different services. In other words, the technology risk had largely faded, the product risk was gone, and its distribution risk had largely been solved many years before Buffett's first purchase. Now, the remaining questions for Apple that Buffett considered were no longer really about technology. They were more about the durability of the business. And if the business was undervalued. While some VC firms might have 100x their investment on Apple, Buffett knew that he would never make those kinds of returns investing in Apple at this stage of its growth cycle. But he also didn't need to underwrite whether certain products they had would actually generate profits. He had a large degree of certainty that Apple would continue selling products for years to come. I assume that Buffett would have been aware of Apple when it went public back in 1980, but you know, back then it was really a tech stock that he had zero interest in at the time. Now, by the time 2016 rolled around, Buffett observed that much of the risk had been removed from Apple as the business scaled up. And he saw it trading for simply a cheap multiple. So he sized up a massive position because he saw the risk profile change. And that's the lesson here. You don't necessarily have to size up massively. You can also take a smaller initial position in a business that you like, then add it as it de risks over time in public companies. What would you look for in a company that's, you know, de risking? To understand this, we have to look at exactly what needs to happen for an investment to blow up. And this doesn't mean necessarily going to zero, but maybe just going down, let's say 50%. I would say there are a few things that would need to happen. One, paying too high of a purchase price. If you buy something that's overvalued and the market re rates it by shaving 50% off from its multiple, you're going to lose 50% of your investment. No good. Second is the risk of cash flow streams either reducing in growth, stagnating, or even going negative. Here it's important to remember that the market has expectations. If the market expects a business to grow its cash flow at, let's say, 20% and then it only grows at 10%, the business will be viewed in a different light and generally the business will get a lower multiple, leading to a lower terminal value. And third here is leverage. If a business is using leverage for its operations, you will always have some sort of risk. If the business can't service its debt, then there's a chance that the company will be liquidated, which generally is a pretty bad thing for holders of its equity. And fourth is competition. Who is out there looking to eat a company's lunch? Are they succeeding in doing so, or are they having great difficulty stealing market share? If you have a business with no competitive advantages, then competitors will easily steal market share, leading to reduced profits and reduced margins. Now, I could go on and on here, but these four are areas that I think are pretty simple to follow. Let's say there's a business that you find that you really like but simply has too much leverage. Let's take a quick break and hear from today's sponsors.
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If you take the VC view here, you might just choose to not invest a penny, but simply wait to see how things play out. And perhaps the business is really good. It has competitive advantages galore and seems to be stealing market share, but also has five times, you know, net debt to cash flow. That's a high number. I know I wouldn't be ecstatic investing in a business with that much leverage. But let's say you throw it on your watch list and as time goes by, the business starts getting cheaper and they get their leverage down to, let's say, two times net debt to cash flow. That to me is quite palatable. Then you can decide if the business is de risk enough for you to be comfortable making an investment. Buffett loves looking at businesses that get de risked simply by looking at a share price. If it's cheap enough, then things don't have to go perfectly for him to make an adequate return. When he bought Apple for instance, at around 10 times earnings, even if cash flow didn't grow at historical levels, he still had a very good view on the terminal value, which was why it was such a success for Berkshire shareholders. Another lesson in the research phase on investing regards popularity. Now there are a lot of different opinions on this and in VC there are many forces at play in the VC world. Businesses which require funding often are funded by the biggest firms first. Think Sequoia. If a really hot startup needs capital and access to highly successful people who can help them scale, they're contacting, you know, Sequoia or Andreessen Horowitz first. If you're some small VC firm that has come across a business that requires financing, there's a really good chance you might be the 50th in line of their preferred investors. This means that you are more or less left with the dregs that others don't want. And this is exactly what can happen in public markets. So a great story is expel this is an American business that specializes in paint protective film that is often purchased by, you know, high end car owners to protect their vehicles paint jobs. Now the business was unable to find funding in the US so it ended up listing on the TSX Venture Exchange up in Canada to get funding. Now who knows how many VC firms passed them up saying that their product could never compete with the likes of 3M and yet this business went from being a 20 cent penny stock all the way up to over $100. So if you were investing in the business in its early days, you were clearly willing to be early and very unpopular. Where many investors attempt to avoid these types of investments, they are often the best ones that you can make. Peter lynch thought a stock was even more attractive when he'd speak to the CEO and learn that he hadn't taken an investor meeting in ages. When you find a business with a lack of interest, you were looking at an unpopular business, sure, but they can remain unpopular for a very long time, and there's a good chance they can remain unpopular before the market gets kind of a wider acceptance of the business and starts to even like it. So if