Virtual currencies fund thesis
Why invest in crypto currencies?
Crypto currencies and tokens in general represent a new type of asset class with unique features and benefits. Unlike stocks which represent shares of a business and for which the value is estimated by trying to determine the future discounted cash flow of future dividends based on the future business performance the value of crypto currencies is determined in a completely different way.
The best analogy for what a crypto currency is is it’s either some sort of virtual asset (imagine like virtual gold) or it’s like prepaying a product.
Let’s look at the 2nd case to understand better. Imagine that there is a casino near your house and in order to play there you need the chips for that casino. People are going to initially convert their dollars or any other currency into those chips, gamble at the casino, then convert back the chips into normal currency.
In this case the chips have a specific dollar amount face value at which they can be converted by the casino. Imagine now however that the casino doesn’t exist yet. Someone wants to build it. They could go to some venture capital fund asking for money saying that they need to build a casino business which will eventually turn a profit. But there is another way which is also called ICO. What if the casino business instead of selling shares of the business would instead sell the tokens that will be used in the future to play at that casino?
Of course if they sell chips with a specific face value in dollars which can be converted back and forth there is no incentive for an investor to buy those as the casino may very well never exist. It would then make more sense to wait for the casino to open and then buy the convertible tokens. But what if however the casino said that the tokens they are selling before the casino actually exists are not convertible into dollars? They have no specific value. The only thing is that only a fixed amount is produced. Let’s say for example 1000 chips. No more chips will ever be produced. You can buy chips right away when they are collecting funds to build the casino or you can wait to buy them later on on the secondary market from someone else. You have no way to know how much they will sell for. You would be operating in a purely free-market system and will have to buy from someone else if you want to gamble at that casino.
Now let’s say that the casino successfully sells the initial tokens, builds the casino and the casino becomes extremely successful: A lot of people want to go there to play but they cannot play unless they have tokens. The casino owner cannot create new tokens as the tokens have already been created on day one and are now in the hands of the participants. You have to buy from other participants at the market price. The same is true when you want to cash out. You have to sell your tokens on the market. Now let’s say that more and more people come to play at the casino. As you notice this you can understand that there would be more and more need for those tokens in the future. So you might buy them today and hold them as tokens assuming that you can resell them later at a profit once many more people are going every day to the casino.
Unlike most startups virtual currencies only need to reach adoption and have a specific structure which will create a market force that will make the price rise. This is very unique in the world of investments. Usually if you invest in a startup first it must manage to get adoption, then it must manage to monetize (revenue) then it must manage to become profitable (profits). Only once those 3 things have happened the startup is now profitable and produces some cash flow. In the case of virtual currencies you only need the first step which is the adoption. If the adoption happened as we can see in the casino example the price of the token will increase and the investor can then resell his tokens for profit.
Young market
This market is very young and immature. The more mature a market is the more it’s ruled by professional investors and traders. The bigger a market is the more resources will be allocated to trying to determine the correct value of the assets involved. Clearly banks and large investment firms will allocate very significant amounts of money to properly estimate the value of shares of Apple or Google. They will put a lot less resources into trying to determine the shares of some small stock. In general a good asset manager will be able to identify some small capitalization gems in order to get good returns. The problem is that in traditional stocks you don’t have much transparency.
Everything is to some extent secret and the news only gets released at specific events like for example earnings dates. When you invest you are to some extent blind. For example if the market price is crashing you don’t know if there is some very good reason for it or if the market is just acting irrational. In the case of virtual currencies however since everything is open source and completely transparent you have full transparency. There is almost no insider information if not maybe for the future intentions of specific players like the developers or other important players in the ecosystem like exchangers, payment processors, minors, etc.
So here you have a market which is much younger and immature which makes the prices a lot less accurate compared to traditional markets and where you also have almost full transparency into your investment.
Minimal reward for founders
In traditional investments it’s common for founders to sell may be 30% of their equity in order to fund their enterprise. That means the founder is keeping like 70% of the business for himself. In virtual currencies however the model is usually reversed. That is when you invest the founders may very well keep like 10% or 20% and give the remaining 80% to the investors. That means that if for example you invest $1000 into an ICO in which the founder keeps 10% you have basically invested into a startup at a valuation which is just 10% above cash value. We are talking here about investing in startups but using value investing criteria of the most depressed cigar butts (a reference to extremely good deals when you can purchase the business at a very good valuation)
Our criteria for investment
As described before, the ecosystem of virtual currencies is completely different than the ecosystem of normal stocks or other investments.
