The Key Insights VCs Have That Value Investors Miss

Value investors too often confuse potential with reality

While traveling in Europe, I came across a jewelry store in Antwerp called 'Be Very Rich.' The name struck me as ironic—buying their expensive wares wouldn’t make you rich; you’d need to already be rich to afford them. It made me think about causality — and how often we, as value investors, get it wrong.

I was listening to a book on venture capital investing during my travels, which made me realize that value investors have a lot they could learn from VCs. Sometimes, value investors also get the causality backwards.

At the risk of drastically oversimplifying, many value investors follow a simple causal rule: stock becomes cheap → buy. If it gets cheaper → buy more.

While that can be the right behavior some of the time, frequently this is a flawed process. That’s where we can learn a few things from venture capitalists and improve our investing process.

How VCs Approach Investing Differently

So how do VCs invest? While I am certainly no expert, here is my understanding.

The initial decision to invest is based on the team first, then on the business idea/size of the addressable market. Price is the last consideration.

The amount of capital given at the seed stage is relatively small, just large enough to get the team to the next set of milestones. Then, at Series A, B, C, etc rounds whether the company can raise additional capital and on what terms is determined by their execution. The money at each stage is enough to get the company to hit the next milestones.

In public-market parlance, venture investors are averaging up, rather than averaging down as is common practice among many value investors. They are paying increasingly higher prices, sometimes dramatically so, the more evidence they get of the company executing well and getting closer to achieving its goals.

So the causal relationship is: demonstrate execution success → buy more stock. Not: price is lower → buy more stock.

It would be easy to dismiss this as not applicable to value investing in the public markets. After all, VCs go after huge, power-law distributed opportunities where the potential big winners can return 100x+ of the initial investment. However, there is evidence that public company returns are also concentrated in a few large winners with a tail of many underperformers. Furthermore, this critique would miss the reason why the VC success-based funding logic works well.

The Danger of Confusing Potential with Reality

I suspect that value investors frequently confuse potential with reality. What’s more, their process often exacerbates the behavioral biases that all of us have. Let me explain what I mean.

Imagine a troubled company with a new CEO. The CEO outlines a turnaround plan — cutting costs, improving margins, and so on. However, this is just a possibility as success is far from guaranteed. The base rate for turnarounds is low because the underlying business challenges are often deeper and harder to fix than management’s initial plan suggests.

The outcome frequently looks something like this: costs are cut, but revenues turn out to be worse than expected leading to a profit shortfall. Why? Because while the company was focused internally on costs, competitors took their customers, secular demand pressures continued to worsen, best performers left, and so forth.

Value investors often focus too much on quantifiable cost cuts and ignore harder-to-measure threats to sales — like competitive pressure or market decline. The result is that they treat what is essentially a near best-case scenario as the base-case, or most probable scenario.

They then make matters worse along the way. As the stock declines in response to negative business developments, they, anchored to their original estimate of value, add to the seemingly ever-increasing bargain. At the end of the journey the mirage dissipates, and the “cheap” stock turns out to not have been undervalued at all based on the actual business trajectory.

Applying the VC Mindset to Public Markets

What is the alternative? Let’s apply the VC approach to investing in a public market turnaround. As the management lays out its initial vision, we recognize that it is just a possibility and wait rather than invest. We establish clearly defined KPIs to monitor. Note that we are not waiting for full clarity in bottom-line results, but rather establishing markers of progress that demonstrate substantially increased likelihood of eventual success.

Using this process, we can make the initial investment further into the turnaround process. It will likely be at a higher stock price but with a much higher chance that it is an actual bargain.

The reason value investors don’t typically do this is that they are afraid of missing out on the opportunity – that by the time the business turns the stock price will have moved up too much. I find this concern typically misplaced for two reasons.

Yes, the price will likely be somewhat higher after the initial signs of progress. However, the probability of a successful investment will be much higher. Also, the time to realizing a positive outcome will be meaningfully reduced. Therefore, the expected Internal Rate of Return (IRR) will frequently be higher, not lower!

Value investors compound their mistake by exiting successful investments too soon. When the gap between price and their estimate of value closes, they sell. Sounds reasonable, right?

Except that frequently they are driving-by-model, heavily anchored on their initial assessment of business value. Instead of dynamically marking their value estimates to reality as they get new evidence of success or failure, they don’t let their winners fully benefit their portfolios. Peter Lynch used to call this approach “cutting the flowers and watering the weeds.”

Are there times when this evidence-of-success approach to investing is unlikely to serve value investors well? One example would be a company experiencing a cyclical problem. Since, by definition, it is just a definition of when, not if, a cyclical problem will be resolved, waiting for “green shoots” as many Wall Street analysts do might be too late.

Even here, I would offer a note of caution. Our ability to separate cyclical problems from internal or structural problems is not always perfect. While I do think most of the time cyclicals are good candidates for investment before signs of improving demand, we need to be sharp in our analysis for that approach to work.

Lessons from My Own Mistakes

When I think about some of my own mistakes over the last 3-5 years, it is backing into a portfolio mostly composed of cheap stocks with no catalysts where the thesis was not tracking. They always seem too cheap to sell, and management will always tell us that prosperity is just around the corner if we just give them more time. That is a trap, as it replaces a clear-eyed assessment of business results with hope and projections.

The process improvements I’ve implemented over the past 18 months have, in my view, created a significantly stronger portfolio. I’m now far more cautious about cheap stocks without catalysts, where business trends remain weak — and our portfolio is better off for it. The next time I’m tempted to buy a stock simply because it looks cheap despite ongoing struggles, I’ll remind myself of the VC approach and ask whether the returns might be far better if I wait for signs of real progress.

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About the author

Gary Mishuris, CFA is the Managing Partner and Chief Investment Officer of Silver Ring Value Partners, an investment firm that seeks to apply its intrinsic value approach to safely compound capital over the long-term. He also teaches the Value Investing Seminar at the F.W. Olin Graduate School of Business.