Bookworm: Should this method have scored me a 30 bagger?

Welcome to Bookworm, my new column that explores a single idea from an insightful book or investor letter every Tuesday. My aim is to give older ideas new life through modern day examples, apply insights from abroad to Australian cases, and provide food for thought.

Today’s insight comes from Richard Koch’s book The Star Principle. Koch started his career with Boston Consulting Group before becoming a successful business writer and – most interesting for us – an even more successful venture capital investor.

On the latter front, Koch is best known for an early investment in Betfair that grew into a not so small fortune. He explains much of the thinking behind that investment, and others of his, in his book The Star Principle.

What is the Star Principle?

The star principle traces its roots back to BCG’s growth/share matrix. The matrix splits companies into four categories based on their market share, and how quickly the market they operate in is growing.

Leaders in high-growth markets are called Stars.
Followers in high growth markets are called Question Marks – can it become a Star or not?
Market share leaders in low growth markets are called Cash Cows.
Followers in low growth markets are called Dogs.

Koch’s Star Principle dictates that getting involved with star companies (preferably as early as possible) is the easiest way for people to grow their wealth. Either by starting such a company, investing in one at an early stage, or being employed by one while it is still small.

All of that probably sounds pretty obvious and simple (especially in hindsight). And when advice is this simple, you usually risk missing something important.

First of all, I think it’s important to understand that the kind of lifechanging result that Koch got from his investment in Betfair is not normal. Most investors in early stage companies have hundreds of losers to list alongside the early round investment in an Uber or Airbnb that made up for it all.

Getting the kind of result that Koch got from Betfair – or that early stock market investors have got from Amazon, Nvidia and Netflix – also usually requires you to stay invested for a long time. And for a wildly successful long-term investment, you need more than a fast-growing niche and a strong early position.

You also need the company to stay in that leadership position amid intense competition from several sides. This is not lost on Koch. A while after writing the Star Principle, a blog post of his called ‘The Star Principle – simplified’ included this warning:

“The trap is that a star stops being a star by losing leadership in its niche. If that happens, a venture worth a fortune can suddenly become almost worthless.”

What you would ideally find, then, is the following:

A fast-growing market
A clear lead in that niche
Something that keeps competition at bay

In other words, you ideally want to see the Star qualities plus a moat. Koch seems to have realised this because in that very same blog post, he says that “recently I have invested mainly in star businesses with strong network effects.”

I may be wrong, but Koch’s gravitation towards ‘network stars’ likely stems from the success of his angel investment in Betfair – one of the purest network effect businesses possible.

The ultimate network effect

A network effect is where every new user of a product makes the product more valuable to other users.

Betfair users place bets at prices set by other Betfair users instead of placing them with a traditional bookmaker. It is basically a stock market for betting. And it is massive – GBP 55 billion was traded on the platform in 2015, the company’s last year before being taken over.
Just like in a stock market, the most important thing to people placing and taking bets on an exchange is liquidity. They want to be matched at the best possible price and in the quantity they want. More users = deeper markets and more liquidity.

In true network effect situations like this, the vast majority of business in a category flows to the number one. Why would exchange traders go anywhere else? Eventually it becomes almost impossible for would-be competitors to lure customers elsewhere.

Betfair was the early leader in a fast-growing market and managed to hold on to that position because its network effect became a moat. Contrast this to Nokia, which had an early lead in the fast-growing mobile phone market but had no sustainable advantage.

A potential use case

Let’s face it, most of us do not have the funds or network to make angel investments like Koch’s hall of famer investment in Betfair. The question, then, is how investors might use Koch’s Star Principle in public markets.

Drawing on Koch’s background in venture stage investing, it occurred to me that his framework might be help identify newly public companies with the potential to one day be much, much bigger.

To do this, I thought I’d see which companies went public in the same quarter as WiseTech Global – a star company if ever I've heard of one.

More specifically, I wanted to see if applying Koch’s framework to the whole cohort might help up sift through the field a bit. I excluded mining, REITs and energy and ended up with the following list of IPOs in Q2 2016:

Figure 1: ASX IPO class of Q2 2016. Source: Morningstar Direct

I started by applying Koch’s bogie of at least 10% per year market growth and a clear leadership position in that market. Most of these fledgling public companies would have been easy to exclude on one or both of those grounds. Others would have been a little harder.

