The Power Law is a book about Venture Capital investing but that doesn’t mean it doesn’t hold lessons for public market investing. These are 12 investing lessons I found in the book.
Lesson 1: Size Your Positions Correctly
Venture investing is big on the Pareto Principle. Most of their investment returns are generated by a small portion of their portfolio.
Khosla routinely put capital behind moon shots with a nine-in-ten chance of failure. But the low probability of a moon landing had to be balanced by the prospect of a large payout: if the company thrived, Khosla wanted to reap more than ten times his investment—preferably, much more than that.
Y Combinator, which backs fledgling tech startups, calculated in 2012 that three-quarters of its gains came from just 2 of the 280 outfits it had bet on.
“Venture capital is not even a home-run business,” Bill Gurley of Benchmark Capital once remarked. “It’s a grand-slam business.”
It’s about knowing the Risk vs Reward of each investment and then sizing your position correctly. It’s OK to make risky investments if those investments are sized right. At the right size, an investor could lose a small amount of money on a lot of investments but still generate above average returns if a few investments turn out to be big winners.
Lesson 2: Average Your Winners
the new venture capitalists came up with a second innovation: rather than organizing one large fundraising, they doled out capital in tranches, with each cautious infusion calibrated to support the company until it reached an agreed milestone.
This reminds me of the image of a young Paul Tudor Jones with the quote over his desk, “Losers average losers.”
VCs learned to invest more capital in companies that reached certain business milestones and the risk of failure declined. They did not put more money into the companies that were struggling.
Public market investors all too often double down on losing investments. Instead of admitting a mistake and cutting their losses, they hold on to the belief that they are right, and the market is wrong. They’ll invest good money after bad. Great investors cut their losses early and let their winners run and sometimes they’ll invest more money in their winners.
An example from the book is Genentech.
But the virtue of stage-by-stage financing became increasingly obvious. As successive risks were eliminated, each financing round valued Genentech higher than the previous one, so the founders could raise larger sums while giving away less equity.
Genentech was eventually bought by Roche for $46 billion.
Lesson 3: Perkin’s law
Tandem offered a spectacular demonstration of what became known as Perkins’s law: “market risk is inversely proportional to technical risk,” because if you solve a truly difficult technical problem, you will face minimal competition.
Perkin’s law is the same as invest in companies with a competitive advantage, a business moat. It’s the best way to fend off competitors and maintain high returns.
The example I’ll draw on from the book is Genetech again.
The first product that Genentech proposed to manufacture was insulin, for which there was a huge and growing market.
But precisely because the technical challenges were so formidable, the barriers to entry in this business would be high, and Genentech would be able to extract fat margins if it succeeded. It was another illustration of Perkins’s law.
Genetech was a big win for Kleiner Perkins because it created a breakthrough technology that created a large barrier to entry to competitors.
Lesson 4: Cultivate Luck
Some of the best parts of The Power Law are the stories of fortunes gained and fortunes missed. The main difference between the two was luck.
The best example is the Englishman who wanted to buy shares of Apple, but Apple just completed their latest financing round, and they weren’t selling more shares. Instead of leaving, the Englishman decided to cultivate some luck. He would stay in their lobby all day every day until someone was willing to sell him shares.
Montagu said he would wait. “I have my toothbrush, and I can just lie here,” he repeated, as though dental hygiene were the only conceivable reason not to bed down in someone’s office. At a quarter to seven that evening, Mike Scott appeared again. “Mr. Montagu, you are really a fortunate guy,” he said. Steve Wozniak had decided to buy a house. To raise the cash, he wanted to sell some of his own equity.
Researchers dug deeper into the role of luck in venture capital success.
