Risk and Reward in Emerging Growth Companies

Many people tell me that angel investment, or investing through a crowd-funding platform is more for a bit of fun than a serious investment exercise. They cite the very poor returns that they have experienced and, like the inveterate gambler in self-denial, almost always claim to be “broadly even”, which I translate to be “lost more than I care to admit to myself”.

I have had my fair share of duff investments over the years but when I look back at those that have failed, and as my knowledge of investing in emerging growth companies has grown, I can see that a common theme running through much of what went wrong was a misunderstanding of risk.

This is quite an admission from someone who has spent their life as an investment professional, but it’s a common problem in the industry; when investing for other people or advising themn how to invest, we give out sage advice as to a balanced approach to investment but when we come to invest our own money we want the stock that we make ten, fifteen or twenty times return.

I remember in my early days working for a large life insurance company’s UK equity team. A graduate trainee had just joined, who went on to become very senior in the asset management world, and he was being introduced to equity investment by a colleague of mine. My colleague detailed how the life company had been an early investor in equities, and how the benefits of that long -term investment in equities, giving a high and rising level of dividends, had flowed to above average returns to policyholders over the previous few decades, and how equity investment laid the foundations for the company’s success. The newbie asked my colleague “So, do you buy shares yourself?”. “Rarely” replied my colleague “because you might double your money but equally you often lose the lot”.

This brief exchange has stayed with me for thirty years, because it encapsulates the problem that many of us have with assessing risk and reward in our personal investments. If there really is a chance to double your money, but also an equal and opposite chance to lose the lot, and assuming it’s a binary outcome, then a portfolio of such investments will, given average luck, turn out to make or lose nothing. You are taking a risk for no return.

Taking it to the more extreme returns that angel investors seek, I often hear people say “there’s a 10% chance I could make ten times my money”, which again suggests an investment approach that is destined to make absolutely nothing for a very high risk, if a portfolio of such companies were purchased.

Instead, investors need to think first about the return that is needed to make a risk worthwhile, then look at their estimated probabilities and returns. The answers may make many businesses uun-investible, but that doesn’t mean that the analysis is wrong.

To make the risk of investing in emerging growth companies worthwhile the returns have got to be high on a portfolio level, especially given the illiquidity of the investments. I think 20-25% per annum is a reasonable target return.

If we choose to invest in businesses with a chance of making a ten-fold return over a period of five years, what probability would you need each to have to achieve a 25% return overall? The answer is a little over 30%. How many investments have that high a chance of making that high a return? For those “all or nothing” companies, that promise astronomical returns, the failure rate I would suggest (based on what I have observed over the years) will be higher than 70% and thus the chances of making any money on a portfolio basis will be extremely low.

The problem with these very high risk/high return type investments is that they are binary outcomes; the company achieves the impossible, changes the industry they are in forever and makes everyone a fortune or they don’t make it and shareholders lose everything. The idea may be sound but the chances of the company delivering will always be low. If the chance of success is, in reality, say 5% for such binary stocks then to achieve a 25% per annum overall return will require each successful company to produce a 60-fold return. That is, to say the least, quite an ask. Below you can see the minimum probability of success required for a range of returns in order to achieve the target 25% per annum return from a portfolio.

Forecast Return Minimum Probability*
10x 31%
15x 20%
20x 15%
30x 10%
50x 6%
100x 3%

*Minimum probability of success required to achieve a 25% return, assuming a five -year return horizon.

A better approach is to seek emerging growth companies with a spread of outcomes possible. The upper end may not be as exciting, but there will be a much higher probability that some return will be earned over time, and having a portfolio of such companies will likely produce a better overall return, for a far lower risk.

Of course, there is nothing wrong with seeking out the company that is going to reinvent the wheel, and I still invest in the occasional company seeking astronomical returns, but I now know just how astronomical those returns need to be, in order that the reward is worth the risk.

 

Posted on August 17, 2017

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