you're a value investor who's only focused on buying businesses that everyone knows and likes, chances are that you're going to pay a pretty high price, which turns up the risk on your investments. This very well could be a position that I put myself in when I started purchasing Lumine. So I started investing in Lumine at the end of 2024, but I've added a lot to the positions over the years and now my cost basis is around $33. So at this point it's been a pretty major loss for me, with shares trading for as little as $20 over the last six months or so, although it's kicked up recently. But when I started buying, the business was generating a lot of cash and still doing so today. But the multiple has obviously changed drastically at this time. I generally like looking at serial acquirers via a price to operating cash flow metric. When I first started buying Lumine, its price to operating cash flow was about 55 times and it stayed there or went even higher for much of the time that I owned it. But since July of 2025, that multiple has contracted considerably, all the way down to 16 times where it sat a couple weeks ago. Now, I think it's fair to say that Lumine, its sister company Topicus, and their parent company Constellation, are names that are quite out of favor today. Only time will tell if the multiple will ever get back up to those lofty numbers of the past, or if the decline in the terminal multiple is here to persist over time. My guess is somewhere in the middle. This business has grown operating cash flow at a 90% kegger since 2022, and while I don't think it continues that kind of growth, 30% seems very reasonable as a number to use over the next few years. I don't think a business growing cash that fast deserves a depressed multiple like that. Now, over that same time period, Walmart has grown operating cash flow at just 13%, yet commands a price to operating cash flow of 24 times. So the disconnect here seems very off. But I don't want to digress too much here. The point is, perhaps I made a mistake buying lumine at such high multiples and luckily I've averaged down considerably. So we'll see what happens. I'll keep you up to date. Now, I want to stick with some VC lessons here regarding adding to positions, because I think VC has a pretty good framework on that front as well. So one member of Kleiner Perkins, which we'll refer to here as kp, made a powerful point on risk. By focusing exclusively on white hot risks in projects, you could find out whether the venture was likely to work while risking as little capital as possible. Now, I'm not sure about you, but to me this sounds like an excellent use of Annie Duke's concept of kill criteria. Now, for those of you who are unfamiliar with the concept, I'll break it down for you. So kill criteria are used to help improve decision making regarding when you should kill or quit an idea simply because the facts change things. Now, you need two things for kill criteria to work. A state and a date. In investing, you might pick something like where a few important KPIs need to be in order to observe whether your thesis is playing out. And then you assign a date by which they should achieve those KPIs. By now, if that date passes and they have achieved all the KPIs, well then that's great. There's no action required other than maybe, you know, adding to the position. But if they fail to achieve them, well then you know that you can sell out of that idea. So here's how KP used white hot risk to help them size positions appropriately. So in 1974, a member of KP had an idea to create his own company. It would create backup systems for computers in case they crashed. And that way if the computers were to crash, the data wouldn't go missing. So this is a highly valuable service, but there was actually no fail safe that existed at that time. So the theory on this idea was that there are some high technical risks but very low market risks. Once KP figured out how to deal with some of the white hot risks, mainly if this could even be done or not, KP invested 50,000 into the project. The business was named Tandem. Now, this represented only 1% of capital. If things didn't work out, they weren't going to lose their shirts. Now. Once Tandem gained some momentum, they went out to raise more capital, but they didn't have any takers. KP then decided to take the risk on themselves and invested a million into Tandem in return for 40% of the equity. As time went on, these investments turned out very well. They went on for a series B funding round and in the short time between that and the company's inception, its revenue increased 14 times, which was what other VC firms were looking for in order to invest. So here you see what KP was doing as the business model was validated by the numbers, not narrative. They increase their cost basis on the bet. This is a technique that I absolutely love, but one that I think value investors have a lot of difficulty executing on. And the reason is quite simple. Value investors tend to get happy when a business decreases in price, but when it goes up, they begin to get a little nervous. They're thinking is the business's price and value fully converged, which can often lead them to sell out of a position. Even when the business is just getting started in its growth journey, what VC gets right is the ability to hold onto businesses that can compound in value. KP didn't sell during this rapid rise up in the funding rounds. They continued to add to their position. That is a lesson worth looking at when looking at public equities. I think there are multiple ways to view this advantage. First off, what are all the available options to add to a position? You can add when the price drops, you can add when the price doesn't move, or you can add when the price rises. But I think the best time to add is based primarily on the fundamentals of a business. When looking at it in that light, you can add when the business growth declines, stagnates or grows. I don't know about you, but my preference is to own businesses that are continuing to grow in earnings power. Now, the beautiful thing about public equity markets is that fundamentals and perception are often at complete odds. For instance, going back to my Lumine example, the business is continuing to grow and there's no