Street Capitalist: Event Driven Value Investments

Intellectually, start ups have always been an area of interest for me. What I often wonder is if start ups can mesh with the kind of Warren Buffett-style practices I use to look at businesses. Right off the bat, the two ideas appear to be pretty incompatible. After all, start ups are typically focused on new technologies that are unproven, often without moats around them. But Max Chafkin over at Inc.com has a great article (“The Start-up Guru: Y Combinator’s Paul Graham”) that details the methods employed by Y Combinator when investing in start ups.

Y Combinator is unique in that its investments are relatively small, they do not sink millions of dollars into any one company. The businesses they invest in are often intended to be disruptive, their goals are to eat away at the moats of competitors. A while back I remember reading about Walmart and Sam Walton. One of the things that he addressed was the fact that you did not have to try to copy Walmart to compete with Walmart. Instead, you had to find holes in its moat, products that they could not deliver to their customers. I look at these Y Combinator start ups in some of the same light. They’re not trying to beat a company like Google, they’re just trying to take a sliver of Google’s giant moat.

Y Combinator’s strategy of limiting the liabilities side of their start ups reminded me of Mohnish Pabrai’s belief that often you need to find low risk high uncertainty businesses. For example:

Tonight’s feast consists of mountains of white rice and a ketchup-hued chili served out of several large electric Crock-Pots. The founders eat standing up or hunched over laptop screens. A quick scan of the Y Combinator pantry, which includes six gallon-size cans of pinto beans, seven large cans of sloppy joe sauce, and a copious amount of canned tomatoes, confirms that the meal is typical. “Goop on rice — the same every week,” Graham says with a smile, as he shovels the stuff into his mouth. He used to cook the meals himself but recently ceded that duty to a professional cook.

Cheap meals are, in a strange way, part of Y Combinator’s formula for start-up success. Graham wants founders to spend as little money as possible. Live cheaply enough, he believes, and you can become cash-flow positive without going on a lot of sales calls or spending too much time talking to investors. Graham calls this “ramen profitability” and says it allows companies to say no to bad investment terms and forces them to think about long-term viability. It also ensures that most Y Combinator founders are in their 20s — or, for the few who happen to be older, that they are capable of living in dormlike conditions. “That culture of frugality and discipline is really important for the Y Combinator mindset,” says Sam Altman, founder of Loopt, a graduate of Y Combinator’s first class. “The start-ups that do well are the ones that are working all the time.”

…The pitch was straightforward: $6,000 for a company with one founder, $12,000 if the company had two founders, and $18,000 if the company had three. In exchange, Y Combinator would get roughly 6 percent in common stock. (Exact ownership stakes vary. The most Y Combinator has taken is 10 percent; the least is 1.4 percent.)

Graham promoted the program with an essay that he posted on his website and that quickly found its way to many college students’ e-mail inboxes. “We give you enough money to live on for a summer, as with a regular summer job,” he wrote. “But instead of working for an existing company, you’ll be working for your own; instead of showing up at some office building at 9 a.m., you can work when and where you like; and instead of salary, the money you get will be seed funding.”

From the start, the businesses funded by Y Combinator seem to be infused by a mantra of doing less with more and living frugal lifestyles. By keeping these costs ultra-low and controlled, the team at Y Combinator seems poised to keep their losses relatively low while keeping their upside high. Graham himself seems like a bit of a renaissance man:

Like many software entrepreneurs, Graham has been writing code since his teenage years, but he also has a range of interests not common among computer geeks. He was an aspiring short-story writer as a high school student and majored in philosophy at Cornell as an undergraduate. After deciding that he found philosophy incomprehensible, Graham landed in a computer science Ph.D. program at Harvard. He excelled as a programmer, but about halfway through graduate school, he started taking classes in Harvard’s art department. After receiving his doctorate, he enrolled at the Rhode Island School of Design with a plan to become a painter. He took classes at RISD that summer and in the fall enrolled at Florence’s Accademia di Belle Arti, a nearly 500-year-old art school founded during the Renaissance. When I suggest to Graham that this was a weird life plan for someone with a computer science degree from Harvard, he says simply, “I never cared about the official rules.”

Such a multidisciplinary approach reminds me of investors like Benjamin Graham or Charlie Munger. One thing I wanted to point out is that I think their approach of building a fairly diversified portfolio of investments is interesting. It reminds me a lot of Ben Graham’s net-net approach, where capital was deployed in many different securities. The same kind of thinking happened with Buffett’s investments in South Korea and more recently in the Pharma-sector. In these cases, there was a considerable amount of uncertainty and while the investors knew some of these companies would be immensely profitable investments, others would be less so. It would be too difficult to only pick the winners, so a diversified approach was employed.

Be sure to read the full article: The Start-up Guru: Y Combinator’s Paul Graham (Inc.com) I feel like we can always learn by looking at areas that we normally designate to be outside of our circle of competence. Most value investors try to shun technology, but as we all know, both Buffett and Munger spoke highly of Google’s moat at the annual meeting this year so it’s likely an area worth studying.