A Venture Capital investment guide in tough times
A few weeks ago, a very interesting presentation from a large venture capital investment firm was leaked online.
It’s from Sequoia Capital, one of the best venture capital funds in the world, and it’s a practical guide on how to invest and conduct business in the tough economic times we’re in today.
Here’s Sequoia’s strategy to invest with a possible recession, higher interest rates, and quantitative tightening coming up.
Disclaimer: this is just a recap of a presentation coming from Sequoia Capital, which you can read here. This is not my personal opinion, and it should not be financial advice in any way.
To recap everything that has happened to interest rates and financial markets over the past two years, Sequoia uses very few words:
Capital is free. Now dear.
According to them, this change will have huge consequences in both markets and in the real economy, and we have not yet seen the full impact of the quantitative tightening that the Fed is currently doing. This will certainly take some time, but it is already seen in some parts of the market:
To give just one example in the housing sector: in the past 6 monthsdue to changes in the value of money, a new mortgage is 67% more expensive for the same house – the largest percentage shock in 50 years, and returned the affordability of housing to levels last seen at the peak of the housing boom.
And the real consequences may unfortunately not be here yet.
The only way to stop inflation is to stop buying: when there is little money to buy, the economy shrinks.
Unfortunately, this means that the only way to stop inflation is to ‘collapse it’ into a recession, and drag prices down in the economy. This is ultimately their prediction: the US will face a tough recession in the next year or two.
Outside of housing, we are also currently witnessing the 3rd largest Nasdaq drawdown in 20 years. And this is not just a story of tech stocks, but it is also a very volatile environment for all other equities:
Although it hasn’t been 2001 or 2008, the Nasdaq is down 28% since last November.
At a high level, the market is less challenged as it was during the dot-com crash or the global financial crisis, but the story beneath the surface is more revealing if you look beyond the mega caps.
While mega-cap stocks like Apple and Google have dropped just 20% since the beginning of the year, small nonprofit niches have dropped upwards of 75%.
As the underlying business thrives: some of these high-flying stocks are seeing profits double and margins are improving, but their stock is down more than 50%. It’s pretty insane to think about it, at least until you realize that the problem has been their over-appreciation over the past two years.
So, with stocks falling and the economy slowing, what’s * really * going on in the market according to Sequoia? Where do people invest?
The focus is shifting to profitable companies:
– The focus on the near term often shifts towards companies that can show current profitability.
– While the Nasdaq was down 28%, Morgan Stanley’s unprofitable tech index was down 64%.
– With the increasing amount of capital (both debt and equity), the market indicates a strong preference for companies that can generate money today.
Honestly, everyone is now discovering what value investors have been saying for two years now. This time is not “different from the past”, And the basics will always be the most important thing in the stock market:
And then Sequoia explains further:
For the medium to long -term: solid growth is always the path.
– These are difficult markets to navigate. This is not just an appreciation, but a “real economic risk”, with the declining consumer depriving himself of fiscal stimulus while simultaneously dealing with rising inflation.
– But, What works in any market is constant growth and disciplined financial management which translates to improving margins. For example, ServiceNow has continued to consolidate revenue at 30%+ over the past decade and each year continues to improve free cash flow margins.
– [Focusing on these things] may not translate into appreciation overnight, but in the medium and long term, disciplined, solid growth is always rewarded and translates into significant appreciation of value.
As I said earlier, welcome to value investing. It’s fun to see the crazy Covid investing mania is finally dying.
Unfortunately for everyone, Sequoia also predicts that the upcoming recession will take a long time to recover from. Just as we have had a very good decade of great growth, the next could be the opposite.
They don’t make any numerical predictions here, but they say this:
That cycle will take a long time, and it’s hard to peg to a particular time horizon. But it won’t be fast.
If this really happens, it will be a huge challenge for investors. It’s not just a matter of appreciation, but also of finding businesses strong enough to deal with an economic crisis.
As an investor, this environment only means one thing: you need to find viable companies, possibly those that act as if nothing happened.
Here are Sequoia tips on how to invest in these conditions:
1. Flexibility
You have to be adaptable: “it’s not the strongest of the species that live, or the most intelligent, but the one that is most responsive to change”.
2. The Safety of the Fastest
The fastest moving companies have the most runways and are likely to avoid the death spiral.
According to them, the businesses with the fastest cost reductions are usually the best: “in 2008 all companies reduced projects, R&D, and other costs [when needed] is better and better”.
Also, as an investor, they suggest you focus on companies that want to maintain their margins rather than push more growth. According to them. some CEOs will inevitably continue to push growth even if their companies can’t afford it – either because they want to please Wall Street or because that’s what they’ve always been taught to do.
But if a difficult recession comes as they say, you should look for companies that act like the green line in the picture above. Cost reductions are a good thing in tough times because they are “a great way to save money and run faster”According to these venture capitalists.
It’s no coincidence that some large companies have already put hiring freezes in place since May.
3. Take advantage of these conditions
One of the first lines of the presentation is the following:
This is not the time to panic. This is a time to pause and re-evaluate.
First and foremost, we must recognize the changing environment and shift our thinking to respond with intention rather than remorse. We believe this is a Crucible Moment, one that will present challenges and opportunities for many of you.
As with any recession and bear market, this is probably the best time to accumulate assets rather than sell them. It’s always tragic when the economy suffers and people lose their jobs, but when you have your own finances, there’s no problem buying stocks cheaply.
See it as a time of incredible opportunity. You play your cards correctly and you will emerge as a stronger investor.
4. Prepare Early
Finally, the last tip is to prepare for it in advance.
Chance only favors the prepared mind. At Sequoia, we believe the winner is the best prepared.
Face your reality, face your fear, and choose courage over fear. And remember that any crisis can also be an opportunity.
And finally, the final message from Sequoia Capital is to be pragmatic but also realistic. “Thinking is a waste of time“according to them:
Don’t sit around talking about ‘good days’ with the hope that they’ll come back. They probably won’t.