argument on that front. You can look at the financials and see that the business is continuing to generate more and more cash. But the market's perception is that Lumine is an AI play that will ultimately lose in the long run. So even though the fundamentals of the business are continuing to get better and better, the share price has been absolutely punished. Since I am of the belief that Lumine will continue to grow for many Years to come. I think this is one of the best opportunities that I've had to increase my position size. Now, I may have to wait for the position to generate a return, but I think that weight will be well worth it. Now, this is an example that isn't usually used in vc. In vc, they're more interested in averaging up. This means that they are taking their equity inside of a business up, but paying a higher and higher price for it. This is where I think there is the largest divergence between value investors and vc. Value investors do not like to take this line of thinking because they believe it's antithetical to the value investing philosophy. If a value investor buys a stock for $20, the business as well, and now the shares are trading at, let's say, $40. They're anchored to that original $20 price. This means even if they wanted to add to the position, the anchoring bias makes it very difficult for them to justify adding to it. Now, I used to think this way too, and it held me back from adding to some of my really good businesses in my portfolio in a very meaningful way. As a result, I've shifted more towards the VC model of averaging up. One of the catalysts that really got me thinking this way was from my learnings in my very first episode I ever did when I was hosting the Millennial Investing podcast. So I asked my guest, Paul Andreola, his thoughts on averaging up, and here was his reply.
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I love averaging up. I love it, I love it, I love it. I've learned the hard way to love it. So much of this is all through experience and what I've dealt with. So my biggest mistakes in the market have not been, hey, I bought this stock and it went down. That's normal. It happens to everybody. My biggest mistakes have always been, hey, I've got this one stock and it's going up, and why don't I start selling it? Because it's going higher and I'm making money. You know where I really learned this the hard way is I had a company years and years ago called Bowflex. And Bowflex, if you're old enough, you remember those exercise machines and you name it on, on tv. But it was a company that was growing very rapidly. It was an undiscovered company. I'd bought it around a dollar a share, and within about a year and a half, it was, it was already 10x, it was like 11:12. And here I am thinking, I'm a genius. I'm selling this because I'm up Even though the company was still putting out the numbers, it was still very cheap based on its growth profile. And I'm selling it, right? And this thing eventually, I think after splits and everything, it went about to 250, $300. I mean, still around. It's called Nautilus on the New York Stock Exchange. It was just a monster. So my mistake wasn't sitting there and owning the stock. My mistake is actually how I held it and how I sold it, right? I should have been averaging up all the way. Instead of selling it all the way up, I should have been averaging up. So, you know, having learned that from so many situations, if you find a company that that is fundamentally still proving out your thesis that you can argue is still undiscovered and giving you a margin of safety to what you think the valuation is, it's telling you you should keep buying it, right? Keep buying it until your thesis breaks or until you have something else that's just egregiously more obvious than this one.
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Now this is a great lesson, but again, it's a lesson that only some value investors really ever take advantage of. What I think is really important to anchor on isn't your initial purchase price. If you're correct on a business that can compound its value, chances are very high that you'll never be able to buy the business at the same price that you originally bought it at. Let me repeat that because it's vital. If you are correct on a business that can compound its value, chances are that you will never be able to buy the business at the same price that you originally bought it at. Now what you should focus on is whether the business is getting better and better and what the multiple is. Let's say you paid 15 times earning for a great business. It compounds earnings at, let's say 26% for three years, meaning that earnings have doubled over that three year time period. Now the business begins to get more and more interest from the market and it eventually gets bid up to a higher PE multiple, let's say 30 or even 40 times. But then a market corruption happens and the people begin selling the stock. This coincides with a bad quarter where the company EPS drops because of, let's say some sort of one off expense that won't be repeated. Now investors are super frightened, causing even more selling. So now the PE gets down to 12 times. Well, now you can buy that company at a higher absolute price, yes, but at a lower evaluation than when you first bought it. This is a strategy that I learned a few years ago and has been a total game changer in how I manage my portfolio. The two winners that I discussed earlier that make up the lion's share of my returns follow this to a tee. The two companies have continued to get better and better over time, rapidly increasing earnings power. But the multiple has moved around in a very volatile manner. When the multiple comes down to my original level or below, I'll add to the position. Now I know what a common argument will be. If you're adding years after, isn't there a risk that the business will just stop growing at historical rates, meaning you should now pay a lower multiple? Now I think for classic value investments that are, you know, mature growth companies that just aren't growing, this is a very valid assumption. If you're buying a business purely for its assets that are unlikely to appreciate in value or increase earnings power, then yes, you're absolutely right that over time you