Why I Prefer Startups to Stocks

Benjamin Graham, widely considered the father of value investing, once said, “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.”

In other words, over short periods, markets tend to move irrationally along with market psychology. But over longer market cycles (at least 10 to 12 years), fundamentals are ultimately what matter.

Since 1996, the U.S. stock markets have acted almost entirely like voting machines. Only during brief bear markets and corrections do they seem to act like weighing machines.

The chart below shows the average price-to-earnings ratio of the S&P 500 since 1970.

Source: Barron’s

As you can see, for the last two decades, stock market P/E ratios have been elevated most of the time. Since 1996, the average P/E has been 23.36. Meaning that stocks are almost always expensive. And dividend yields are almost always low.

Only during brief and sporadic crashes and corrections do we get a chance to buy stocks at bargain prices.

The average bear market lasts around 15 months (since 1900), though they vary widely. The crashes happen fast, while the bull markets take years to peak.

Source: Wealthfront (Editor’s note: the S&P is up another 20% from 2015.)

Now, once again, we find ourselves facing historically pricey stocks pushing higher and higher.

Clearly, it’s good to own some stocks for the long run. So you can either “dollar cost average” into it (invest the same amount monthly over years), or try to time it using stops and/or gut feeling.

Both strategies can work, but they have their own drawbacks. Dollar cost averaging into stocks means that you’re overpaying most of the time.

Trying to time the market is difficult and can be terrifying.

Personally, I use a combination of the two for stocks. I mostly dollar cost average into stocks I want to own forever. But I do hold onto more cash when stocks are pricey, take some profits, and wait for a correction or crash. It’s the modern version of value investing.

The Cause and Result

I believe this problem is primarily created by persistent low interest rates.

Eight years of near-zero percent interest rates have distorted markets greatly.

The sheer size of government as a percentage of the economy is also problematic, since large bureaucracies are woefully inefficient.  But that’s another article entirely.

It’s primarily these low rates that have convinced the market that risk/speculation will be rewarded. And it’s “working” in the sense that stocks are going up due to artificial forces acting on them.

Toss in the rise of algorithmic trading funds, which now make up 27% of all stock market volume, and the moves are even harder to predict.

This is probably why 90% of actively managed funds underperformed against their indexes over the last 15 years. That’s 1.5% a year for a cumulative gain of 25% for the Jack Bogle fans.

Startups: A Market That Always Has Bargains

I still own public stocks, don’t get me wrong. But that stuff is mostly on autopilot, with a few exceptional cases.

My attention is 95% on startup equity these days.

With startups, you can almost always find attractive investments. It’s truly one of my favorite things about this private market.

At the early stages, there will always be reasonable founders out there who know they should raise money at a reasonable valuation.

Overpricing a startup damages the founder as much as the investor. Experienced founders know this. They’ve seen companies raise money at valuations that are too high.

When it’s time for its next round of funding, the company typically struggles (unless it’s taking off like a rocket). The startup may then have to raise cash at a lower valuation in a “down round.” That’s a bummer for everyone.

Sure, there are times when seed-stage investments get pricier. When new pre-revenue companies are successfully raising seed money at $10 million valuations, that’s overpriced. (Unless there’s a legendary founding team or some other extraordinary circumstance.)

But not all startup deals at any given time will be overpriced. There will always be bargains in such a small inefficient market (inefficient in a good way).

Think about it. These companies are often raising $500,000 to $1 million. That means only so many people will even see the deal before it either fills or fails. With startups, there is limited “price discovery.” This is a good thing, as it keeps valuations reasonable.

When deciding whether a startup investment is a good value, I look at a number of factors.

  • Is the product valuable?
  • Can the company sell that product?
  • How much would it cost someone else to build it?
  • How much money can the company realistically generate five years out?
  • What’s its edge?
  • How defensible is it?
  • How attractive is it as an acquisition target?
  • How well has it used the capital it’s raised so far?

These are the types of questions I like to ask when investing in a company. It’s why I’m naturally drawn to startups.

With stock trading, the question you’re asking is “will it go higher for a bit?”

I’d much rather be asking the startup questions when investing. Success boils down to using intuition, curiosity and diligence. That’s what investing should involve.

Today’s stock market feels a long way from those questions. It’s more about trying to correctly predict short-term winners.

Thoughts? Comments? I’d love to hear them in the comment section.

Good investing,

Adam Sharp
Founder, Early Investing