How to Identify Underrated Markets


Extraordinary performance in venture capital hinges on the ability to identify overlooked and underrated opportunities in entirely new markets.

This requires, by definition, a significant divergence from the consensus perspective. Successful investors detach their thinking from the abstracted trends and third party narratives driving day to day capital and attention flows. They keep their eye fixed on the tactile reality of the game on the ground.

But resisting the urge to conform as peers and competitors move in the opposite direction is much easier said than done.

The Value of Predictions

Howard Marks' 1993 letter to clients is the clearest articulation of the "non-consensus and right" framework he has become known for and provides a powerful look at the tradeoffs inherent in taking a non-consensus position.


In the letter, he writes:

The more a prediction of the future differs from the present, (1) the more likely it is to diverge from the consensus forecast, (2) the greater the profit would be if it's right, and (3) the harder it will be to believe and act on it.

Venture Capital is an exercise in funding a future that is radically different from the present.

But the feedback loops between the present and the future in venture capital are long and the opportunity costs associated with betting big on the wrong market opportunity (or not betting at all) can be significant.

These unique dynamics amplify the importance of identifying the right opportunities in the right markets.

Forecasting the Future

Whether we look to Marks or other investors like Seth Klarman and Benchmark's Peter Fenton, the lesson we can draw is that solving for the challenge of forecasting extremely different futures in new markets dominated by uncertainty is best done by anchoring on what is observable — "seeing the present clearly". Bottoms up instead of top down.

We can put this idea into practice by asking the following three questions about both markets and the companies within them to understand where underrated opportunities lie.

  1. Does the audience skew "young"?
  2. Is there a gap between engagement and monetization?
  3. Are there artificial barriers holding back scale?

Understand the Demand

The distinction is subtle, but framing the evolution of a market in terms of what is happening (early engagement) and what could happen (catalysts) vs. what should happen (intellectualization) can help us see reality more clearly and build a framework for independent decision making.

1. Does the audience skew "young"?

Startups spend far too much time trying to convince investors that they are attacking massive markets. On the other side of the table, VCs shun anything that could be considered niche.

The reality, as Aaron Harris wrote, is that "many of the largest companies in the world started in markets so small they looked like toys." They also tend to start with what incumbents would consider to be the least attractive customers.

In some cases "young" speaks to the age of a company's early adopters and the way it designs its product to drive deep engagement and loyalty within that cohort — Snap's early user experience, which confounded older users, is a good example of this.

More broadly, this speaks to classic Christensen Disruption Theory.

The "youth" analogy holds well beyond consumer products. Over the last decade, companies like Slack, Stripe, and Carta built their initial go to market strategies around and scaled alongside the teenagers of the enterprise world: Startups.

Just like young consumers on Snap, startups as customers are (often rightly) considered flaky and cheap. They also represent the future, both in terms of how products will be used and where economic power will rest.

2. Is there a gap between engagement and monetization?

In underrated new markets, there is often a significant gap between engagement and revenue. This may be due to companies seeking scale in advance of monetization or, as explained above, because early adopters in the market are not particularly valuable or monetizable.

Facebook circa 2009 is a good representation of the value at stake for investors capable of developing a more nuanced, "know the knowable" perspective of how and when the monetization gap will close.

As it set out to raise its Series D round of funding, Facebook was in the process of recovering from the Global Financial Crisis that had slowed its growth and crushed advertising spend. But the company was consistently cash flow positive, growing revenue 70% year over year, and was still being valued by some Silicon Valley investors vying for the round at north of $5B.

What came next — outsider Yuri Milner and his firm DST leading the round at a $10B valuation — was one of the most impressive and lucrative investments in the history of venture capital.

Forgive the long pull quote but the entire story below, told by Marc Andreessen, provides an almost perfect description of the value accessible to investors who gain a unique perspective by being "on the ground" and reasoning with a view of the tactile reality of the situation at hand:

Yuri came through Silicon Valley in 2008 or 2009 for the first time, and he basically said ‘I’m in business and I want to invest.’ His first big deal was the Facebook deal. As you may recall what was happening in this timeframe: Facebook had printed an investment from Microsoft at a $15 billion valuation. Then the stuff hit the fan and there was a serious downdraft in valuations.

After the financial crisis, Facebook almost raised their next private financing round at $3 billion. Then there was a reset of the process, the economy started to recover a little bit and the process was re-run. Top American investors were bidding at the $5, $6 and $8 billion level for Facebook and Yuri came in at $10 billion. I was on the Facebook side of this and I had friends who were bidding on and I’d call them up to say ‘You guys are missing the boat, Yuri is bidding 10. You are going to lose this’ They basically said: ‘Crazy Russian. Dumb money. The world is coming to an end, this is insane.’

What Yuri had the advantage of at the time, which I got to see, was that Yuri and his team had done an incredibly sophisticated analysis. What they’d basically done is watch the development of consumer Internet business models since 2000 outside of the U.S., so they had these spreadsheets that were literally across 40 countries — like Hungary and Israel and Czechoslovakia and China — and then they had all of these social Internet companies and e-commerce companies that had turned into real businesses over the course of the decade but were completely ignored by U.S. investors.

What Yuri always said was that U.S. companies are soft because they can rely on venture capital, whereas if you go to Hungary you can’t rely on venture capital so the companies have to make money. So he had a complete matrix of all the business models across all of these countries and then came all of the monetization levels by user and then all adjusted for GDP.

Then, out at the bottom came: Therefore, Facebook will monetize at X. And his evaluation of what Facebook would monetize for was like four times higher than anybody else’s evaluation of what Facebook would monetize for. So he got the deal and has now made, now 24x on his $1 billion of capital in five years on the basis of superior analysis. To this day, I still greatly enjoy teasing my friends who missed that deal. He had the secret spreadsheet and you didn’t.

Immediately after the investment, Milner joined Mark Zuckerberg and TechCrunch founder Mike Arrington for an interview where he sheds additional light on the reasoning behind the Facebook investment that would go on to earn him billions.