Reliance’s SharkBite brand makes it the leader in its category of plumbing fittings in the US. But I might have leaned towards labelling its overall business as a Cash Cow rather than one likely to grow at the rate of a Star.
Afterpay was clearly a prominent player in a fast-growing space. Yet there were quite a few other early movers in other markets. Without the benefit of hindsight, I may have given it a Question Mark.

And then you have WiseTech Global.

Notwithstanding the potential for huge hindsight bias here, I think this company would have at least registered on the radar of investors trying to apply Koch’s Star Principle. I say this because WiseTech’s IPO prospectus included the following pieces of information:

An estimate by Gartner that WiseTech’s supply chain execution software market was set to grow at 10.4% per year from 2015-2019. Koch’s criteria of solid market growth was met albeit not blown out of the water.
WiseTech shared that “our customers include 19 of the 20 largest global 3PL logistics service providers in the world”. You’d need to do more research, but that was a promising sign about the competitive position it held in the market.

WiseTech had also been in business for a long time, had several years of impressive revenue growth under its belt, and was predicting 20%+ sales growth in each of the next two years.

Taking every IPO forecast on its merits is a dangerous game. But if that one held up (spoiler: it did), it hinted that WiseTech was either outgrowing its category or that the niche was growing by more than 10% a year.

Out of all of the companies above, I think WiseTech was the cleanest fit with Koch’s two main star criteria.

What about the moat?

Earlier I suggested layering a preference for some kind of moat on top of the Star Principle.

With companies and markets at this stage of their life, I think this is usually very hard to ascertain with much confidence. Having a stab at it would likely require industry knowledge, a fair amount of work and a healthy recognition of the potential for you to be proven wrong.

Seeing as WiseTech is a software company, I would mostly have been looking out for evidence of switching costs. However, I note that WiseTech listed “stimulating network effects” as a key pillar of its growth strategy in the prospectus.

As I said, you have to take any prospectus puffery with a pinch of salt. But even seeing that the company was making a conscious effort to build a network effect into their product and dig a moat would have struck me as a positive.

A couple of potential issues with this approach

An issue I ran into while trying to use this approach was what to measure when it came to market growth.

Take WiseTech, for example. Would you look for data on demand for logistics software in general, freight forwarding software more specifically, or what? Do you put more date on historical data or forecasts? And where is the best place to get those forecasts?

Thinking about this is especially important when you consider how promotional a lot of IPO prospectuses can be. Another company that IPO’d at a similar time and since delisted used overall Software as a Service adoption as evidence of their market size. Was that really their market, though?

I am tempted to say that in many cases, it will just be obvious that a company’s market niche is growing faster than 10% per year (like TV streaming in 2013, for example). But you should always check your assumptions. And remembe, a category’s growth may not matter if the company is an also-ran in its field.

The V word

Another potential issue is valuation. Even if a company has fantastic long-term potential, the price you pay – and the expectations baked into that – will have a big impact on the result you get. Unless the blue-sky scenario really does play out.

A company ticking all of Koch’s boxes at IPO time is highly unlikely to look cheap on traditional metrics. Especially if there is any hint of a moat. Don’t forget, either, that the company deciding to go public now may also reflect an opinion that they will get a good deal for their shares.

Of course, you don’t need to buy into the company on day one anyway. Perhaps those sky-high expectations proved to be a little too optimistic, but you still think it is a star company and can now invest at a lower price.

Buying in later at a higher price may not be that bad either. If, for example, the market opportunity or company’s moat becomes clearer and the investment now meets more of your investing criteria.

A key thing to keep in mind

Stories like Koch’s investment in Betfair can have a dizzying effect on investors. But it’s important to remember that the vast majority of early-stage companies do not end up as stars, even if they have exhibited star qualities at some point in their life.

Betfair, WiseTech and Afterpay are not normal outcomes. Any investments you make in the hope of achieving a similar outcome should be weighted accordingly, and only made as part of a deliberate strategy.

Consider also that if you are right about the company’s fate and keep on holding, your initial investment in such a company does not need to be massive to end up having a massive impact on your portfolio.