probably should be paying a lower multiple. But those aren't the businesses that I'm referring to. I'm talking about growing businesses that tend to be a little bit earlier in their growth stage. For those businesses, they can still have multiple years of growth ahead of them where they can continue to grow at historical rates. And even if you add a margin of safety by heavily discounting future growth rates, you can find some businesses that make a lot of sense to buy even when the price looks optically expensive to 99% of the market. Now, if you're interested in holding long term businesses, you will need to take a lesson from VC and get comfortable holding positions that fluctuate wildly in price. And these will often move in directions that make you feel very uncomfortable. Now I want to move to the question of concentration versus diversification because VC has some very interesting takes on that as well. If you look at some of the larger VC firms like Andreessen Horowitz, they own over a thousand companies. But if you look at the early days of vc, some of these firms were concentrated. Like I'm talking about single digit number of positions now. To me this sounds incredibly dangerous given the wide range of outcomes that early stage businesses have. Of course, we hear only about the VC firms that were successes due to survivorship bias. We failed to see the VC firms that made, you know, 10 bets and all of them went to zero, never to be heard from again. I think this speaks to the inherent riskiness of small VC firms. In the adolescent years of vc, these firms had very little capital, maybe you know, a million dollars. So if they made bets in, let's say 50 to $100,000 increments, that's only 10 or 20 bets. If they couldn't access more investors, that was it. And they were forced to work with what they had. The Andreessen Horowitz model makes a lot more sense to me. It's probably a little too much diversification, but they know what they're doing better than I do. So the lesson here is that concentration is required to get your first win. Then diversification is probably needed in order to survive. And I think we see the exact same thing when looking at public equity investment funds. Really talented managers build a good track record simply by leveraging their edge as a small guy. Fewer positions, higher concentration, less efficient markets. Once they begin scaling and collecting assets, they lose that edge and conform to the institutional imperative of just mirroring their benchmarks. They diversify into hundreds of positions. They can't buy stocks in less efficient markets, and their concentration levels drop precipitously. But the good news here, if you're not an institution, then I'd highly suggest playing to the strengths that you have available to you now. In 1998, Sergey Brin and Larry Page, the founders of Google, were looking to raise money for their, at the time, undifferentiated product. There were 17 other firms engaged in Internet search services, but Brin and Page felt the product was a little bit better Now. One day they found themselves waiting to speak to a highly successful Silicon Valley engineer named Andy Bechtelsheim. Andy gained popularity because he created two technology businesses that worked out incredibly well for him. The first was Sun Microsystems, and the second was Granite Systems. Granite Systems had sold to Cisco for $220 million, and Andy held significant equity in that business. So at this stage of his life, he was more of an angel investor. Andy spoke with Bryn and Paige about their business, and while they didn't have a business plan, nor were they even incorporated, he decided to write them a check for 100k because he liked them. And this kind of money was obviously peanuts for him. And the lesson here might seem small. Some successful entrepreneurs with deep pockets help fund Google's early days. So what? The point is how money gets recycled. And I think that's a much more important lesson than investors think. And it happens in all sorts of markets, not just vc. Since I tend to invest in smaller businesses, there's even a recycling of capital into smaller positions. The theory is this investors invest into large or medium sized companies. After a bull run, they take profits. They now redistribute those profits into more opportunities. Now, since the Opportunities at larger market caps can get pretty thin during a bull market. They tend to look down market to smaller companies that aren't yet discovered. The best example of this today is to look at, you know, software versus AI based companies. In the first half of 2025, there are approximately 377 billion in AI based financing, eclipsing the total for all of 2024. But these funds had to come from somewhere else. Yes, some of it was raised from investors, but a lot of it was also just taken from investments in other areas. In today's case, we're seeing flows exiting SaaS names and being reinvested into AI, much of it into hardware. Now the reason this event is important is that it opens up a number of new opportunities. And it was the same during the tech bubble. If you saw a business that had large amount of outflows, but you felt they could last a long time and then you bought them and did well. So let's say you found a business that had outflows, meaning the stock price had been punished, but you felt that it could last a long time, well then in that case you could have just bought them and you probably would have done incredibly well. And the cool part is you didn't even need to invest in tech to make a good return. Today. I think there are a lot of SaaS businesses that have a great chance of thriving in five to 10 years time that are just getting killed by the market. Now during the tech bubble you could have invested in tech businesses like Amazon and made an absolute killing. Alternatively, you could have invested in one of the most boring businesses out there in Berkshire, which is trading at a multi year low. If you're looking at SaaS businesses today, you'll want to focus on businesses that have the highest likelihood of survival. Certain businesses just scare the hell out of me. Something like Duolingo for instance, is scary. I can easily see using ChatGPT to just learn a new language. I've heard Duolingo bulls claim that