25iq

My views on the market, tech, and everything else

Lessons from Josh Wolfe (Lux Capital)

 

Wolfe is the co-founder of Lux Capital, a venture capital firm which invests in emerging science and technology ventures. The firm manages $1.4 billion in assets across five funds. Before founding Lux, Wolfe worked in investment banking. He grew up in Brooklyn (Wolfe has many interesting stories to tell about his childhood in Coney Island) and graduated from Cornell with a B.S. in Economics and Finance.

1.“Edge is a key element of Lux’s investment philosophy: edge can derive from informational, analytical or behavioral sources. Get better information about an asset (an entrepreneur or technology), or the same information but sooner; analyze that information differently in a way that leads to a novel conclusion (a variant perception) on the importance or magnitude or timing of the asset’s value; or behave individually and as a team in a way that uniquely leads us to great assets (avoid herds and fads, seek what others don’t, venture out a limb as that’s where the proverbial fruit is). 

It is worth taking some time to discuss a few examples of each of the sources of edge identified by Wolfe.

Informational: Bill Miller has written that this type of edge “is the easiest to exploit and the hardest to find.” One method for acquiring better information is to have what Phil Fisher called a “scuttlebutt network” of people he could consult for advice or expertise. In interviews Wolfe has talked about how his informational advantage often comes from his existing relationships with people and including board members of portfolio companies. An informational advantage can also be found by reading what few other people read which I will talk about more in the next set of quotes.

Analytical: Bill Miller view on this is: “Analytical advantages come from taking publicly available information and processing or weighting it differently from the others.” One way to generate an analytical type of edge is to focus on having a better investing process. Wolfe and I are huge fans of the work of Michael Mauboussin. If you want to improve your analytical edge, read everything Mauboussin writes and hear him speak whenever you can. Ray Dalio has worked to create an analytical edge at Bridegwater with his “principles” including radical transparency. Sustaining the idea meritocracy universally in a company is difficult, even with computer facilitation, because (1) the number of connections grows with the square of the number of involved employees; and (2) people are unwilling to accept that much unfiltered feedback all the time (human empathy evolved for a reason). As another example of someone trying to gain an analytical edge, I like to understand the business models of as many businesses as I can. More more different types of business models I learn about, the greater my analytical edge can become. Understanding businesses makes me a better investor and understanding more about different types of investing investing makes me better at business. This idea is borrowed from a famous Warren Buffet quote. Specialization in one type of analytical edge which trying to understand the basics about all styles as best I can has worked well for me. It is also a lot of fun. If you would rather play golf, buy a low cost diversified portfolio of funds that are indexed.

Behavioral: Bill Miller believes: “Behavioral advantages are the most interesting because they are the most durable. The field of behavioral finance is still in its infancy yet has already yielded results that can be incorporated profitably into a sound investment process. The best part is that such results are likely to be systematically exploitable and not able to be arbitraged away as they become more widely known. That is because they represent broad findings about how large groups of people are likely to behave under well-defined circumstances. Until large numbers of people are able to alter their psychology (don’t hold your breath), there is money to be made from prospect theory, support theory, cognitive psychology, and neuroscience.” One approach to creating a behavioral edge is to arbitrage a factor like time. For example, payoffs that are later in time are less popular with most investors since most people are biased toward immediate gratification. It is easier to find mispriced bets that have longer term payoffs that acceptable to many people. The more focused Mr. Market is on realizing immediate gratification on a given type of asset, the bigger the opportunity for someone who can be patient over a longer term. Wolfe also believes that potential for gain that is too long term is also unwise. For example, basic research with very long-term payoffs is best funded by universities and governments since it is what is known as a “public good.” For investors, there is an investing time horizon that is “just right” to create a behavioral edge as was the case in the Goldilocks story. 

