A couple of weeks ago, a very interesting presentation from a big venture capital investment firm was leaked online.

It comes from Sequoia Capital, one of the best venture capital funds in the world, and it is a practical guide on how to invest and conduct a business in the tough economic times that we are living today.

Here is Sequoia’s strategy to invest with a possible recession, higher interest rates, and quantitative tightening coming up.

Disclaimer: this is just a recap of a presentation coming from Sequoia Capital, which you can read here. This is not my personal opinion, and it’s not meant to be financial advice in any way.

The Current Economic Environment

To recap everything that happened with interest rates and financial markets over the past two years, Sequoia uses very few words:

Capital was free. Now it’s expensive.

According to them, this change will have huge consequences on both the markets and the real economy, and we have yet to see the full impact of the quantitative tightening that the FED is currently pursuing. This will inevitably take some time, but it’s already visible in some parts of the market:

To give just one example in the housing sector: in the last 6 months, due to the changing cost of money, a new mortgage is 67% more expensive for the same house — the largest percentage shock in 50 years, and putting housing affordability back to levels last seen at the peak of the housing boom.

And the real consequences might unfortunately not be here yet.

The only way to stop inflation is to stop purchasing: with less money to buy, the economy shrinks.

This unfortunately means that the only way to stop inflation is to ‘crash it’ with a recession, and drag prices down with the economy. This is ultimately their predictions: the US is going to face a tough recession over the next year or two.

This Is Hurting Tech Stocks In A Big Way

Outside of housing, we are also currently witnessing the 3rd largest Nasdaq drawdown in 20 years. And it’s not only a story of tech stocks, but it’s also been a very volatile environment for all other equities:

While it’s not quite 2001 or 2008, the Nasdaq is down 28% since last November.

At a high level, the market isn’t as challenged as it was in during the dot-com crash or the global financial crisis, but the story underneath the surface is more revealing when you look beyond the mega caps.

While the mega-cap stocks like Apple and Google are down just 20% since the beginning of the year, small unprofitable niches are down upwards of 75%.

All while the underlying business has been thriving: some of these high-flying stocks are seeing revenues double and margins improve, but also their stock being down more than 50%. Pretty crazy to think about it, at least until you realize that the problem was just their overvaluation over the past two years.

Fundamentals Suddenly Matter Again

So, with stocks down and the economy slowing, what is *actually* happening in the market according to Sequoia? Where are people investing?

Focus is shifting to companies with profitability:

– The focus on near-term momentum is often shifting toward companies that can demonstrate current profitability.

– While the Nasdaq is down 28%, Morgan Stanley’s unprofitable tech index is down 64%.

– With the cost of capital (both debt and equity) rising, the market is signaling a strong preference for companies that can generate cash today.

Essentially, everyone is now discovering what value investors have been saying for two years now. This time is not “different from the past”, and fundamentals will always be the most important thing in the stock market:

And then Sequoia elaborates further:

For the medium to long-term: durable growth is always the path.

– These are tough markets to navigate. It’s not just valuation, but also a “real economy risk”, with a weakening consumer that is weaning itself off fiscal stimulus while simultaneously dealing with rising inflation.

– But, what works in any market is consistent growth and disciplined financial management that translates into improving margins. For example, ServiceNow has continued to compound revenue at 30%+ over the last decade and each year consistently improved free cash flow margins.

– [Focusing on these things] might not translate into valuations improving overnight, but over the medium and long-term, disciplined, durable growth is always rewarded and translates into meaningful value appreciation.

As I said before, welcome to value investing. It’s nice to see the crazy Covid investing mania is finally dying off.

Recovery Will Be Long

Unfortunately for everyone, Sequoia also predicts that the upcoming recession will take a long time to recover from. Just like we have had a wonderful decade of great growth, the next one might be the opposite.

They don’t make any numerical predictions here, but they do say this:

That cycle will take a while, and it’s hard to peg it to a specific time horizon. But it won’t be quick.

If this were to really be the case, this would be a very big challenge for investors. It wouldn’t be just a matter of valuations, but also of finding businesses strong enough to face an economic crisis.

How To Make The Best Of It

As an investor, this environment means only one thing: you have to find the companies that will survive, possibly those that will behave as if nothing happened.

Here are Sequoia’s tips on how to invest in such conditions:

1. Adaptability

You must be adaptable: “it is not the strongest of the species that survive, nor the most intelligent, but the one most responsive to change”.

2. The Survival of the Quickest

Companies that move the quickest have the most runway and are most likely to avoid the death spiral.

According to them, the businesses that cut costs the quickest are usually the best: “in 2008 all companies that cut projects, R&D, and other costs [when needed] were better and more efficient”.

Also, as an investor, they suggest you to focus on companies that want to retain their margins instead of pushing for more growth. According to them. some CEOs will inevitably keep pushing for growth even if their companies cannot afford it — either because they want to please Wall Street or because it’s what they have always been taught to do.

But if a hard recession comes as they say, you should look for the companies that behave like the green line in the picture above. Cost cuts are a great thing in tough times since they are “a great way to conserve cash and run faster” according to these venture capitalists.

It’s not a coincidence that some big companies have already put hiring freezes in place from May.

3. Take advantage of these conditions

One of the first lines of the presentation is the following:

This is not a time to panic. It is a time to pause and reassess.

First and foremost, we must recognize the changing environment and shift our mindset to respond with intention rather than regret. We believe this is a Crucible Moment, one that will present challenges and opportunities for many of you.

As with any recession and bear market, this is most likely the best time to accumulate assets instead of selling them. It’s always a tragedy when the economy suffers and people lose job, but once you have your own finances secured, there’s no problem in buying stocks that are cheap.

Look at this as a time of incredible opportunity. You play your cards right and you will come out as a stronger investor.

4. Prepare In Advance

Finally, the last tip is to prepare for this in advance.

Chance only favors the prepared mind. At Sequoia, we believe that the one who wins is the one most prepared.

Confront your reality, confront your fear, and choose courage over fear. And remember that any crisis can also be an opportunity.

And lastly, the closing message from Sequoia Capital is to be pragmatic but also a realist. “Wishful thinking is a waste of time” according to them:

Don’t sit around talking about ‘the good ole days’ with hope they’ll return. They probably won’t.