An investment thesis is an essential piece of document that every reputable business requires. It is a reasonable argument about a particular investment strategy backed by research and analysis of its workability. The investment thesis is a very popular document in the financial world; hence, you can see analysts prepare the document outlining the investment strategy as a presentation to the investment committee or investors.
At the end of this article, here is what you should know:
- An investment thesis is usually a written document that involves research and analysis. It usually recommends a new investment enlisting its profit potentials.
- Professionals can use the investment thesis to explain their ideas.
- Individual investors are not left out as they can use this method to investigate and choose an investment that meets their objectives.
An investment thesis enables investors to assess different investment ideas and determine the best option that would have them actualize their investment goals. Similar to any thesis, it needs to start with an idea. However, for it to continues, it needs to undergo systematic research, which entails taking it from an abstract concept to a stage where actions can be recommended. Another way to see an investment thesis is like a game plan for your investment.
Understanding Investment Thesis
Generally, most investment theses come in a written form, which gives allows you to review and analyze what triggers a particular action or not. From the thesis, you can see why a particular action was the right one or not. For instance, an investor buys a particular stock based on a recommendation from the investment thesis that the stock will be undervalued. According to the thesis, the investors should hold the stock for five years, during which the price will rise to represent its true worth. In five years, you can sell the stock for a profit.
Assuming a year after following the investment thesis action, the stock market experienced a crash; the stock you pick also crashed. The investor remembers the investment thesis, then depends on the conclusions’ integrity, and decides to hold the stock. It looks like a sound strategy unless something unexpected happens, which is absent in the investment thesis. Perhaps, you can think that cannot work; well, do you remember the 2007-2008 global financial crises, the recent coronavirus outbreak that rocked the world. All of these events are unexpected and can affect an investment thesis.
Developing Investment Thesis
To begin, we will guide you on how to develop an investment thesis for venture capital.
- Give it a Thought and Be Creative
In developing an investment thesis, you need to spend time brainstorming ideas. On your brainstorming sessions, ensure to use notes to jot down your thoughts. A straightforward thesis to develop can be “creating a driverless car in the future” or as complex flying cars without drivers. You have to come up with a various hypothesis, which reflects knowledge, instincts, and needs.
Starting an investment thesis is never as easy as many consider. It is challenging as you will face trouble starting. If you get trapped at how to start, you can start with your personal experience. What is your thought about starting a company? Do you have any particular niche or industry? Do you have any relevant insight into such an industry that you are willing to die for it? Do you have what it takes to be Mark Cuban? If that is a positive answer, then you can use that information to start your investment criteria.
To make it easier, you can follow experts or people you look up to invest in companies. Remember, an investment thesis is limited as the investor’s creativity. Therefore, the more creative you are, the more ideas follow in your thesis.
- Be Specific
The moment your investment thesis begins to take shape, you can move to the next phase. Here, you list every specific of the strategies you have written. What sector or industry are you interested in? What is your financial capability to invest? What area do you want to invest in? Venture or seed stage? Are you a serial entrepreneur or first-time founder? Are there any deal breakers? During this period, you need to be specific with everything to hone your thesis better.
- Become an Expert – Research
Once you have gathered everything you need, the next phase is to assemble them. When it comes to building an investment strategy, you need education – research. Importantly, you need to understand the area you are interested in, looking at the startup’s perspective and incumbent aspect.
You can read various respected publications such as Bloomberg, Financial Times, and WSJ that cover incumbents’ issues. Every major publication has a technology aspect that features innovation, including columnists talking about key areas. For instance, Matt Levine is a respected person from Bloomberg that has excellent insight into fintech and the financial market.
If you want a startup perspective, your best place to find relevant information is TechCrunch. Besides this, there are other places to source resources to help you build an investment thesis. You can start with Eric Reis’s blog, Mattermark Daily, Startup Lesson Learned, etc. Furthermore, you can find blogs dedicated to a particular industry like Ethereum’s and CoinDesk blog, which are the best place to source information on blockchain and cryptocurrencies.
However, if you want social news and forum platforms, you have Quora and Reddit to help. On these platforms, you can find posts, view and read questions about everything you can imagine on this earth.
- Discuss with Peers and Colleagues
Like the famous saying, “Nobody is an island.” You need to get some friends and start practicing selling your investment thesis to them. Warren Buffett and Bill Gates employed the same strategy when they started. If you can’t defend your thesis with your friends and convey your idea to them, then you should consider going back to your drawing board to get things in their right perspective.
