Contrarian Investing in Venture Capital Vs Public Markets
Recently Temasek's investment into FTX made headlines, and the former chairperson was quoted defending the decision as being "contrarian". Putting aside the debate on whether investing alongside other large investment funds can be considered contrarian, we would like to explore further the pros and cons of Contrarian Investing.
George Soros of Soros Fund Management, Warren Buffet of Berkshire Hathaway, Ray Dalio of Bridgewater Associates, and more recently Michael Burry of Scion Capital: legends of the game we call investing. Each has amassed a fortune over the years using thoughtfully refined investment techniques which in some way or form often lead back to good-old 'contrarian' investing. The contrarian investment technique consists of betting against existing market trends and patterns to generate significant returns. Where the average investor sees fear and pessimistic sentiment, the contrarian sees opportunity and optimism, and vice versa. In pop culture, spectacular examples such as Moneyball and The Big Short reflect the critical principles of contrarian investing, as each film's story is based upon rejecting widely agreed-upon sentiment and thinking, to produce an exponential return. This angle of investing can provide enormous rewards to the extent realised by the legendary investors mentioned earlier. Still, it remains a hazardous practice and can take years to realise gains that the market fails to foresee.
Markets are notably subject to herd-like behaviour, similar to a murmuration of birds. The murmuration moves and shifts direction at a moment's notice, and where the majority move, the rest follow. We liken these movements to the price movements in stock markets, often controlled by fear, greed and more recently, algorithms, resulting in over and underpriced securities. Despite being far more evident in public markets, this idea is still present in private markets, including venture capital (VC). VC markets exhibit a weak form of Efficient Market Hypothesis (EMH) detailing how past security prices and trading volume place no impact on current value, that instead fully reflects all available information concerning the security (Fama, 1970). Therefore, VCs must emphasise forward-looking information to assess a startup's expected return. Most notably, this comes from evaluating how a startup can disrupt (or innovate) a fragmented conventional market and redraw the established landscape and the human element of assessing whether a startup's leadership team can build a successful business. This, by definition, is a contrarian approach as VCs place support behind ideas that go against the grain in order to realise tremendous rewards. A VC searches for value within the asset class or market where others believe there to be none (Szalontay, 2021). However, in reality, VCs more commonly herd together when crafting investment strategies and don't venture down the scary path of contrarian thinking. Often this is because funds act as co-investors and rely on due diligence carried out by lead investors, in turn causing them to fail in adopting a contrarian approach and instead follow the herd. Additionally, whenever big-name VCs, the likes of Y Combinator, Andreessen Horowitz, and Sequoia Capital, throw their weight and capital into a project, the move often garners the attention of smaller funds seeking to capture the same potential return of the big boys and in doing so further builds upon this 'herding' mentality, to the detriment of the contrarian proponents.
Before you plunge all your cash into underpriced securities or the new startup on the block, it's important to note that quantitative research doesn't support the theory of contrarian investing generating abnormal returns. Over 200 contrarian trading strategies were once tested using historical market price data to assess whether one could benefit from investor overreaction creating under or overpriced securities (Duvinage et al, 2016). Results found no significant relationship between the contrarian investment strategies and an abnormal return. However, when it comes to VC investing, evidence suggests VCs who suffer from 'style drift' and invest in a herd-like fashion with other VC firms generated lesser returns than those VCs who operate under a contrarian approach, choosing to invest oppositely to the herd (Bubna et al, 2013). Food for thought, no?
It's important to highlight the main drawbacks when employing the contrarian investing style. Namely, the level of gall possessed by the investor must be great to preserve an out-of-consensus viewpoint in the face of extended periods potentially without evidence of their gamble being correct. Investors must have strong patience, resilience, and a suitable cash reserve to see the contrarian strategy come to fruition should any short-term underperformance harm the position. Michael Burry is the most apparent advocate of the required iron will, as he suffered significant short-term losses in pursuing a 489.34% return on his 2008 housing market collapse strategy (Lewis, 2010). A vast opportunity cost is present when utilising these strategies that investors must willingly accept to see their investments be successful. A final drawback must underline the intense research required to justify a sound contrarian strategy, making it inhospitable to the average investor who may not have the skill or time needed to prove the market wrong.
Yet, should you have the prerequisites of time and necessary attention to detail, contrarian investing has many benefits (including more than just proving everybody wrong!). The level of expected return is monumental when an investor can successfully prove an entire market's sentiment is incorrect. Warren Buffett's acquisition of more Coca-Cola shares, to a value over $1b, remains a spectacular example of contrarian investing. The beverage giant suffered from the 1987 stock market crash, and investor sentiment was overly bearish, yet by the end of 2020, the investment had returned 1,550% (Duprey, 2022). On a more general level, when investors attempt to enter a position at the market's bottom, a rough entry point will still return a substantial profit should prices begin to rise again. The possibility of missing the optimal entry point will not overly hinder the generated return, so long as the contrarian strategy pays off.
So, knowing the varying results of contrarian investing, do you back yourself enough to go against the masses in seek of fortune?
Bubna, A., Das, S.R. and Hanouna, P. (2013) Persistence pays: Evidence from investment style dynamics in the venture capital industry, SSRN. Available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2286213
Duprey, R. (2022) Why Warren Buffett loves Coca-Cola's stock, The Motley Fool. The Motley Fool. Available at: https://www.fool.com/investing/2022/10/06/why-warren-buffett-loves-coca-colas-stock/
Duvinage, M.D., Mazza, P. and Petitjean, M. (2016) Testing the profitability of contrarian trading strategies based on the overreaction hypothesis, SSRN. Available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2720392
Fama, E.F. (1970) “Efficient Capital Markets: A review of theory and empirical work,” The Journal of Finance, 25(2), p. 383. Available at: https://doi.org/10.2307/2325486.
Lewis, M. (2010) Betting on the blind side, Vanity Fair. Available at: https://www.vanityfair.com/news/2010/04/wall-street-excerpt-201004
Szalontay, M. (2021) Council post: Contrarian investment techniques in venture capital, part 1, Forbes. Forbes Magazine. Available at: https://www.forbes.com/sites/forbesfinancecouncil/2021/06/18/contrarian-investment-techniques-in-venture-capital-part-1/?sh=549388485d2c