Unlike traditional securities analysis methods that rely on proven business models with predictable future cash flows…
Investing in early-stage companies – who often have limited operating history and revenue – relies on our belief in the management team’s vision for the future… and how they plan to create and capture value in a changing marketplace.
As early-stage investors, we are constantly faced with the difficult task of “predicting” in the pursuit of higher returns.
However, as baseball legend Yogi Berra once said, “It’s tough to make predictions, especially about the future.”
So how does Equifund think about managing the madness, as we search for investment opportunities worthy of consideration for our community of retail investors?
That’s the topic of today’s issue of Private Capital Insider.
-Jake Hoffberg
Top-Down vs Bottom-Up Analysis: An introduction to building an investment thesis
As investors, we’re all secretly hoping someone has the answer to the question I think we’re all asking…
“Is this a good investment or not?”
From a very high-level perspective, this question is impossible to answer in a vacuum; what makes an investment “good” or “bad” must be considered relative to the investor’s goals, and all other options they have access to at the time.
However, I think we can all agree that we are going to “Reject the Default” and do something other than low-cost passive indexing…
We would prefer that the risk we’re taking produces better risk-adjusted returns (called “Alpha”) than the benchmark.
But here’s the problem with mindlessly chasing after Alpha:
In the same way that a good product doesn’t necessarily make a good company, and a good company doesn’t necessarily make a good investment…
A market-beating stock pick doesn’t guarantee a market-beating portfolio – which, in turn, doesn’t guarantee you’ll meet your financial goals in life.
This, in a nutshell, is why you want to get clarity on how much money you actually need to live the lifestyle you want to live, and what type of returns you need in order to achieve your personal lifestyle goals.
If the goal is to stop working for money and have your money work for you, the first thing you need to do is put your money to work.
How do we do this? By implementing both a Top-Down and Bottom-Up approach to investment decisions.
- Top-down analysis starts by looking at the broader macroeconomic trends (which we call Mega Trends, ie. geographical, political, economic, demographic, or pretty much anything at a global or country-wide level). Once the investor has formed a worldview on the economy/broad market, they will then move down a step to narrow their choice of investments.
For example, if you’ve ever seen something on the news about something happening in the world and thought “I wonder how I could make money from that?” – that is a top-down approach.
- Bottom-up analysis involves starting with microeconomics. The investor starts with a specific stock/security and analyzes the fundamentals of that security and the underlying company in detail before even looking at its industry, sector, or market climate.
This approach is generally favored by value investors like Warren Buffett. The rationale is that a great company will perform well regardless if its industry or the market is on a decline.
So, what do we do here at Equifund when deciding on what types of early-stage offerings to list?
We consider three factors:
- Does it meet our listing criteria (Bottom-Up)?: Generally speaking, we are looking for companies who desire to go public in the next 1-3 years
- Does it fit into our overall investment thesis (Top-Down)?: Generally speaking, our team has expertise in certain sectors and industry groups – mainly Healthcare, Technology, Real Estate, Manufacturing, Industrials, and Energy.
- Can we fill the offering in a timely manner (adoption risk)? Sadly, oftentimes the best money-making opportunities are in really boring businesses that don’t capture the attention of retail investors.
So that is always a consideration when we are looking at deals and asking ourselves “do we think this is something our members would be interested in? Or is this just too hard to promote, even if we think it’s a potential winner?”
In public markets, where you have large businesses with long track records, investors have a ton of tools at their disposal when trying to perform investment analysis.
But in private markets – especially in early-stage companies – you are heavily reliant on the information provided to you by the issuer (who is trying to sell you the security) and whatever knowledge you already have.
So, what happens when you’re looking at an exciting new trend that might move fast; there’s lots of hype about it potentially being the “next big thing,” and you don’t want to miss out?
Here’s how we approach it here at Equifund.
Hype Cycles and Adoption Rates: An introduction to investing in today’s hottest trends
Early-stage companies have to tell an exciting, yet fair, story about the future – and their unique advantage – in order to raise capital at an attractive price.
But when faced with bold promises about new technologies, how do you separate the story from what’s commercially viable?
More important, how do you tell when will such claims pay off, if at all?
According to the technological research and consulting firm, Gartner, the answer is something called the Hype Cycle – a graphic representation of the maturity and adoption of technologies and applications, and how they are potentially relevant to solving real business problems and exploiting new opportunities.
For the past 20+ years, several members of the Equifund team have helped tell those stories about how early-stage companies could become the next big thing.
We’ve seen how these Hype Cycles play out over time… and we’ve seen who really profits from the speculative mania (hint: it’s rarely retail investors).
We’ve also seen life after the speculative bubble inevitably bursts, how the hyped technology eventually becomes viable, and how the next titans of industry emerge from the ashes.
Through these many booms and busts, we’ve developed our process for navigating the Hype Cycle to guide investment decisions in speculative, early-stage companies.
What’s our secret?
Instead of trying to predict what will (or won’t) happen next, we are more interested in gaining a clear understanding of what is actually happening right now in the current market cycle.
To do this, we look at three things as part of our underwriting process: Mega Trends, Market Dynamics, and Mechanisms.
According to Martin Zweig – author of the 1986 book Winning on Wall Street – rule #1 of investing is “The trend is your friend.”
But what exactly is a trend? It’s an emerging pattern of change that gives us clues about what could happen in the future.
For investors, the benefits of being able to accurately spot trends early – and the opportunities within them – are enormous.
However, the hard part is deciding if the trend in question will persist over the long term… or if it’s a flash-in-the-pan fad that will quickly fizzle out.
For this reason, we look for what we call Mega Trends – large social, economic, political, environmental, or technological changes that are slow to form, but once in place, can influence a wide range of activities, processes and perceptions… possibly for decades.
