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The Role of Outliers in Emerging Company Investing

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The world of successful startup and emerging company investing is one of outliers.  Winning big requires identifying the "needle in a haystack" company that becomes big and famous.  And  to do so while they are small and fledgling.  The biggest investing fortunes of our era have been made by the early investors in Google, in Amazon, in Apple, in The Body Shop, in Kinko's, and will be made in current high-flying startups like Digg, LinkedIn, Twitter, and Simply Hired, among others.

These companies are outliers.  They beat or are beating the statistics that show that over 90% of all new businesses don't make it one year, that 70% of those that remain don't make it 10 years, and that less than 2 out of 10 achieve exits that make money for their investors. 

Here is the rub, though.  Companies like The Body Shop and Kinkos, when they hit, are so incredibly wealth-producing that they more than make up for the significant majority of companies that do not get to profitable exits for themselves and their investors.  The central rule of startup and emerging company investing is that to win you MUST have one or a few BIG successes in your portfolio.   And by big success, we mean it in the context of Fidelity's famous Peter Lynch, as in a "10-bagger" -- or a return of more than 10x on your principal investment.

So how to get these winners in your portfolio? A heavy influence on my investment philosophy is Nassim Nicholas Taleb, and pecifically his groundbreaking economic and philosophical masterpiece, The Black Swan.  Taleb's 2 main theses as they apply to our investment space are as follows: 1) That all huge early-stage investment successes are, by their very nature, fundamentally unpredictable "outlier" events, and 2) through the cultivation of humilty in the face of this randomness does investment wisdom spring.

So a few cautionary notes. 
First, imbibe deeply the overwhelming evidence that nobody, not Bill Gates, not Steve Jobs, not Sergei Brin, not Jim Kramer, not Kleiner Perkins, not Sequoia Capital, not Genentech, not the sellers at AIG of collateralized debt obligations, not the Federal Reserve Chairman, and certainly not your friendly neighborhood financial advisor can predict the future with any true level of certainty.

Secondly, run, don't walk, away from those who purport that they can or have because this reveals them as being either naive or disingenuous, and usually both. The road to investment hell is paved by those who, through the simple law of averages, got lucky in predicting last month's price of gold, or of oil, or the Dow, or interest rates, or Las Vegas real estate, et al -- and then again, either naively or disingenuously, confused and/or promoted this luck with predictive ability. 
As Warren Buffett once famously noted, if there are a 1,000 stock pickers, the law of averages are such that, every year, 10 of them will show once-in-a-century return performance.  In short, take to heart that past performance is absolutely not indicative of future results and that big negative outlier events -- like the banking and real estate collapses of the past year -- can wipe out decades of investment return in just a few short months.

And to "get in the game" of startup and emerging company investing, approach it, as Taleb would say, with a "fractal" approach.  Expand your perspective beyond the usual investment suspects -- the Dow and big NASDAQ companies -- and look for the following qualities in your investment choices:  Companies with the aforementioned Peter Lynch "10-bagger" potential and ones which, because of the "micro" factors that determine their success, have return dynamics that are uncorrelated with the stock and bond markets as a whole.  Not a hard and fast rule, but the vast, vast majority of companies with these characteristics have high technology and intellectual property-based business models. 

Keep these few thoughts in mind and you will be head and shoulders above the average investor in doing the kind of deal-picking that puts a life-changing deal in your portfolio.

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Ken Wesson says

Dear Jay, I Resently came accross a deal on a 1/4 share in a new custom home that rents by the week in Beautiful Winter Park. My question to you is, are these Real Estate deals worth it? I know it's off the subject a little but im getting $76,000 in Equity on the deal and i plan on investing in the future. I have an Idea to build another Custom Home up there with the right Investors, and i've already got a mortgage Sr.Partner ready to go in with me. What do you think? Ken Wesson
Posted at 2:16 am

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