Michael Szalontay, Co-founder and General Partner at Flashpoint, an international tech investment firm

There’s a saying, often attributed to Thomas Edison, that goes, “Opportunity is missed by most people because it is dressed in overalls and looks like work.”

Contrarian investing is not a new strategy. It has existed ever since humans started operating markets driven by demand-supply forces with information as the main medium.

Public markets exhibit strong form efficient market hypothesis (EMH) with stock prices following a “random walk,” leaving almost no opportunity for gaining advantage through superior information, as analysts are gathering every bit of available public and non-public information about every market and traded company, and using the powerful combination of human intuition and computers to capture arbitrage opportunities. Contrarian investing is at the top of the Olympus in this endless game of information gathering as it involves either finding a completely new piece of evidence or, more likely, coming to a conclusion that is contrary to the general views in the market. The Big Short shows an excellent real-life example of contrarian investing during the global financial crisis.

While EMH was developed first and foremost with a view to explain the behavior of stock markets, where price movements are instantaneous and friction is minimal, these theories are also inherent in private markets, especially in the modern information age. Contemporary private markets, including venture capital (VC), exhibit a very weak form EMH, where fundamental analysis provides a medium-term advantage, but returns are diminishing fast as information about assets and investment decisions is spreading with ever increasing speeds.

Venture capital, like any other investment business, is a game of probabilities played with information as its main input source. What does contrarian investing mean in a VC context? VC tech investing has been a mainstream asset class for decades; however, contrarian investing is not just a strategy, but rather a cognitive method. It can be applied within an asset class by searching for value, where others believe there is none. There is definitely hype around technology investing as the overall amount of capital invested and average valuations have been steadily rising in recent decades.

Nevertheless, I believe there is plenty of value to be found by thinking outside the box and going against the established practice in the industry. A spectacular example is the purchasing of baseball players in Moneyball, where the use of sabermetrics led to contrarian investments into players who were undervalued or overlooked by other baseball clubs. To conceptualize this in the VC space, you have to understand the investment workflow of a venture capital manager and apply contrarian thinking every step of the way. VC firms differentiate themselves by their investment strategy and process, which always consists of entry, portfolio management and exit.

The soul of any VC firm is the framework used to evaluate companies and deals upon entry. An investment decision is based on analyzing information and assigning respective value to the various pieces of available information in some form of an evaluation matrix that facilitates the final decision. The two most critical information elements on the company side are the idea and the people who will drive its execution.

The modern term used by VCs describing innovation is disruption, which implies going against the current state of affairs of an industry. In this sense, VC investing is contrarian by definition, since every investment assumes an upstart company will redraw the established landscape and the huge reward in case of success is coupled with a write-off being the most likely outcome. A more nuanced view is looking at contrarian investing within the set of VC investments, and this would involve supporting ideas and markets that are off the beaten path. In my experience, most VCs look at the size of the market as a key input in their evaluation framework. They want to see a large and fragmented market that the company will attack with its product, as this is inherently a much easier process than creating a new market from scratch. However, the best investments generally involve ideas pioneering nonexistent markets. Think of Apple or Microsoft, which created completely new industries with their first products.

Assessing human capital is the backbone of VC investment decision-making, since businesses are built first and foremost by people. This is compounded further in tech, where labor is a critical productivity factor often taking up to 80% of total costs, in my experience. VCs are looking for experienced teams with a breadth of skills, diversity and significant skin in the game — ideally a team consisting of successful serial entrepreneurs with a shared history. The opposite end of the spectrum is a single first-time founder with limited presence on the cap table. However, contrarian doesn’t necessarily mean being on the low probability end of the scale. It means playing the odds and seeing value, where it’s not obvious.

Think about the VCs supporting Mark Zuckerberg or the duo of Steve Jobs and Steve Wozniak. At the time of launching Facebook and Apple, they were college dropouts and not serially successful entrepreneurs. When Peter Thiel led Facebook’s seed round valuing the company at $5 million in 2004, he made a bet even though the pitch was far from convincing. Apple’s funding story is even more intriguing as Jobs’ initial pitches weren’t met with much success. Eventually Mike Markkula, a Fairchild Semiconductor and Intel veteran, who was ironically referred to Jobs by Don Valentine, founder of Sequoia Capital, joined them as an angel and co-founder by investing $92,000 in equity in 1977. Markkula went against street opinion by supporting founders, who even according to their first outside investors “weren’t very appealing people in those days.”

Finding value off the beaten track of the VC world often requires following that old “opportunity” adage to the letter and involves a lot more perspiration and work than many VC players are ready to undertake. In part 2, I will discuss applying the contrarian mindset to deal selection, portfolio management and exit.

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