users don't use it to learn a language, but more for the gamification aspect. Well, doesn't that then mean that Duolingo is then competing with literally tens of thousands of undifferentiated mobile game titles. It just goes over my head. So for me, easy pass. The point is if you follow the market, you can see where flows are flowing to. If you're early to the party, it can be exceptionally rewarding. But if you're late, chances are you will invest in the worst businesses or in deals that are just priced for perfection. Now let's dig into this a little more because the concept of investing into inflection points can be very powerful if that's your cup of tea. Now in vc, if you're too early, that's a mistake too, because then you can run into narrative risk. A business may have a wonderful narrative, but just no substance to it. Remember when I spoke about white hot risk earlier in this episode? If a business has too much white hot risk, you'll want to make sure that you aren't getting sold too heavily just on the narrative, because there's a chance that the white hot risk could eventually burn down the entire thesis. Now the hard part for VC is knowing when it is too early, when you're just early enough, or when you're too late. Since I invest in inflection point businesses, I find this concept to be quite fascinating. My strategy is a sort of hybrid VC value investor approach. I am purposely trying to find investments that are pretty early in a business inflection. And by inflection here I'm not talking about a narrative. For business to get on my radar, the narrative clearly has to be working because they have to have a working product that is actually selling something as well as generating cash flow or profits. Let's take a quick break and hear from today's sponsors.
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- [45:34]
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All right, back to the show. Now the inflection that I most focus on is whether the business can now take their product and scale it up while doing it in a profitable way. VC places much less emphasis on profits because they're trying to capture a lot of that early revenue growth upside. If a business isn't generating a profit, it doesn't really matter as much because they have equity in the business that might go from zero in revenue to a billion in revenue. If it doesn't generate a cent in profit that whole time, I doubt they'd care much because clearly their equity would have gone up many multiples in value. Now I don't follow that same string of thought since I think about businesses as if I owned the whole thing. I want businesses that are generating cash for me. I prefer they grow their cash flow at a very adequate level. Now for inflection points, I'm generally looking for cash flows that can double within three years. Now what I do share with VC is that many of these inflection point businesses won't work out. The advantage that I have on risk is that even if they don't double cash flow, let's say they only grow at, you know, 50%, I could still make a pretty good return or I can sell out and have the liquidity to do so. Another bonus of this strategy is that if I'm wrong, I won't have a zero. I generally look for businesses with pretty low amounts of leverage, so if they don't over lever and generate cash, they can service their debt and therefore the risk of bankruptcy is a lot lower. Now I was just speaking to a friend of mine in the micro cap field and he was saying that some of the best ways that he likes to find great opportunities in investing is by asking a simple question. And the question is, does this company have a large or small history of past financing and what do the next few years look like? His point was that businesses that do not require outside financing to grow tend to have a very, very good chance of success. VC loves businesses that require financing because that's how they build their positions. And that ability to continually finance also helps shape their ability to eventually exit the investment. If a business doesn't require financing, the VCs can lose interest in the position simply because the founders aren't on the phone asking them for things like advice or for help. Financing to grow now value investors can examine inflection points in various ways. I like my way of looking at inflection points, but there are other ways as well. So you could do things such as find already established businesses that have the ability to generate new products or business lines that have a lot of potential. So the Mag 7 businesses tend to do this incredibly well. You can argue businesses like Amazon, Microsoft and Alphabet are helping to fund the AI infrastructure building that we're seeing now. The difference is that if it doesn't work out as planned, these businesses are just so good and have so much cash flow that they'll continue to generate billions of cash and they won't go out of business. Then you can look at businesses that might have areas of their company that are starting to inflect at a faster pace, which might take over for legacy lines and have even better economics. So I have a business that I won't name here that creates a suite of products for the oil and gas industry. Their legacy products run differentiated and commoditized, but they have developed a new suite that utilizes a lot more automation, which is much more differentiated and much less commoditized. As a business, the new products have much higher margins, so as they shift more of their sales to the better product line, they'll also have a margin bump. That means they'll be able to generate cash at an even faster rate than revenue growth. Now, you might look for businesses that have some semblance of a moat but just aren't quite there yet. You can follow the business and its industry, and once you feel comfortable that the business in question has developed advantages over competitors, you can invest into the inflection with some conviction. And lastly here you can look to just basically monitor when a business can internally fund operations and its growth. This works very well on inflection point businesses that I discussed earlier. So later stage businesses might generate large amounts of cash and just have no need for debt. And in that case, this