2. “Be obsessively interested in topics where you can know a little, ideally a lot more, than others. Asymmetrical knowledge is currency.”  “I have information anxiety. I skip a page in the newspaper, I’m like, ‘I got to go back, because maybe there’s a tidbit there that’s going to change my life.’ It’s probably not the healthiest thing, because I’m insatiably curious, and I want to meet everybody, and I want to know a little bit about everything, but it’s a humbling thing, because you just never know. I’m highly confident that you just never know where the next thing is going to come from.” “I am trying to get some piece of information other people don’t yet know.” “At any point of present, any moment of ‘now,’ 100% of the information we have is based on the past and 100% of the value of the action we take on that information is based on the future which is inherently probabilistic and unpredictable. You can have strong beliefs loosely held, as is the scientific way. But uncertainty itself is like gravity, always present if not always felt and sometimes defied.”

Wolfe believes in Charlie Munger “worldly wisdom” approach to learning and analysis. Reading voraciously and learning about many mental models allows an investor to pull in other principles and create valuable variant perceptions. I share this “information anxiety” attribute with Wolfe. Part of what is addicting about learning for me is the more I learn the more I know that there is even more to learn. When you have observed lots of failure in your own life and read about even more, it is rational to be very driven to acquire an informational edge (#2 above). Even the very best investors fail and make big mistakes. The difference between great investors and business people and most others is that they more often make new mistakes and do a better job of avoiding circumstances and behavior that resulted in past failures.

3. “Lux started with this sort of definitional focus on areas we thought were totally neglected. Even the derivation, the etymology of Lux, Latin for ‘light,’ was about looking where other people weren’t looking. “I like to find areas where there’s really high scientific and technical complexity so people sort of don’t understand something yet.” “We said, ‘Let’s go after the chemistry, physics, and material science departments.'” “We like to think differently, but the truth is, we want people to agree with us… but later.” “Try to understand what the consensus is, find a variant perception, something that people aren’t thinking about, and generally for the wrong reason.” “The best ideas happen when you can understand what is consensus and what is the variant perception? What is no one else thinking about?”  

Markets are very efficient but not totally efficient. Wolfe shares with me an appreciation of the ideas of Charlie Munger, who has said on this point:

“I think it is roughly right that the market is efficient, which makes it very hard to beat merely by being an intelligent investor. But I don’t think it’s totally efficient at all. And the difference between being totally efficient and somewhat efficient leaves an enormous opportunity for people like us to get these unusual records. It’s efficient enough, so it’s hard to have a great investment record. But it’s by no means impossible. Nor is it something that only a very few people can do. The top three or four percent of the investment management world will do fine.”

One of the hardest problems in investing is identifying who these three or four percent of managers are in advance. The other problem is that far too many people believe they are in the top three or four percent.    

What Wolfe is talking about when he says he strives to “think differently” is what Andy Rachleff had in mind when he created this matrix which describes the ideal quadrant for a venture capitalist:

Being contrarian for its own sake is dumb. The reality is that the consensus view is usually right. Any non-consensus view is only valuable if it is also right.

The art of venture capital is to know when the investment is in the bottom right quadrant even though identity of possible future states of the world as well as their probabilities are what Richard Zeckhauser calls “unknown and unknowable.” Venture capitalists like Wolfe are skilled at finding optionality in areas that are what he calls “intersection of deep tech and finance. That optionality pairs well with this investing style since venture investments reflect a power law statistical distribution (massive potential upside but, because of optionality, limited downside.”

Renata Quintini who is Wolfe’s partner at Lux Capital describes the objective:

“One thing about moonshot investing is that you know the market is there. If you cure cancer, are people going to buy the drug? Yes. If you figure out completely autonomous transportation, will people use it? Yes. So the market risk is close to zero. That leaves a big technical risk, I’m not underestimating that. But then you ask — What changes in science and technology would actually make this breakthrough possible? Before investing, we ask ourselves three questions. The first is “why now,” which is critical for deep tech investing. It’s a combination of either platform changes or a new sequence of discoveries — a big change that opens up a bunch of new experiments that weren’t possible before. The other thing we spend a lot of time thinking about is whether this is feasible in the time frame that is conducive to venture capital. If a founder says they’ll spend 15 years developing something, it doesn’t work for the model. And the third question you ask is, “Given your timeline of development, how does a business stack on top of that?” It’s really fun to invest in these types of companies because you have people who know the science deeply and they’re missionaries. They’re more purpose-driven than opportunistic.”

