My last post drew a distinction between two classes of shares: potential “moonshots” (those with fat-tailed and/or right-skew returns), and “mundanes” (those with symmetrical returns). I argued that when selecting potential moonshots for a portfolio, one should be more tolerant of false positives than when selecting mundanes.
However, I can also see a good case that it may not be worth spending time looking actively for moonshots. This is for the following reasons.
The incidence (frequency) of true moonshots in the entire investment universe may be too low. It may be high enough in an exceptional period like 1998-2000 (my formative investment experience), when there were many technology moonshots. But in more normal times, the incidence may be too low.
The losses on false positives are often high. Potential moonshots which fail often fail disastrously, with loss of most or even all of your investment. A smaller investor might be able to use a stop-loss, but this is not practical for a larger liquidity-constrained investor (and for a fundamental investor, I’m doubtful it is ever a good idea anyway – see p60 of Free Capital).
The large gains on the few true positives are hard to realise. It is hard to hang on to quoted company moonshots. Even when the moonshot takes off, you may not recognise the scale of the company’s potential; and the daily temptation to prudently realise part of your gains is hard to resist.
Incidence and classification accuracy are unknown parameters. You have no way of knowing the true parameters for the population incidence of moonshots, or your accuracy in classifying them correctly. Therefore when you have a long stream of costly failures, you cannot tell whether this is because of (a) bad luck (in which case you can reasonably expect a success soon), or (b) the true parameters are too low (in which case you may go bust before you have a success).
Moonshots give big deviations from index returns. If the deviations were modestly positive in most periods, this would not be a problem. But the more likely scenario is that a moonshots portfolio will produce mediocre returns in most periods, and (we hope) a few big hits to compensate in other periods. This irregular pattern of returns gives little reassurance of your ability, and so is psychologically difficult for most investors.
Moonshots are hard to recognise ex-ante. I held potential moonshots QXL and ASOS in reasonable size in 2004, but sold them far too early. Even with hindsight, I don’t see that either of these had features which made them easy to recognise as moonshots in 2004. For ASOS, one comparable was the privately-owned Figleaves, which was founded as long ago as 1998, and sold for slightly over £10m to N Brown in 2010. Considering the information which was available in 2004 with hindsight, I still see no way of telling in 2004 that ASOS was going to grow into a £1.5bn business, and Figleaves only into a £10m business.
For all these reasons, I don’t screen actively for potential moonshots. I just remember that anything can happen, including good things. Or in the words of poet Alice Walker: "Expect nothing. Live frugally on surprise.”