inflection wouldn't apply, of course. But on smaller businesses that are earlier in their growth trajectory, if you know that they can grow profits without adding finance risk, you are looking at an investment with a lot of potential. Now, in public markets where information is widely available, investing into inflection points early can be difficult. This is why you can take smaller position sizes as I outlined earlier. Maybe you feel a business you like is about to inflect, but you maybe aren't willing to back up the truck until it's a little more obvious to you. In that case, taking a tracker position is a pretty good idea just to help ensure that you follow it closely and don't, you know, let it fall to the wayside. Now Peter Thiel and Elon Musk had a very interesting relationship. They came together to help build PayPal. They each had their own experiences leading PayPal, even though there was a lot of contention around that. But Thiel learned a lot working with Musk, who was definitely a little bit of an oddball. Now, reflecting on how Thiel's founders fund missed out on Uber, he realized a few things. For one, he wasn't crazy about Uber's co founder, Travis Kalanick. He found him abrasive, difficult, and a bit of an extremist. But Uber was a massive success. And after spending some time thinking about what Thiel could do differently. He said we should be more tolerant of founders who seem strange or extreme. Musk certainly fit this mold. So when Thiel had a run in with Musk at a mutual friend's wedding in 2008, they got to talking. When Musk was ousted from PayPal, he used some of his winnings to invest in two new startups, Tesla and SpaceX. Musk told Thiel he was looking to raise capital specifically for SpaceX, and Thiel agreed to bury the hatchet and invest. Now, this was an interesting bet by Thiel because he invested $20 million for 4% of SpaceX before they even had a working rocket. So they had already crashed multiple test runs. But the thinking was the crashes were just an additional learning experience, and Thiel thought Musk was the type of leader who could learn from his mistakes and improve. Now, I'm not sure how many shares Thiel still owns, but I sure hope he held onto them. So the business is reportedly now valued at approximately 1.25 trillion, meaning Thiel's stake, if he hasn't touched it, is now worth $50 billion. That would be a 54% kegger since 2008. Simply mind boggling. Now, the lesson here for public equity investors is very clear. If you've had success with the CEO before, pay very close attention to what they do as time goes on. If you have very early success with a leader and they choose to start something new, you should probably be first in line to invest if the setup is correct for you. One of my favorite stories of this was when I attended an Investing Conference in 2024. I was scheduled to speak to the CEO of Beware, along with one of the other members of the TIP Mastermind community. So we asked a ton of questions. But one of the coolest conversations we had was with an elderly gentleman who was part of our little group conversation with their CEO, Owen Moore. So he told us that Owen had made him a lot of money on two prior ventures. He was implying that he was also invested in Beware, which Owen was now heading up. When we had that conversation, Beware shares were trading around 20 cents, and today they're 91 cents. Now, I think about this a lot, and I think that much of my learnings came from Buffett, who instructed investors to look at histories of their CEOs. I think Buffett is one of the best evaluators of talent who has ever lived, which is why his decentralized business model with Berkshire has worked so well. If he hadn't been able to evaluate talent. I just can't see how Berkshire would have had anywhere near the success that it's had today. While investing in CEOs with a long track record of success is no sure thing, it definitely tips the odds in your favor. So how can you tangibly assess a CEO's track record? Here's what I've learned on that, largely inspired by Buffett. The first thing here Scour their quarterly Q&As. Find out what they've been working on for the last few years in the past and how they executed on those initiatives. You can now use AI very, very well to help you on this. You can. You can just copy paste transcripts into a document and then upload them. Then you can prompt them based on how they've executed on former initiatives, or if they've just chosen to completely ignore former initiatives because they were failures. Next, you can prompt your LLM to also search for the language that they use and whether it's short term or long term oriented. I've used this on a few businesses and it does a really good job of pinpointing quotes that are strong signals of whether management is thinking long term or not. Next is just look at the KPIs that they use in their earning releases and presentations. Are these changing over time? Are they changing the order of them? Because sometimes if numbers are ugly, managers will just change them up or sometimes they'll just use a different KPI that's less ugly after that. I like looking at capital efficiency. So obviously if a manager is managing a company properly, he is basically the ward of their capital efficiency. So looking at things like roic, return on invested capital and return on equity ROE are very important. And when you're looking at these numbers, pay attention to a couple things. Are they falling? Are they stagnant or are they rising? Now that alone can tell you very, very clearly if a CEO is allocating capital in value creating or in value destructive ways. Now one note here. You don't necessarily have to have a business with a rising capital efficiency number. If a business can simply maintain its numbers while deploying more and more capital, I think that means you're looking at a talented capital allocator as that's not an easy job. Lastly, here is to just look at their incentive structure. Managers will generally focus on the KPIs that they're incentivized to achieve. Do you like the incentive structure? Is it structured to create shareholder value? I like businesses that use things like per share metrics which tend to avoid dilution and capital efficiency metrics, but these are a lot rarer than I'd like to