4. “My work is at the intersection of science and finance. Venture capital is a perfect hybridization of those two things.” “We have what I call a 100-0-100 investment philosophy. It’s this mix of ambition and arrogance and intellectual humility. The arrogant part is the first 100. I am 100% certain that Lux will be investing in the most cutting-edge, crazy things that you can imagine in the next two years. The 0 part is the intellectual humility. I have no idea what those things will be. None. The next 100 is the ambition and the confidence, which is, I know with near 100% certainty where we will find those things, and it’s at the edge of our already cutting-edge companies. As long as I stay curious and paranoid and ambitious, and we listen in the boardrooms about the hard problems that these companies might be solving, that’s where the next thing will comes from, but it’s all random until after the fact.” 

Wolfe’s viewpoint is described by Nassim Taleb as follows:

“You don’t have to be right that often. All you need is the wisdom to not do unintelligent things to hurt yourself (some acts of omission) and recognize favorable outcomes when they occur. (The key is that your assessment doesn’t need to be made beforehand, only after the outcome.)”

What could possibly be more fun for someone like Wolfe than making investments at the intersection of finance and science? The investment and business environments are constantly changing and provide an investor with an endless stream of new challenges as well as performance feedback. An investor’s ideas and theories can be tested in real world situations in ways that are far more challenging than playing to most complex video game ever invented.    

5. “Randomness and optionality are defining forces of my life. Ex post facto everything is an obvious linear chain of events. A priori? Intellectual honesty demands reporting I had no clue what came next…” “I got very fortunate and met a guy, Bill Conway, who’s one of the founders of the Carlyle Group. And he took a stake on me and put us in business. And that was luckiest day of my life, and we never look back.” “Our business especially is dominated by luck… right place, right time. You have to be smart to get access to the best entrepreneurs and you got to structure deals well and have adequate reserves. And it’s a lot more art than science, but there’s still some science to it. But I do think luck dominates.” 

Wolfe has learned how to create high levels of optionality in his life and to capitalize on that to generate superior outcomes. Wolfe knows that activities like living in a city, travel, going to parties, taking classes and acquiring a wide range of skills increase optionality. Nassim Taleb describes the objective: 

“That which benefits from randomness (increased potential for upside in the presence of fluctuations) is convex. That which is harmed by randomness, concave. Convexity propositions should be embraced – concave ones, avoided like the plague…. ‘optionality’ is what is behind the convexity of research outcomes. An option allows its user to get more upside than downside as he can select among the results what fits him and forget about the rest (he has the option, not the obligation).” 

6. “What can you do, or what can you assert that you can do that will scare competitors that nobody else can do? From that flows good unit economics. If you have a true moat of whatever kind, an unfair source of supply, something on a brand, the ability to get scale where a competitor can’t, a technological innovation that somebody literally can’t access, and they look at that and say, ‘It’s not fair. I can’t make that,’ that is a beautiful thing. From that, you have a moat. From moat, you have pricing power, you have monopsony, like pricing leverage with suppliers. I just, I think everything flows from competitive advantage.” 

The book Bill Gurley inevitably recommends when asked for list of suggested reading material is Competitive Strategy by Michael Porter. The principle behind what Porter calls sustainable competitive advantage (a moat) is simple: the greater the supply of any product sold in a market the more the price of that product will drop to a point where there is no long-term profit above the cost of capital. Moats need not be absolute to be valuable and are always transitory (no moat lasts forever). The test of whether a moat exists is quantitative. If a business has not earned returns on capital that substantially exceed the opportunity cost of capital for three to five years, it does not have a moat. The biggest challenge in creating moats is that they result from qualitative factors that are neither fully predictable nor understandable. Charlie Munger has said that the task of creating a moat is so hard that Berkshire instead focuses on buying them. Why is it so hard? Wolfe and I share an admiration of the work being done at the Santé Fe Institute, including understanding research complex adaptive systems. Wolfe is on the board of Trustees of SFI with people like Michael Mauboussin and Bill Gurley. What these investors and others appreciate about the work done at Sante Fe and other places on complexity is that it helps them understand (1) what they do not know and (2) what is not knowable. Knowing what you do not know helps you define a circle of competence and knowing what is not knowable helps you to identify areas to avoid. 