In 2018, a working paper published by the National Bureau of Economic Research tested this logic directly on the venture industry. Sure enough, the authors confirmed the existence of feedback effects. Early hits for venture firms boost the odds of later hits: each additional IPO among a VC firm’s first ten investments predicts a 1.6 percentage point higher IPO rate for subsequent investments. After testing various hypotheses, the authors conclude that success leads to success because of reputational effects. Thanks to one or two initial hits, a VC’s brand becomes strong enough to win access to attractive deals, particularly late-stage ones, where a startup is already doing well and the investment is less risky, according to the authors.
Luck is luck. You can’t practice it. But you can do things to increase your capacity for luck.
One way is to eliminate dumb decisions. I’ve used this diagram before.
If investment decisions are a bell curve, we want to eliminate the left tail. These are the dumb decisions that can lead to a permanent impairment of our capital. If we can eliminate poor investment decisions, we increase our likelihood of good decisions and making good investments. And with a little luck, some of these good decisions turn into great decisions and phenomenal returns.
Another tool to increase your capacity for luck is to build out your network. The underlying theme for the Power Law and the success of Silicon Valley Venture Capitalists are the personal networks they built.
Take Warren Buffett as an example. He was already a great investor but as his personal network grew so did the opportunity set for great investments. From Insecurity Analysis.
“Buffett’s huge network of knowledgeable and influential friends also has been a help along the way. Buffett has been an original thinker, but it cannot have hurt to discuss prospects for a television station with Tom Murphy, chat about a common investment with Laurence Tisch, or talk with Jack Byrne about insurance. ‘His network of mends has been very important,’ says broker Hayes.” Of Permanent Value, The Story of Warren Buffett
Warren Buffett’s investment in American Express after its salad oil scandal helped create the Warren Buffett mythology but it almost wasn’t. It was Buffett’s network that convinced him to hold onto his initial Amex investment and add more. A decent return turned into a phenomenal return and propelled Buffett into investing stardom.
Lesson 5: Metcalfe’s Law
The utility of a personal computer would rise exponentially when it was hooked up to a network, they both agreed. Indeed, this insight came to be known as Metcalfe’s law: the value of a network rises with the square of the number of devices connected to it.
Companies with strong network effects can produce big gains like Visa and Mastercard.
Later in the book, we meet Bill Gurley, and he understood the power of Metcalfe’s law and the power of networks.
Before joining Benchmark, he [Bill Gurley] had been struck by the writings of Brian Arthur, a Stanford professor who studied network businesses. Companies that enjoyed network effects inverted a basic microeconomic law: rather than facing diminishing marginal returns, they faced increasing ones.
In network businesses, contrariwise, the consumer experience improved as the network expanded, so producers could charge extra for their products. Moreover, the improving consumer experience was matched by falling production costs because of the economies of scale in building a network.
Lesson 6: Don’t be Penny-wise but Pound-foolish.
everybody around the table remembered another one of Tom Perkins’s dictums: you succeed in venture capital by backing the right deals, not by haggling over valuations.
Sometimes the best companies look expensive now. But in 5-10 years because of their market opportunity and its competitive advantages, today’s price will look wildly cheap. Paying a fair price or slightly more for a great business is far better than missing out on a potential multi-bagger.
Lesson 7: Leave when Masayoshi Son Arrives
Son’s bid implied that Yahoo’s value had shot up eight times since his investment four months earlier. But the astonishing thing about his offer was the size of his proposed check: Silicon Valley had never seen a venture stake of such proportions.
Leveraging his new reputation as a digital Midas, he followed the Yahoo bonanza with a dizzying investment blitz, barely pausing to sort gems from rubbish. To borrow the language of hedge funds, he didn’t care about alpha—the reward a skilled investor earns by selecting the right stock. He cared only about beta—the profits to be had by just being in the market.
Besides, so long as the bull market continued, Son would earn more money than the venture old guard simply by deploying capital faster. He could spray capital at the unicorns without worrying about his aim. It was the old script all over again, except now he had a fatter hose to play with.
When Son starts whipping out the checkbook, it’s time to start selling. He is the top of the capital cycle. He has marked the top twice in his life. Too much capital is chasing too few deals, pushing prices to extremes. No matter how good a business is, if you pay too high a price, you’re making a bad investment.
