The Case for Investing in Underdogs

view original post

Brand X Pictures/Getty Images

Investors often see a company’s initial success as evidence of superior capabilities. This article suggests that in many cases initial success is down to luck or circumstances beyond the company’s control, and that many companies that fail may in fact be more capable of superior performance. The authors explain the dynamic and illustrate how investing in underdog companies and people often pays off in the long run.

Most people assume that those who are more successful must have done something right and, thus, deserve our attention and reward, if not our learning and imitation. For example, firms that happened to have an initial success are more likely to attract talented employees, can more easily attract consumer attention to their products, and can access opportunities and capital that others can only dream of.

Our research suggests that initial success many not be the best predictor of performance ability. Follow-up wins by successful companies are more likely to be a result of consumers’ and investors’ reactions to the initial success rather than evidence of the companies’ superior abilities. Our conclusion, in summary, is that the success-breeds-success dynamic should make us all — consumers, investors, and media — skeptical about the most extreme performances, even if gut feeling may suggest otherwise. As the saying goes, if it seems too good to be true, it probably is.

And that conclusion points to an interesting opportunity: the failures of unsuccessful market players that get passed over are more probably victims of their bad luck than of their lack of abilities and resources. They could, therefore, represent undervalued investment opportunities. To see how this works, let’s look at one of our favorite examples on the impact of luck: the birth months of Canadian professional hockey players.

It turns out that at least 40% of Canadian professional hockey players were born between January and March; far fewer are born between October and December. It has nothing to do with star sign. If you want to become a professional hockey player in Canada, then you need to join a junior league when you’re a kid. However, the annual cut-off for joining is January 1, New Year’s Day.

So, let’s say that you’re a junior league coach who is recruiting kids for the team. Who are you likely to pick? The older kids — the physically mature, bigger ones — are more likely to be selected because, for age, cognitive ability, and size, they appear to be a better choice. Of course, none of those factors equals talent. Moreover, the probability here suggests that this initial luck — the arbitrariness of when they were born — will be reinforced over time. Some of these lucky-born kids will be given more resources, better teammates, more attention from coaches, which eventually contributes to them becoming professional hockey players who enjoy higher status and salary compared to unlucky-born others. If you are born in December, even if you have world-class talent, sadly, your odds of becoming a professional hockey player decrease significantly.

But how well do they perform when they do make it? We used the same data to compare merit to luck. That is, we wanted to know how the unlucky-born professional Canadian hockey players competed on the ice rink in comparison to their lucky-born fellow players in terms of salary and average point per season. Our finding showed that the unlucky-born players earned more and scored more on average than their lucky-born NHL peers. It means that these “underdogs” who made it — despite this well-known relative age effect — are often the best ones on the ice.

What is the lesson that can be drawn from this example? The luck factor in hockey can be generalized to the business world where the luck-driven privileges of gender, race, and place of birth — factors beyond our control — have enduring impact on our opportunities, career development, earning potential, and more. It is hard to persuade the privileged (lucky-borns) and already successful that their enduring successes are largely driven by luck. But their resistance creates opportunities for those who not only see through the success bias but also act on it.

Consider Backstage Capital, a venture capital firm founded in 2013 that invests in companies led by underrepresented founders. They are picking some low-hanging fruit — less than 10% of all venture capital deals go to women, people of color, and LGBT founders. It is unlikely that all the ideas developed by these underrepresented founders are less viable than their privileged counterparts, but even when their ideas are superior, they receive much less attention and are systematically undervalued. Moreover, research shows that “homerun” start-ups with game-changing ideas are more likely to come from the “underdog,” because they are less aware of or constrained by the taken-for-granted wisdom held by their privileged and well-connected peers.

Surprisingly, Backstage Capital doesn’t have many competitors looking to invest in these untapped opportunities. One reason may be how luck is legitimized and dominates sociopolitical norms. Take South Korea. The majority of those passing the bar exam are women. “When we interview new job applicants, if we were to select only based on the score, we would have only women,” shared a South Korean executive quoted in this research. Thus, partners in law firms and corporate managers are still predominantly male in South Korea. These men fail to promote women because they cannot see how a female lawyer or manager could succeed — a blind spot created by their own biased frame.

As in the hockey example, those who are willing to see the world differently could easily capture the gems that overlooked by the majority. Firms that retain female managers by introducing policies that balance work and family, and that actively hire more female executives have superior performances than those firms that do not: the difference is about 2% nominal return on assets on average. The more some luck factors are unfairly legitimized, the more hidden gems are preserved for the better informed.

The logic of searching for hidden gems from others’ luck bias does not need to limit to gender, race, or sexual orientation. Take Ultranauts, a software engineering company that leverages the power of neurodiversity, which is invisible to or misunderstood by many other companies.

Most companies recruiting data scientists and software engineers will screen candidates and interview the shortlisted to examine their fit with the company and its needs. What Ultranauts realized was that some candidates will fail this standard evaluation process systematically — particularly people on the autism spectrum. “There’s a real societal challenge around this system that continues to penalize humans for being different,” said Ultranauts CEO Rajesh Anandan.

Where others see autism as disability and liability, Ultranauts sees it as an opportunity and assembles teams that build on the more common strengths associated with individuals on the autism spectrum, such as pattern recognition, memory, mathematics, and entrepreneurial mindset. At least 75% of Ultranauts employees are on the autism spectrum, and the company has an edge over global consulting firms for contracts in software and data quality engineering services from Fortune 100 companies.

The main takeaway: rather than letting our business systems succumb to mere bias and luck, hiring managers and executives can choose to be careful of the “more successful” and to look for the hidden gems among the underdogs. Fortune favors those who do not take successes at face value and appreciate that more is not often better, but less is often more.