7. “People tend to pine for the nostalgia of yesteryear. It used to be that a single person like Ben Franklin could create large easy to understand and widely applicable breakthroughs. Today incremental discovery requires scientists to be more and more specialized. But the bigger combinatorial possibilities are bigger than ever. The best entrepreneurs put many technologies together almost in a Renaissance manner to create the big breakthroughs.” 

Science and business today are much more competitive and distributed today than was the case in the past. Anyone who is involved in a real business and paying attention knows this reality first hand. There are some people who “pine” for an era when a single inventor working mostly on their own produced singular easy to understand innovations like the flush toilet. The world does not work that way anymore. Scientific and business capabilities are more and more widely-distributed. Scientists and business people are connected by highly networked systems which enable collaboration at levels and with speed never before possible. As a result, innovation and credit for innovation is much more distributed than it has ever been before. As Wolfe points out, many of the most important innovations are combinatorial and incremental. There are (1) many more innovations (2) happening much more frequently (3) on a far more distributed basis (4) developed by more people, than ever before.

8. “We’ve had incredible executors, operators, and other people that get stuff done, that can come up with a plan and execute on it, but they can’t raise money, recruit, sell a story, talk to the media. Those missing skills creates a major deficit. On the other hand, you have people who are amazing at telling stories, and they can lower the cost of capital because they can raise expectations, but they can’t execute. You need a marriage of both. You need the storyteller, and you need the executor and the operator.” “Passion is the best predictor of success.” “Our number one job on the board is making sure that she or he, whoever is running the company, are doing a good job, and if they are, I basically view it as, we work for them, and if they’re not, then we have to replace them. That’s the hard thing, and you can never do that too soon.” “The greatest entrepreneurs are risk killers. They think about killing failure paths. They also understand that risk and value can change form. When risk has been killed then value has been created and a subsequent investor should pay a higher price for a percentage ownership interest in a business.”

Wolfe defines risk as “more things can happen than will happen.” This definition was created by Elroy Dimson at the London Business School and has been adopted by other investors who share Wolfe’s outlook on investing. For people who adopt this view of risk, the future is not fixed but rather an endless series of probability distributions. Great entrepreneurs are not “risk takers” and are instead “risk killers.” They have skill in identifying which are the most valuable risks to kill (or at least retire). The best entrepreneurs know how to destroy pathways that can lead to harm, which results in better outcomes. The goal of a sound investment or business process is always defined by expected value: “Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain.” Killing risk increases expected value.

9. “What is predictive of financial returns is how much capital is going into the sector. The more capital that is going into the sector, the worse financial returns will be.” “The higher the price you pay, the lower your expected return.”

Investing in a business at a pre-money valuation of $10 million will generate twice the financial return than if you had invested at $20 million pre-money. This applies both to individual investment but also to all investments taken as a whole. The number of financial exists is top down limited by the economy as people like Fred Wilson has pointed out. The level of financial exists in any given year has not leaped up in response to more capital being deployed to venture capital. There are only so many Facebook or Google style financial exists in the economy. More generally, the more capital and investors that inhabit a market the harder it is to find the edge that Wolfe desires. Markets in which less capital has been put to work tend to have a greater probability of generating a substantial market inefficiency.

10. “Inspired by Charlie Munger, I keep records of people that have made really bad decisions. I’ve debated this with Peter Thiel where he’s like, you only want to focus on people that have been really successful, and I totally disagree, because a lot of that has been luck, but I think if you focus on people that have really screwed up because they’ve made bad choices, that’s something to avoid.” “Failure comes from a failure to imagine failure.” “If you can imagine all the things that can go wrong, then you can flick them off the table, because I think of it almost like the first law of thermodynamics, like energy is not created or destroyed, risk and value just change form. Technology risk, product risk, market risk, finance … All those things are risks. I kill one of those risks with time or talent put into it. If you’re a subsequent investor, you should be paying a higher price and demanding a lower quantum of return, because you’re taking a low quantum of risk. When this entrepreneur comes in and is pitching us, maybe they’ve eliminated the financing risk, but all those other things exist.” 

