I’ve written before about the wisdom of Charlie Munger, Warren Buffett’s older and smarter investment partner.
He’s a big fan of mental models.
Munger credits his wealth to identifying the way smart, successful people think and applying their logic to the world of investing.
(You can listen to a speech – “The Psychology of Human Misjudgment”- Munger gave at Harvard where he describes his favorite insights.)
I’ve recently come across a new mental model that I’ve never heard Munger describe.
It’s one that can help you understand – and perhaps even replicate – the massive returns made by early investors in Silicon Valley’s booming high-tech sector.
Jason Calacanis is one of Silicon Valley’s leading angel investors.
Over the past seven years, Calacanis has invested in more unicorn companies than anyone else in Silicon Valley.
(Unicorns are startups that have achieved a valuation of at least $1 billion.)
Those investments helped Calacanis turn an initial investment of $100,000 into $100 million.
His experience offers a new model for how angel investors make their money.
Let me explain…
The conventional wisdom goes something like this…
Make 10 investments. One or two will go bust. Six or seven will roam in the land of the living dead until they fold or sell themselves.
And one or two investments will be big winners.
These will make up for the losses in the others.
So far, so good…
So what new insight did Calacanis gain while angel investing in Silicon Valley?
It turns out a few massive winners account for a much larger portion of investment gains than you’d ever expect.
Calacanis describes this phenomenon with a clever baseball metaphor.
If you’re a baseball fan, you know that a grand slam – a bases loaded home run – is worth four runs.
Calacanis says that returns on a successful angel investment are as if the rules of baseball changed overnight and…
A grand slam became worth 100 home runs.
An investment that would normally earn you four to five times your money…
Instead generates a 100X return.
And in Silicon Valley, that 100 home run metaphor may even be conservative.
Calacanis writes that he invested $25,000 in Uber at a $5 million valuation.
Uber’s peak valuation eventually hit $72 billion. (Today its valuation is around $48 billion.)
My back-of-the-envelope calculation shows that Calacanis’ investment was then worth $360 million.
That’s an astonishing 14,400X return.
A couple of caveats are in order…
First, hindsight is always 20/20.
Yes, once you hit a grand slam, it’s game over – you’ll have more money than you’ll ever need.
But you still have to hit that grand slam. Betting on your ability to pick the next Uber is tempting.
But you must be more than just smart. You also have to be lucky.
Second, you have to play to win.
Calacanis once decided not to play – when he passed on investing in Twitter.
He didn’t find compelling the prospect of investing in a company that limited its content to 140 characters.
Today, Twitter has a market capitalization of $23 billion.
And Calacanis estimates that his decision not to invest cost him $50 million.
Third, Calacanis is adamant that you have to be in the right place at the right time.
He says that place is Silicon Valley.
So Calacanis has harsh news for the Silicon Valley wannabes of the world.
Yes, Stockholm may produce a Spotify. London may be home base for a TransferWise.
But the next Google is likely not coming out Brazil.
Even the internet giants of China that scale hugely – Baidu (Nasdaq: BIDU), Alibaba (NYSE: BABA) and Tencent (OTC: TCEHY) – operate only in their home markets.
Unlike Google or Facebook, Chinese techs don’t have global brands.
So if you want to play the angel investment unicorn game, you need to be in Silicon Valley.
Calacanis says he’s moved promising startups from Shanghai to Palo Alto just for that reason.
What’s the takeaway?
Calacanis’ “a grand slam is worth 100 home runs” metaphor explains how angel investors make their money.
It’s an insight you can also apply to other high-risk investments like cryptocurrencies and small cap mining stocks…
And I bet it’s a mental model that even crusty old Charlie Munger would appreciate.