The Crypto Fit
Dr. Evangelo Damigos; PhD | Head of Digital Futures Research Desk
- Blockchain
- Sustainable Growth and Tech Trends
Publication | Update: Mar 2020
Jeff Dorman, a CoinDesk columnist, is chief investment officer at Arca makes a point that bitcoin trading is exactly how stock and bond markets traded for the first 300 years.
In 1602, the Dutch East India Company issued the first paper shares. This exchangeable medium allowed shareholders to conveniently buy, sell and trade their stock with other shareholders and investors. For hundreds of years thereafter, investors and traders did their best to anticipate price moves, without any of the tools available today for valuing these securities. Back then, a stock trading at $ 100 was viewed more expensive than a stock trading at $ 10, independent of number of shares outstanding, underlying revenues, or business prospects.
It wasn’t until the 1920s, following the stock market crash and the Great Depression, that two Columbia University professors, Benjamin Graham and David Dodd, came up with a methodology for identifying and buying securities priced well below their true value. Their book, “Security Analysis,” was published in 1934, and Graham and Dodd’s principles provided a rational basis for investment decisions that are still applied today by the world’s top value investors.
Warren Buffett chose to attend Columbia specifically to learn from Professor Graham (and received an A+ in his class). Almost 50 years later, Professor Frank Fabozzi introduced similar valuation techniques and concepts for investing in fixed income securities. And shortly thereafter, even newer valuation techniques (like Metcalfe’s Law) were introduced to help value computing networks, and these methods were utilized decades later to value pre-revenue internet giants like Facebook, Tencent and Netflix.
According to Gisli Eyland, who has written about the value investing philosophy, Graham and Dodd “described a fundamentally different approach to stock picking and investing in corporate securities by proposing that the investor should refrain from trying to anticipate price movements entirely. Instead, the investor should try to estimate the true Intrinsic Value of the underlying asset. Given time, the Intrinsic Value and market value would converge.” Today, investors and financial media throw around financial ratios like P/E, P/B, EV/EBITDA, P/S, Dividend Yield and many others as if they’ve been around forever, while smugly chastising digital assets for having no intrinsic value. This may be a good time to remind readers that digital assets are less than 10 years old.
Fundamental models emerging in crypto
When will the Graham and Dodd of crypto emerge? They’re likely already here, working tirelessly behind the scenes on valuation techniques that will be utilized by the Warren Buffets of crypto 50 years from now. Digital assets are still in their infancy, but new fundamental valuation techniques are being built, tested and discovered every day, from the original MV = PQ analysis, to discounted sum of utility models, to everything else in between. Many of the models in existence are unproven, with only a few years’ worth of data to support their methodologies, while other models have likely yet to be conceived.
Each of these methods has advantages as well as shortcomings. Digital assets are unique, similar to corporate bonds, making different valuation techniques appropriate for specific token types. Just like a bond has different coupons, different maturities, different covenants and different features (callable, putable, convertible, warrants, etc.), most digital assets have unique features as well, making each analysis different than the last (there is a reason Fabozzi’s fixed income bible is over 1,800 pages long).
In our view, the DCF analysis is best used for tokens issued by cash-producing companies such as exchange tokens like Binance Coin (BNB) or Unus Sed Leo (LEO). The NVT Ratio may be better when comparing across smart contract platforms such as Ethereum, EOS and NEO. A variation of Metcalfe’s law or total addressable market analysis can be used for tokens that are in the early pre-launch stage or are servicing a sector that is difficult to currently measure.
The smartest crypto analysts in Arca are developing new methodologies to value digital assets. Once these metrics become widely accepted, price floors and ceilings in crypto will be set based on agreed-upon, well-tested fundamental valuation – just like in the debt and equity markets.
The crypto markets to date have been dominated by crypto-native investors. There is very little cross-asset ownership largely because the infrastructure is totally different. Crypto investing doesn’t fit with traditional investor mandates, nor does it fit within the work flows of traditional banks, prime brokerages, exchanges or algorithms. This is slowly changing with the entry of traditional financial powerhouses to the digital assets space like Fidelity, CME and NYSE, but this asset class is still largely foreign and unappealing to the majority of investors.
Digital assets. Investors might want to adopt a more open-minded, long-view approach to investing in this new asset class. Needs investors to come and go who aren't solely crypto investors. This asset rotation and opportunistic investing will help the market find equilibrium at both market tops and bottoms, helping to reduce the crazy highs and the depressing lows historically associated with this asset class.
What matters most is understanding how crypto assets can meet their goals and fit within their risk tolerances, as well as how it fits as a smaller piece of an overall balanced and diversified portfolio.
The ‘Traditional Hedge Fund Due Diligence’ Investors
They spend most of their time seeking out strategies that expose them to the potential upside while limiting downside risk:
- Don’t focus on how high it can go; focus on how low it can go. A good fund manager in any asset class tries to capture most of the upside, while ensuring that downside risk is mitigated. This is an especially important message for investors to hear in crypto, since most of what they see and hear strictly focuses on outlandish return potential.
- DO NOT short this market today. I’ve spent my entire career trying to isolate idiosyncratic risk and removing market risk through cap structure arbitrage trades and long-short trades, but this strategy does not yet work in crypto for a variety of reasons (asymmetric upside, low liquidity, high costs, etc). As such, the best hedge today is simply not to own a token that you don’t like. Currently, the best way to protect against the downside is by sizing positions correctly according to risk/return profiles, taking chips off the table when this equation is no longer favorable, and using derivatives to hedge tail risk.
- A top-down AND bottom-up approach. Active management matters in crypto, perhaps more than in any other asset class, because of the large swings and bifurcations between top performers and underperformers. Understanding the macro landscape (top down) while simultaneously searching for value (bottom-up approach to security selection) is how to take advantage of current market conditions. Few investors want to hear about best ideas because they are not ready to execute them on their own − but they do want to understand the process.
Conversely, the biggest pushback from this group is that the underlying asset class itself is still so new, and it’s hard to invest in something that has unknown tangible value. But it’s important to remember that many asset management strategies can work on top of any underlying asset class.
The ‘Savvy Crypto’ Investors
They are trying to figure out which managers they trust to generate high risk-adjusted returns in the crypto space.
- Developers are the new research analysts. Research has greatly evolved over the past decade, especially with the emergence of digital assets. The ability to read lines of code in GitHub, test pre-launch products and engage with various development communities is a must for any fund investing in this space.
- What is ‘fundamental research’ in crypto? Unlike traditional asset classes like equities and fixed income, there is no widely agreed upon Graham & Dodd Security Analysis in crypto. It’s right to question the fundamental value of these new technologies, but wrong to dismiss the lack of progress.
Looking ahead, this group is already excited about today’s crypto assets, but also focused on what is coming in the future. They want to align themselves with managers who are in a position to take advantage of today’s opportunities, while also being on the front-line when new opportunities arise.
Digital Themes: Blockchain, Sustainable Growth and Tech Trends
Industry: Financial Services HTML
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This study has assimilated knowledge and insight from business and subject-matter experts, and from a broad spectrum of market initiatives. Building on this research, the objectives of this market research report is to provide actionable intelligence on opportunities alongside the market size of various segments, as well as fact-based information on key factors influencing the market- growth drivers, industry-specific challenges and other critical issues in terms of detailed analysis and impact.
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The degree of necessity. Luxury products and habit forming ones, typically have a higher elasticity.
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