Anyone going through life is constantly conducting experiments and generating feedback. Some people realize this process is happening more than others and as a result are more aware of and responsive to positive and negative feedback. One challenge for humans is properly internalizing the feedback, which can lead to repeating old mistakes. Making the challenge harder is the fact that there are many heuristics or biases that people use to get through life that are often useful or at least were useful long ago in human history that can sometimes cause people to make a bad decision or a mistake. By paying close attention to your mistakes and successes you can improve your skill. By reading and talking to a lot of people about mistakes that other people have made you can learn vicariously about more mistakes that if you have never read or heard the same stories. Learning about painful mistakes by reading books is a sound way to live your life. There is no need to pee on an electric fence yourself to learn something about that outcome. If you do pee on an electric fence yourself, it will be particularly memorable.

As an example of developing good judgment, let’s assume someone approaches you with a compelling story about new product X. When you look at the projections you see a graph that resembles a hockey stick. What some with sound judgment knows is what Wolfe said here: “One of the biggest mistakes people make is creating predictions about trajectories. For example, ‘Such and such market by 2020 is going to be this many billion dollars.’ The trajectories in these predictions are always hockey sticks. That is never predictive of financial returns. Ever.” The more hockey sticks you see in presentations the better you get at understanding them and the people who present them.

11. “Science fiction imagines what could be. The best entrepreneurs also imagine what can exist in the future. “I see the gap between science fiction once imagined and science fact now realized is ever shrinking.” “I’m both an optimist about the endless frontier of technological possibility and a realist who believes failure comes from a failure to imagine failure.” “The gap between– we actually catalog this in a sort of funny but true way– the gap between science fiction– that which was once imagined– and sci fact– what becomes real- – keep shrinking. You can watch Star Wars and see the Luke Skywalker robotic surgery. We’ve got a company called Auris from the Intuitive Surgical founder doing tiny robotic surgery. You can look at the Taser gun, which was inspired by the Star Trek phaser. You can look at the 3D scanning and 3D printing from something like Disclosure where Michael Douglas gets scanned and dons these virtual reality goggles.” 

In addition to what he said above, Wolfe also said that science friction authors are either getting more creative or scientists more creative. The investments that Lux has made reflect this viewpoint and reality. For example, Lux has invested in what is essentially a drone racing league and robotic surgery seen on Star Wars. He appreciates that science fiction writers let you know that they are imagining things and that they inspire people to make their imagination come to life.

12. “The best advice I ever got was Jim Watson, who co-discovered DNA. Jim is brilliant, and as many brilliant people are a little bit crazy, and Jim has this admonishment which is double meaning, three words: ‘Avoid boring people.’ I love it, because what he’s saying is, ‘Stay away from people who are not interesting,’ avoid boring people, and, ‘Avoid boring people. Don’t be boring to people. Be interesting.’”

Being around interesting people increases the probability that you will be exposed to positive optionality. It also makes your life a lot more fun. Wolfe is about as far from boring as anyone I know. Dos Equis beer should have selected him as the new “Most Interesting Person in the World.” Friends don’t let friends hang out with boring people.

End Notes: 

Josh Wolfe:

https://medium.com/@patrick_oshag/this-is-who-you-are-up-against-transcript-8dd488896d80

http://www.perell.com/podcast/josh

https://medium.com/lux-capital/the-certainty-of-uncertainty-ac89c307a81b

https://www.spreaker.com/user/10626432/can-we-learn-to-invest-in-the-future-med

http://firstmarkcap.com/insights/fireside-chat-josh-wolfe/

http://www.thetwentyminutevc.com/joshwolfe/

https://www.ozy.com/rising-stars/the-science-nerd-turned-big-think-vc/65133

Andy Rachleff: https://blog.wealthfront.com/venture-capital-economics/

Bill Miller: https://millervalue.com/sources-of-edge/

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