see. So now I want to move on to arguably my favorite tool that value investors can use in their toolbox, and this is taken directly from the VC world. Now this is a concept I once heard Robert Hagstrom discuss on a podcast that I've long forgotten the name of, but I did find where he mentioned it in one of his fun letters that I'll link to in the show notes. So the concept here is called Long Horizon arbitrage. VC has specific guardrails in their investing process that essentially forces them to take a long horizon strategy in their investment. Since they are illiquid and private, exiting becomes very difficult. As a result, they're actively searching for businesses that will be hopefully worth many multiples more than what they bought it, let's say five or 10 years ago. They aren't just wiggle guessing or staring at charts to determine when they should sell a position, but even more powerful for listeners who are more fundamentals focused, they are forced to assess their businesses based on fundamentals and not nearly as much on the opinions of others. Note how I said here, not nearly as much. A private business will often go through multiple financing rounds, and that's where a VC firm can get some validation on whether their bet is working or not. If the business is valued at 10 million in its first funding round, then it's worth 100 million in the second. That's considered a win. But I think value investors should focus their attention on whether a business is getting better or not. Because in the long run, if a business is increasing its earnings power and it's widening its moat, there's a very good chance that the business will be valued more by the market at some point in the future. Over the short term though, it's really anybody's guess. Now this is what long term arbitrage is. It means that you can withstand the short term volatility of the market while maintaining conviction in your names. Because fundamentally speaking, it's continuing to do exactly what you want it to do, which is simply to increase in intrinsic value. Another way to look at it that Hagson points out is that if a business is earning returns above its cost of capital, this is a great way to evaluate a business that is generating shareholder value. Because if it's earning returns at a rate above its cost of capital, it's creating value. Hagstrom learned this by analyzing the S&P 500 outperformers over a 10 year period from 2009 to 2018. Over that time period, there are 161 businesses that outperformed the broader index. One similarity among the outperformers is that they earned cash returns above their cost of capital. Interestingly, even businesses with below average sales growth still outperform the market with average annual returns of 15%. If you had above average revenue growth, returns climbed to 17%. Now I've discussed a few ways here on how to assess management and businesses, but just how do you assess your own performance? Now, VC loves a metric that I never really see value investors mention, which is multiple on invested capital or moic. Now MOIC is a very simple calculation of total value realized divided by total capital invested. If you invested 250k into a business and you sell it for 10 million, you have a MOIC of 40 times. But MOIC misses one key variable, time. Having a MOIC of 40 times is different if it happens over three years versus 10 years. If you look at the math, I know I would be perfectly happy with both outcomes. And you could even argue that having it happen over a longer period of time means the investment is more de risked versus a shorter time period. But I digress. The reason VC is more concerned with MOIC than with internal rates of return is what I harped with at the beginning of this episode. VC knows their returns rely on power loss. If you get just 150 to 100 times, chances are very good that you'll succeed and make yourself and your partners a lot of money. For this reason, speed matters a lot less. Now I plugged in a 40x return over 3 and 10 year time spans. Over 3 years it's a 240% kegger. For 10 it's a 45% kegger. So you can see why many value investors don't bother with this number. If you have a mediocre business that is mature and growing at 5% per year, MOIC becomes a useless measure because the best case scenario is that you maybe double your money and make most of your returns off of a multiple re rating or some form of short term catalyst. Now you don't make a career in VC by getting 18% returns every now and then. You win by having one 100x investment that can carry results over multiple years or multiple decades. I think value investors use a different nomenclature for similar metrics because of people like Peter lynch who coined the term multibagger. A multi bagger is no different than MOIC. If you get a 50 bagger that's the exact same thing as having a MOIC of let's say 50x. Now I think your investing style will impact if you care about multibaggers and moic. I recently had a great conversation with a member of our tip mastermind community. This member had 30% returns for over a decade and he told me that he very, very rarely had multi baggers. He was just looking to stack small WINS, you know, 40% here, 70% there and then just sell out. So it's completely possible to succeed that way for certain investors. But I know I'm not wired that way. I like multi baggers. That's generally what I'm on the hunt for. So when I look at some of the moics in my portfolio, you can probably guess my two biggest winners also have the highest moics. And I know I'm not using the MOIC numbers in its pure sense because it uses total value realized where I'm using an unrealized numbers as these are still in my portfolio. My number one position has a MOIC of 5x and my second largest has a MOIC of 4.5x. To derive these numbers, I'm simply just dividing the current value of my holdings by my cost basis. Now I use my own form of moic. When looking at evaluating my businesses, I tend to look at forward evaluations just two to three years ahead. I do this because I feel I have a small degree of extra accuracy over looking at 5 to 10 year time Spence. Now one way I assess my return is by looking at a bear base and bull thesis. If I can find an investment with a 2x bear case, a 3x base case and a 10x bull case, that's a great