Jeff Dorman: Fundamental Investing Is Alive and Well in Crypto

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Following recent moves in GameStop (GME) and AMC (AMC) stocks, as well as DOGE and XRP tokens, investors around the world are right to be questioning fundamental investment research. While cryptocurrencies are often heralded as a gambler’s playground, the irony is that digital assets are one of the few asset classes left for real fundamental investment analysis.

Jeff Dorman, a CoinDesk columnist, is Chief Investment Officer at Arca, where he chairs the Investment Committee and is responsible for portfolio size and risk management.

Ideas are a dozen. What distinguishes good investments from bad investments is how you express these ideas to maximize the uptrend and minimize the downward trend. For example, in 2011–2012, many very smart investors were looking for ways to express the same idea: that there would be a double-dip recession and that inflation would be widespread after unprecedented monetary policy interjections (2009 of course) stimulus was a Breeze compared to the ruthless government spending today, but 10 years ago stimulus was a big deal.

What instruments have most investors used to express this view?

  • Short selling US stocks (into a 10 year bull run)
  • Spanish, Italian and Greek government bonds short (yields are now at or below 0% after the European Central Bank essentially nationalized these countries’ debts over the last decade)
  • Buying gold (which traded straight down and then sideways for seven years before re-bidding after COVID)
  • Teams of distressed analysts moved to Europe to buy European bank debt which in theory should be offered by these distressed banks at pennies on the dollar (this didn’t work as the banks simply held this debt on their balance sheet at face value and never sold)

As you can probably imagine, even though the idea worked, none of these investments worked. One of the best investments to capitalize on the monetary policy and recession theme has been to buy bitcoin. Unfortunately for most investors this instrument was not yet in their playbook.

Most uninformed investors still believe that all digital assets are a copycat version of Bitcoin and other cryptocurrencies, but the reality is that today’s investable universe for digital assets is very diverse, unique and idiosyncratic. As such, the game book has expanded, as have the investable topics an investor can express. For example, if you want to express that Coinbase’s IPO will increase 100% when it is listed, there are several ways you can express that view:

  • Buy Coinbase private shares on the secondary market
  • Buy stocks of similar publicly traded companies (Galaxy, Voyageur, etc.) that should benefit from relative value
  • Buy tokens from other exchanges (BNB, FTT, VGX, etc.) to be recalculated after Coinbase S-1 and provide details of how the company is generating revenue
  • Buy Bitcoin or Ethereum to represent the market to show the renewed interest in digital assets.

Not all of these investments will necessarily work. The point, however, is that developing the idea yourself is less important than figuring out the best way to express that view. Paul Tudor Jones’ bitcoin investment thesis from Q2 2020 is a good example of this thought process, as it wasn’t a bitcoin investment thesis at all. It was an inflation thesis. Bitcoin was just one of four ways Tudor expressed this view (the others were a) long the Nasdaq 100, b) long gold, and c) buying a 2s / 10s Treasury steepener.

Another good example is the recent MicroStrategy (MSTR) convertible bond offering. Due to a high level of cash on hand and no other debt in the capital structure, the likelihood of default or impairment of this bond is very low. If you bought this convertible at face value, you were effectively paid 0.75% interest per year to own a long-term bitcoin call option. If you were optimistic about Bitcoin, it was a very cheap and low risk way to express that view.

At Arca, we do basic research in the field of digital assets. That is, we create a top-down overall view of higher-level theses and macro-topics designed to drive long-term growth, then search the universe for investable assets that best express those views, and then do a bottom-up analysis for each individual through tokens, stocks or bonds to make sure they appreciate in value when we’re right.

See Also: Jeff Dorman – What This Digital Asset Investment Firm Missed And Used For In 2020

Each investment has different risk / reward settings, different time frames for measuring success / failure, and different total return outcomes. An investment with only 10% upside potential but only 2% downside potential can be a better investment from a risk / return perspective than an investment with 1000% upside potential but also 50% downside risk. The aim is to find the largest upside per unit of potential downside risk.

While this may come as a surprise to many, digital assets offer a variety of ways to structure these investment configurations, where fundamental analysis can be used to estimate both downside and upside potential. The digital asset ecosystem has evolved into a complex asset class and may be the perfect asset class for fundamental research and low risk, high yield investments. In addition to simply searching for growth resources, there are now large risk / reward setups that are often implemented organically. For example:

Would you like to give your opinion on the growth of digital assets?

In this case, there are logs where volume and revenue are up over 100% from the previous quarter while spitting off hundreds of millions of dollars in free cash flow. Uniswap (UNI) and Sushiswap (SUSHI) are clear market leaders in trading with decentralized exchanges (DEX) with annual sales of over USD 500 million and USD 200 million respectively. While the UNI and SUSHI tokens have uncertain fates as to the value of these cash flows for the tokens, they can still make a strong basic argument. For example, the price-to-sales ratio based on futures is below 5x, which is incredibly cheap compared to the stock prices of traditional exchanges, which trade between 10 and 20x on average and don’t have the same exponential growth potential . It doesn’t often happen that you can invest in a blue chip growth asset that is also a value asset.

Interested in buying Ethereum with a very affordable option for perpetual calls to grow DeFi?

This is exactly what the WNXM token (Wrapped Nexus Mutual) offers. The NXM token is an asset-backed token that is secured by ETH in the capital pool and is used to pay out potential insurance claims. Based on the amount of ETH currently in the capital pool, Nexus Mutual’s net market cap (beyond assets) is only $ 43 million, and WNXM only trades at 1.2 times book value, despite Nexus Mutual a cash is a Flow Producing Entity with very strong growth metrics. Comparable insurance companies on the public stock market trade at 2-5 times book value, with high-growth companies like Lemonade and Root trading closer to 50 times book value. At one point, you could even have owned WNXM below book value! Owning WNXM is an inexpensive way to invest in growing the Ethereum blockchain and DeFi.

Do you want to buy Bitcoin with a 47% discount on the current trading level?

While this one has a lot more hair and it will take longer to determine its value, buying EOS is possibly the cheapest way to buy Bitcoin right now. The company behind EOS has at least 140,000 BTC ($ 5 billion) on its balance sheet, while EOS has a market cap of under $ 3 billion. This means that buying EOS is the same as buying Bitcoin with a 47% discount if you can extract that value.

The list goes on and on, but the point is that basic investment analysis can and will be used in this growing asset class. Cash flow analysis and book value analysis are just some of the instruments we use to analyze and evaluate these instruments. Similar to fixed income securities, each digital asset is unique and has different properties and attributes that create value. Our job as fundamental analysts is to find and extract this value in the least risky way possible. In our view, finding the uptrend is nowhere near as important as limiting the expected downtrend.

See also: Jeff Dorman – Digital assets are more recession-proof than you might think

We often find that digital asset investors these days are impatient or have a unique point of view. In a world with typical weekly returns of 50% to 100%, many want and expect immediate results and satisfaction. Therefore, anything that does not increase immediately has to be wrong or incur too high an opportunity cost to justify an investment. We find that very short-sighted. Every investor and every investment has a different mandate, and certain investment configurations fit into different areas. We approach investing in digital assets from a value lens and believe that this area has a lot of value when you look beyond charts and volatility.

Disclaimer: Arca has positions in BTC, BNB, FTT, NXM, EOS, UNI, SUSHI and ETH as of this writing. This information is not intended and should not be construed as investment advice. Past performance is not an indicator of future results. Every investment involves the risk of loss, including the risk of loss of capital.