What Howard Marks, Buddha, and S-Curves can say about the current state of Venture Capital in Brazil
Sunday Drops 🌊 #43
How can we make smart decisions when nothing stays the same, and the future is unknowable?
Howard Marks and Buddhism may have some answers.
As the book Zen Mind points out, everything changes is the fundamental truth for each existence. No one can deny this truth, and all the teaching of Buddhism is condensed within it.
Marks, a remarkable investor, has Buddhism changed acceptance as a life mantra. During an interview with Willian Green, he explains how this has shaped his philosophy of investing and life. "Change is inevitable. The only constant is impermanence," he says. "We have to accommodate the fact that the environment changes. . . . We cannot expect to control our environment. We have to accommodate to our environment. We have to expect and go with the change."
Everything flows in a state of constant flux: nature, economies, markets, industries, companies, and our own lives. It's almost impossible to predict the future: has anyone (other than Bill Gates) pointed out a global pandemic in their radar screen? Marks likes to say that investing is something like divining the future. We tend to project a lot that we believe will occur. This exercise is dangerous: we likely imagine the world as a stable place and usually reflects our emotions, biases, fantasies, and fears about the future.
What Marks does differently is to think in a cyclical mood: Marks operates on the assumption that the cycle will eventually self-correct and the pendulum will swing back in the opposite direction. The future may be unpredictable, but this recurring process of boom and bust is remarkably predictable. Once we recognize this underlying pattern, we're no longer flying blind.
Remember dot.com bubble? Or the 2008 great crisis? In all of these cases, Marks was cautious at least years ahead. If we think well, almost all the bubbles and economic busts in history were similar: Overconfidence, high valuations, and focus on returns instead of true value. We have to remember that price is a game, and as Ben Graham says, the stock exchange is a voting machine. With the global liquidity and this immense amount of money searching for opportunities in the private market, we are also getting closer to being a voting machine.
Back in cycles: This is a strong premise. The whole history of humanity exposes that we tend to live in bust and booms. The benefit of recognizing where we stand in the cycle is that it enables Marks to chart an appropriate course based on prevailing conditions, much as he'd drive more carefully on an icy road at night than on a sunny afternoon. "We have to recognize the market for what it is, accept it, and act accordingly," says Marks.
Stoicism has the same roots as the change acceptance mindset: The reality is what it is and the only thing you can control are your responses. The environment is what it is. We can't demand a more favorable set of market conditions. But we can control our response, turning more defensive or aggressive depending on the climate.
The question in my mind is: Where are we in our cycle?
To reflect on our moment in Venture Capital at Brasil, I will bring one of my favorite mental models: S-Curves.
An S-curve is a graph that plots a relevant cumulative data field — such as man-hours or cost — against time.
S Curves are everywhere. They appear in business, biology, politics, social media, internet usage graphs, covid infection, vaccination rates, and all aspects of our minds, society, and economy. There are two parts in an S curve: acceleration and deceleration, with a hypergrowth phase in between.
If we think in the total investment volume over startups in Brazil over the years, it's clear that we are currently in the "hypergrowth" phase:
The Brazilian startup investment volume in 2021 was US$ 8.85 billion1 until November (source: Distrito). Brazil's GDP is forecasted to be 1.51 trillion dollars GDP2. It's fair to consider that the GDP was more or less 1.38 trillion dollars until November. So, the ratio of startups investment volume over GDP until November results in a 0,63% ratio over GDP.
We can see that the Brazilian market is ~60% smaller than the total USA.
I see 3 possible scenarios ahead in terms of where we are in the cycle:
Optimistic: In the cycle, consider that we can catch up in terms of startups investment volume to the USA, and it can be as high as 1.57% of the GDP in the next few years. That means we are still in the hypergrowth phase, and the market will grow more each year (not at the same pace as 2021).
Base case: We will maintain a ~50/60% poorer level than USA. The curve points out that we are reaching a peak in the medium term (can be 2021 or 2022, 2023, 2024). In the next few years, we are transitioning from hypergrowth to stabilization to deceleration in terms of S-Curve.
Pessimistic: An upcoming crisis or the uprise of interest rates will take venture capital money to other asset classes. In the medium/long term, money for startups will be more scarce in Brazil.
The only thing I know for sure is that we are in the golden years of startups investment volume. My base case analysis forecasts that the pace of growth (doubling, tripling) may not be sustainable in terms of 2-3 years because I consider the 1.57% USA ratio as the possible peak. If we maintain this acquired level of investment (ratio over GDP), it will be enough to be a relevant and robust sector of the Brazilian economy. Remember that this number was not more than 0.10% five years ago.
Two risks to my analysis:
The macroeconomic scenario assessment - I do not have the expertise to analyze it.
I can be wrong by applying the current USA ratio of investment volume over startups. Maybe I am conservative in Venture Capital penetration in the economy, and due to the digitalization trend, this number can be as high as 3 or 4% in the future.
This exercise aims to recognize where we stand in the cycle.
Most investors act as if the latest market trend will continue indefinitely. As critical thinkers, as investors, we need to avoid the most ingenious biases: the recency. Behavioral economists use the term recency bias to describe the cognitive glitch that leads us to overweight the importance of our recent experiences.
Using a surfing analogy, we cannot control the wave. We will surf the one that nature sends to us. Right now, in Brazil's Venture Capital market, it seems that we are in "perfect" conditions today: It's time to drop and catch the best wave of our existence. But keep an eye that tomorrow can be a storm day on the sea. Or it can be a great day again; I don't know.
As Marks and Buddha would say, change is the only certainty. So, let's embrace and take the maximum advantage right now.
May 2022 to be a fantastic year for you all.
Sunday Drops 43.
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Many of Howard Marks's quotes were found in the fantastic book Richer, Wiser, Happier by Willian Green.