- Invest and Continue Evaluation
If you were able to conveniently defend and pass your ideas to your colleagues and peers, then you have made it. However, the most challenging part comes in putting in your money. You have to invest your money where your treasure lies. Take the plunge and invest in your project. Ensure to select the right company and funds to invest in; additionally, avoid cool-looking companies who might disguise to get the best out of your ideas. The last step is to continue evaluating your thesis. At times, you still have to do a little twerking to your thesis.
Components of an Investment Thesis
Before writing an investment thesis, you need to understand individual components that must be included. To give you an idea of what a thesis should contain, here is a summary of essential items your investment thesis must-have.
- Investment Amount – A lot of funds come with a minimum and maximum limit. An investment thesis has to have an investment amount for investors to not what they are investing in.
- Target Audience – Where will the funds be directed? Some funds focus on business-to-business companies, whereas others rely on business-to-customer companies.
- Verticals – you can only invest in some verticals, whereas others are explicit. Example of verticals includes cryptocurrency companies, education tech, surveillance companies, advertising technology, medical tech, etc.
- Ownership Targets – Some investment funds are only targeted to a particular company. If the investor can invest in the company, can they hold a particular percentage of the company? These are issues that have to be clarified in the investment thesis outline.
- Educational Requirement – Some funds are expressly set up to aid graduates from particular schools or alumni. They tend to raise money for this particular alumni network to finance their activities.
- Demographic – some companies rely on investing in specific demographics because they believe those people can help recoup their investment. For instance, older founders, young founders, female founders, Latinx founders, etc.
- Geographic Location – Most investment firms have boundaries when it has to do with sourcing for deals. In other words, they can only invest within these areas – states, regions, or countries. For instance, some investment firms would prefer to invest in upcoming projects in Africa than those in the European countries.
- Opportunity Size – In line with the previous point, most investors love to invest in more significant opportunity size areas. For instance, if they can invest $50m in any project, they will get a return of $4m in investment. Investors are looking for opportunities to make huge returns on their investments.
These are just a few items you need to include in an investment thesis. Remember, the points listed above are tied to the investor’s aspect. Besides these, you would have to get a good team, a big market solution, solve a significant problem, and credibility for the market you want to enter. These can serve as a blueprint for you to know what you need to include in an investment thesis.
Building a Successful Investment Thesis
Now you have a fundamental idea about the investment thesis. It would be best if you constructed a real and actionable investment thesis. To start a successful investment thesis requires three essential elements.
- Understanding the general trade setup
Let’s summarize each element and the role they play in building a successful investment thesis. In this article, our focus will be on the micro and macro environment.
Regarding the microelements of an investment thesis, the company should have good qualities. These qualities should include:
- Growing industry
- High return on capital
- High margins
- Barriers to entry
Another vital thing to consider is good management. Here, you should look for the following qualities:
- Not overly promotional
- Well respected
- Good allocators of capital
- Clean accounting
- High insider ownership
- Infrequent restating of earnings
Although these qualities won’t differentiate your pitch, they are essential and should be discussed in your thesis.
While it is not ideal, stocks in industries with bleak macroeconomic outlooks can be a good investment. Importantly, you must understand the ins-and-out of what is happening in a company at different levels – national, industry, and subsector level. Doing this will enable you to determine if you are investing in the right house but in a bad neighborhood.
The company level is the analysis that we described at the micro-level, whereas the subsector level deals with that are happening with your immediate competitors. Does it look at who the winners are? Who are the losers? Are their imminent substitute products or competitive products in the market?
At the sector level, you find out what the current trends are in the industry. For instance, is the industry doing well because of restocking, which is global or regional? Nevertheless, the national level will help you know if you are going national or just within a particular region.
Before investing in any organization or company, there are certain things to consider in this section. We will explore some of these that can help you determine if you should invest or not.
Once you began working with a hedge fund, you will learn that every fund has a unique investment style. Some hedge funds won’t invest in companies with weak management teams despite how attractive or lucrative such an opportunity might be. Applying this principle often led to investors getting burned once management makes a wrong decision, focusing on short-term earnings or bad acquisitions.
When studying a management team, you need to look at their previous accomplishment and understand both the team’s sell and buy-side. Furthermore, study the internal company philosophy such as how they allocate capital; if the team follows what the company does. Another essential thing to consider when it comes to the management team is how the team members are compensated.