way to use MOIC to assess the asymmetry of a bet. Since I'm looking for multi baggers, I generally tend to focus on certain qualities of businesses like scalability, capital allocation, Runway TAM expansion optionality and the durability of its competitive advantage. This further helps me filter businesses because I pretty much never concern myself with businesses that have, you know, maybe just 20% upside down, are pure reversion plays, or have very, very low ceilings. For my compounder bucket, I'm looking for businesses that can at least double in intrinsic value every five years or so for my inflection points. I won't bother looking at it if I don't think the return will be less than 26%. Of course I'm wrong on both of these very regularly. Fortunately, because I focus so much on multibaggers, my winners tend to outperform these metrics by a very Wide margin. Now I took some data from my stock picks from my Q4 2025 portfolio update that I did with the Tip Mastermind community. In that update, I looked at the asymmetry of my winners and losers purely in publicly held corporations. About 50% of my stock picks provided returns above 0%, meaning 50% provided returns below 0%. Seems pretty bad, right? But this doesn't take into account the asymmetry of my investments. And that's why I can lose money on half of my stocks and still outperform the index. Since inception, I had three calculations. The first is the percent of my picks that are beating my 15% hurdle rate. This envelops the entire portfolio in terms of both my compounders and my inflection points, and that was a very low number, just 26%. This number states that about one in four businesses that I choose actually beats my hurdle rate. But now we get to the really interesting figures. The average annual return of my hits and misses Keep in mind, these aren't weighted averages as the math will just get too complicated with businesses moving in and out of my portfolio. But the average annual return on my hits? 51% and my misses only 17%. What this tells me is that I can improve my future returns by either increasing returns on my hits or by decreasing my losses on my misses. My primary goal more and more is to just focus on downside protection or just decreasing the number of misses and how much I lose on them. There's certainly still a value investor inside of me. Now I want to close this episode by discussing my thinking about three mental models that came to mind when I think about vc. The first was ecosystem. VC takes advantage of a very narrow ecosystem that it can thrive in. It finds businesses that tend to be very small, often with no working product, but a highly impactful idea because it can thrive in this ecosystem. It also opens up to additional ecosystems once these businesses scale. But at its heart, they really just focus on small businesses with the hope that they can scale over time. You can think of VC as a forest after a wildfire. The fire destroys the environment, the soil is unstable, many seeds won't survive, and the conditions tend to be harsh and uncertain. But that environment has a powerful feature. It favors fast growing and highly adaptable species. There's a plant called the Lodge Pole Pine. Now I know these trees very well because they're all over the Pacific Northwest where I live. These are your typical trees that I see all the time and have very large pine cones. Now the pine cones come off the Trees closed and require high amounts of heat to open. Fire is one such source of heat that helps open the pine cone, allowing it to release its seats. VC is like the lodge pole pine. It begins its life in a hyper volatile environment, in this case startups, where the majority of these businesses will ultimately fail. But with the right leadership, ideas, advantages and capital, it can scale fast. The second mental model that came to mind was catalysts. So inflections are by nature a type of catalyst. The whole VC system is full of catalysts. Look at Vinod Khosla. He made two investments into Juniper and Sorent that had massive moinks. These investments were done because he believed there were large catalysts on the horizon when it came to bandwidth. And these businesses created products that would directly benefit once the adoption curve went vertical. And VCs don't just look for catalysts in entire industries. There's more than one way to take advantage of catalysts. You can invest in a founder you trust who is on the cusp of a technological or business breakthrough. You can search for specific markets that are about to tip into a different direction and invest into the beneficiary of that change. You can look at the changing regulatory landscape and determine whether new smaller businesses are set up to succeed in a rapidly changing environment. Or you can search for a business building just innovative platforms that can scale up over time. Now the final mental model here that comes to my mind is critical mass. So critical mass is defined as the minimum amount of fissile material required to sustain a self sustaining nuclear chain reaction. But no nuclear event is required to use this mental model. So in business, a critical mass is the point in time when a business's growth becomes self reinforcing, defensible capital, efficient and hard to displace. VC aims to be very early to the party. They want to be part of the fissile material that has to be built to properly get these businesses in place and reach a critical mass. What VC is doing is simply supplying capital to several businesses in the hope that one of them will reach that critical mass point. And when it does, that's where the magic happens. If you look at the tech businesses that are top of mind today, like Uber, many of them start as companies, you know, a week away from bankruptcy. But VC provided the capital injection and direction needed to eventually help them reach a critical mass. That's all I have for you today. Want to keep the conversation going and follow me on Twitter, Rational Mrks or connect with me on LinkedIn. Just search for Kyle Grief. I'm always open to hearing feedback, so please feel free to share with me how I can make this podcast listening experience even better for you. Thanks for listening and see you next time.
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