Lesson 8: Let Your Winners Run
In the case of Apple, for example, Valentine had sold out before the IPO, realizing a quick profit but depriving his limited partners of the bounty from Apple’s flotation. Moritz, in contrast, was a child of the postwar boom and had experienced little but success in his own life:
By winning this argument and cementing his authority within the firm, Moritz saw to it that the last distribution of Yahoo was put off until November 1999, when the company was trading at $182 per share, fully fourteen times more than the price at the flotation.
Referring to lesson 1, the bulk of your returns will come from a few positions. So, when you have a winner get out of the way and let the company do the heavy lifting for you. Be like the Connoisseurs from The Art of Execution.
It takes a lot of nerve to do nothing or merely trim a position when winning. Everything points to us being hard-wired to sell out of an investment when we have made a reasonable profit…
Their strategy was therefore to take a small bite and leave some for later, extending and maximising the pleasure of success as long as possible.
Taking small profits along the journey like a Connoisseur allows us to get instant gratification without ruining our long-term wealth aspirations. This ‘trick’ is one that I have seen in action and which allowed my best investors to stay in absolutely phenomenal winners.
Lesson 9: Stay Within Your Circle of Competence
Startups working on wind power, biofuels, or solar panels were capital intensive, heightening the risk of losing large sums; their projects took years to mature, depressing annual returns on the few that succeeded.
Astonishingly, the firm that had minted money during the first internet wave, preaching the power of Moore’s law and Metcalfe’s law, rushed into a sector that lacked these magical advantages.
You need to know your strengths and your limits. It’s Buffett’s circle of competence. Capital intensive firms can be winners, especially if the capital intensity creates large barriers to entry, e.g., railroads. But it takes a different investing skill set than software and technology. Kleiner-Perkins learned the hard way.
Lesson 10: Does a Company Have Operating Leverage?
Rather than looking at profit margins—that is, the share of revenues remaining after costs are deducted—he looked at incremental margins, meaning the share of revenue growth that falls to the bottom line as profits.
As revenues grew, costs grew much less, so most of the additional income showed up as profits. It followed that growth would soon drive the three portals into the black.
Operating leverage can turn an unprofitable emerging company into a profitable one and doom those without. Pandora and Spotify do not have operating leverage with music streaming. Their music licensing costs rise with in line with user listening time. This is why Pandora failed and it’s why Spotify is pushing hard into podcasts. It’s a business with operating leverage.
Lesson 11: No Bonus Points for Degree of Difficulty
Unlike venture capitalists, Tiger was not looking to bet on original ideas. To the contrary, it liked companies that implemented a proven business model in a particular market. The goal was to invest in the eBay of South Korea or the Expedia of China. “The this of the that,” Coleman and Shleifer called it.
If a business model is raging success in one market, can you find a similar company in an underfollowed market? No reason to reinvent the wheel or make your search harder. You don’t get rewarded for an original idea. You get rewarded by making a good investment. It’s OK to copy someone else’s investment idea if it’s a good one.
Lesson 12: Systems to Reduce Bias
At Sequoia, the partners sometimes missed attractive Series B deals because they wanted to make themselves feel good. They hated to admit they had been wrong in saying no to the same startup at the Series A stage.
Ahead of a decision, each of them would read the investment memo with an unpolluted mind; they should do their utmost to avoid groupthink. Then they would come to the Monday meeting prepared to take a stand.
We can’t avoid our behavioral biases, but can we develop systems to help us reduce their effects? Sequoia came up with a way to reduce the harm from their own egos. They realized they were missing out on great investments because they didn’t want to admit a previous mistake. It is OK to make a mistake, but it is egregious to let one mistake compound into bigger mistakes.
The thing about cognitive biases is it’s tough to reduce their effects by just being aware of them. It takes systems and automation to reduce their effects. What systems and processes can you implement to help yourself get out of your own way of good investments?