If you’ve read Pitch Anything by Oren Klaff, you might recognize this as the “Winter is Coming.”
In the hype cycle, there might be a LOT of excitement around new technology, but that doesn’t mean that NOW is the right time to invest.
Why? As the saying goes, “A rising tide lifts all boats.”
When it comes to investing, one of the simplest secrets to picking winners is to buy companies in sectors that are in bull markets.
Sometimes this is referred to as Sector Rotation or maybe even Trend Following.
Regardless of what you call it, the principle here is the same…
It’s easier to make money in markets that are “hot,” versus ones that aren’t.
That’s why we want to first look for the broader macroeconomic conditions that are creating structural changes in supply and demand inside of a defined market.
Here’s why. A friend once said to me:
“If you want to be rich, sell products and services. If you want to be wealthy, create and control markets.”
What is a market? A market is a place where buyers and sellers meet to transact.
According to Economics 101, prices in any market are determined by one thing, and one thing only: Supply and Demand.
Every time a transaction is made, this creates Price Discovery. This is the central function of a marketplace, be it a financial exchange or a local farmers market.
In these types of environments, information becomes one of the most valuable advantages any buyer/seller can have.
Why? When new information arrives, it changes both the current and future condition of the market and therefore, can change the price at which both sides are willing to trade.
This means that fundamentally, the only way to get an “edge” as an investor is to have an information advantage about the market itself.
What information are we most interested in?
Information about markets going through a structural change in supply and demand (“Market Dynamics”)…
For this, one of the things I commonly use is what I refer to as a Market Model – or a framework that describes the overall “shape” of how the market has formed, what stage the market is in, and what stage is likely to come next.
I’m personally a big fan of The Consolidation-Endgame Curve, first published by German management consulting firm AT Kearney in their 2022 book “Winning the Merger Endgame: A Playbook for Profiting From Industry Consolidation”
By appropriately identifying the stage, and understanding the defining traits and behavior of our stage… we can better understand – and potentially predict – market behavior and trends.
What types of market behaviors and trends are we most interested in?
Personally, my interest is “Where is unmet Demand that is unsatisfied with current Supply, and is willing to switch to a new solution?”
And if so, is there an opportunity to capture unmet demand – at scale – through the use of new technology and/or business model innovation (“Mechanisms”)?
Here’s why…
For eight years I’ve visited leading companies in more than 20 industries around the world that claimed to be in the process of being disrupted.
Each time, I’d ask the executives of these incumbent companies the same question: “What is disrupting your business?” No matter who I talked to, I would always get one of two answers: “Technology X is disrupting our business” or “Startup Y is disrupting our business.”
But my latest research and analysis reveals flaws in that thinking. It is customers who are driving the disruption.
They are the ones behind the decisions to adopt or reject new technologies or new products.
Disruptive startups enter markets, not by stealing customers from incumbents, but by stealing a select few customer activities. The activities disruptors choose to take away from incumbents are precisely the ones that customers are not satisfied with.
Simply put, it doesn’t matter how big of a need there is or how breakthrough the technology is… the only thing that matters is “Who will buy this?”
For nearly 40 years, this question has largely been answerable by the technology adoption model – based on the Diffusion of Innovation (DOI) Theory, developed by E.M. Rogers in 1962 – was popularized by Geoffrey A. Moore in his 1991 book Crossing the Chasm.
For those who are unfamiliar with this framework, there are five segments of buyers as a market matures.
- Innovators: These are the risk-takers, the technology enthusiasts, who are willing to try out new innovations even when they are not fully developed or proven. They thrive on being the first to embrace something new
- Early Adopters: These are the opinion leaders, the trendsetters. They carefully observe the innovators’ experiences and are more willing to adopt new technologies if they see potential benefits
- Early Majority: The early majority group is more cautious. They need to see clear evidence that an innovation works and provides tangible benefits before they adopt it
- Late Majority: These adopters are even more skeptical and tend to adopt an innovation only when it has become widely accepted and integrated into mainstream usage
- Laggards: Laggards are the last to adopt any new technology. They are often resistant to change, and may only adopt an innovation when they have no other choice
While this method certainly isn’t perfect, it solves one of the most immediate problems investors face when analyzing early stage companies: “Is there an existing – and viable – market for the products and services the company is selling? Or does a new market have to be created from scratch?”
With these three elements explored, we can now develop what we call an Investment Thesis – which is a set of beliefs (or mental models) about what we think could happen next.
Based on this, we can now make a more educated decision on the types of investment opportunities we think will allow us to potentially capture outsized returns, based on our key assumptions of how the world works.
Final Thoughts on Early-Stage Investing
One of the things we pride ourselves on at Equifund is the underwriting, due diligence, and market research/analysis we perform before any listing.
As much as we would like to offer a rating system for the offerings we have performed extensive due diligence on…
We are legally prohibited from providing any individualized investment advice, buy/sell recommendations, or provide any sort of “ratings” for our listings.
Not to mention, because we are effectively the “Sell Side” participant in this marketplace, we have an obvious conflict of interest, as we earn success-based fees.
However, if you go to any of our current listings, you’ll get 6,000 – 10,000 words of us “showing our work” from both a bottoms-up and top-down approach.
You’ll also likely see additional market research and investor education as part of our Private Capital Insider editorial.
Why do we do this? Because we believe that the right way to win the “realization of private markets” is by building a brand people trust.
By nature, investing in private or early stage offerings (such as Reg A, Reg D, or Reg CF) involves a high degree of risk.
This means no matter how good we think the deal is, by definition, early stage companies have a very real risk of failure.
However, we believe that you’ll forgive us for being “wrong,” but you’ll never forgive us for being “sloppy.”
And for that, we put our best efforts into the things we can control – the quality of the content we publish to help our members make more informed investment decisions.