You have to determine if their compensation is connected to return on capital, earning, or revenue, or they have other metrics. Additionally, does the management team own any stocks? If yes, how much stock would that be? You can also look at their risk appetite, whether they are selling or buying stocks. These are just a few checklists when it comes to the management team for investment consideration.
Here, you have to analyze both the absolute and relative valuation of the company. When you compare a stock with another in a different sector, it might be cheap. However, when paired against another in the same sector, it can be costly. Therefore, different investment situations warrant different valuation metrics.
In valuation, you need to study the consensus sell-side expectations against the estimates. The factors below will play a key role when you want to perform the valuation for your investment.
- Are there differences between your earnings estimates and others on the street?
- If your answer is no, then is your investment thesis interesting or merely a consensus trade?
- Does the street care about what happens in the future?
Another critical investment consideration is a risk. According to Donald Rumsfeld, “Known unknowns and unknown unknowns.” All risks are not the same: some risks are riskier than others. In such a situation, how do you handle it? What do you do when investors begin to assess the downside risk from the situation?
The primary question required to answer if you want to understand the downside risk fully include:
- At what stage will the downside case happen?
- What will happen before you lose some benchmark amount?
- Peradventure the event happens, what will be the outcome of the multiple? Is there room for expansion, or will it go down?
- What is the likelihood that a downside will happen? What is the maximum loss if it does happen?
Catalysts are essential in recognizing when you get paid. It is an essential factor when it comes to position sizing. Peradventure, a catalyst is expected to happen in the future; you wouldn’t have to get a full-sized position immediately.
Outline for Investing in Large Market
The typical reaction when a stock price is rising, is to chase the returns. It means that once a particular stock continuously goes up, the investors think he is missing a massive opportunity in the market. This will trigger him to buy the stock hoping the uprise will continue.
However, this pile-on mentality has made many investors regret their actions. It is a classic human reaction to chase the market but has led to many low returns because of an undisciplined approach to entering the market. It doesn’t mean it happens to a rising stock alone; it can happen when the stock price drops continuously. During drastic moments, investors panic and enter the market at the wrong time as their emotions tend to get the best out of them.
Investment Business Model Advantages
This section will explore some investment business advantages as it has to do with an investment thesis.
Barriers to Entry
Organizations with entry barriers have a high advantage compared to those who don’t have barriers to entry. These barriers can happen for various reasons, but the most common reasons include substantial investment requirements, economies of scale, favorable government regulation, technological innovation, and networking effects.
For instance, eBay is a difficult company to compete against since it has already established itself as a formidable company online. Both sellers and buyers are unlikely to visit other sites since eBay offers more. This makes it hard for newer companies to compete effectively with eBay.
Many companies claim they have high entry barriers, but soon their company earnings show something different as the earning is higher than their capital cost. Look at it this way when a company is earning outsized returns on the invested capital. It attracts competitor investment seeking to gain comparable returns. The competitive investment leads to increased sales competition and production while diminished profit-earning potentials in the future.
Low-cost producers have high advantages over their competitors. In large legacy assets industries such as coal or cement production, the key players with the newest assets are usually the lowest cost providers. On the other hand, there is an opportunity to learn, which creates a reverse effect, wherein the old participants in the industry have lower costs while the new players are finding out the next action to take.
Frequent purchase of items such as office or paper supplies can become a massive advantage for a producer. How rooted a company is within its customer bases will determine if the switching cost for that company will be high or not. For instance, if a company roll-out an extensive technology, it can effectively lock a customer.
Economies of Scale
Companies that have high fixed costs require scale to make a profit. The more the fixed cost is, the larger the scale needs to be. Incremental margins are high immediately a company crosses a particular threshold. With this, it can make a company highly attractive for investments.
We have taken a broader look at what an investment thesis is all about. It is an essential piece of document that every reputable business requires. It is a reasonable argument about a particular investment strategy backed by research and analysis of its workability. An investment thesis enables investors to assess different investment ideas and determine the best option that would have them actualize their investment goals. Furthermore, we explored some essential components of an investment thesis, looking at the investment amount, the target audience, verticals, demographic, educational requirements, and the ownership targets. You need to understand these before drafting your investment thesis.
Finally, starting an investment thesis is never as easy as many consider. It is challenging as you will face trouble starting. If you get trapped at how to start, you can start with your personal experience. What is your thought about starting a company? Do you have any particular niche or industry? Do you have any relevant insight into such an industry that you are willing to die for it? In developing an investment thesis, you need to spend time brainstorming ideas. On your brainstorming sessions, ensure to use notes to jot down your thoughts.
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