Market pressure:
The first thing we look is if the right incentives would be present to ensure the right market pressures will make the price of the token rise. This doesn’t always happen. Since virtual currencies are not business that need to be profitable they need some market force that will increase the value of their token.
The casino example we made before is a good one, in general the rule is that people must be willing to purchase the token and then hold to it. What is going to make the price increase is that as more and more people buy and hold the scarcity of the tokens that are trading in the market increases. There must be an incentive for people to hold the token or to keep it locked.
For example for the casino if people always cash out their tokens after a few hours of play the price will raise significantly less than if they decide to hold the token as some sort of reserve or value or because they believe adoption will increase and so they would be able to sell it later at a much higher price. Let’s however not forget that adoption alone would have increased the price anyway, that is the more people go to play at the casino the more the token would be needed (demand increases). But if people actually decide to hold it even while they are not playing it gets even better.
For example a smart contract platform in which people can make bets using a specific virtual currency will force people to buy the currency in order to place their bets. This would be the adoption part, so the more the adoption the more the price will rise. However let’s say that there are 2 of those smart contract platforms for bets on future events. One would be for extremely short range events like for example tomorrow’s weather. Another one would be for much longer term events like for example the price of a stock in several years. At same adoption levels the 2nd token will appreciate much more because people need to lock the tokens for the duration of the bet. If you make a one day bet you lock the tokens only for one day but if you make bets regarding events far in the future you potentially lock tokens for many years which will significantly increase their scarcity and make the price skyrocket.
Team:
We are here investing into something that doesn’t exist yet, that’s why we are buying tokens that are basically the equivalent of prepaying for a product. It is true that the terms of ICO are usually favorable to the investor in terms of equity percentage, however the barriers of entry for creating an ICO are usually very low. This means that a lot of people will try to raise money through that mechanism. Just like in traditional venture capital investing you want an experienced team when possible to increase the chances of your investment succeeding. So looking at the team, their background, their reputation is extremely important as it’s going to determine the chances that the product gets completed. The previously described criteria of market pressure is what is going to determine if the price of the token is going to rise but that only applies if the product is ever going to be completed. By definition if the casino in our initial example never gets completed the tokens will be worthless. The team is one of the main elements that is going to determine the chances that the casino ever gets completed.
Amount raised:
Another very important element is the amount raised. The idea is that you want the project to raise enough money to complete their product but not too much more. If the project raises too much money it would make it harder for your investment to increase in value significantly. Let’s say for example that it takes $10 million to build a casino. However for some reason the team is very experienced and everyone wants to give them money. They will collect $1 billion. So now they have way more money than they need and the percentage of your share of all the tokens is much less than it could have been if they only had raised $10 million. What this means is that let’s say that one casino raises $10 million and becomes very successful and the market capitalization of all the tokens will become worth $1 billion, you made 100 times your investment. Now however if the same project has raised $1 billion in order for you to make 100 times your investment the market capitalization of the tokens should become $100 billion which is almost impossible. That’s why usually the best investments are when you find some small gem with a small market capitalization. Once a virtual currency is well known and everyone is talking about it it means to some extent it must already have a decent market capitalization and so the chances of making exponential returns are greatly diminished.
Fear and greed:
Since those markets are mostly ruled purely by sentiment (the desire to hold versus the desire to sell) and by adoption (and not by traditional financial metrics like profit and revenue) they are much more prone to fear and greed. People may just feel very optimistic when the price go up and start buying like crazy or very pessimistic once the price goes down and start selling rapidly. It’s important to understand that to some extent those products are self-fulfilling prophecies. Let’s say for example that there are several platforms for smart contracts. For some reason everyone believes that one of them is going to be the best one so they start buying that virtual currency. As the price rises more people will buy but also some people may start using the platform. As more people start using it most people will also buy to speculate. The idea is that the price is a very strong factor for creating awareness of the product, so basically just because people believe the price will go up and they start buying the price may actually go up just because of that, then create more adoption, then create a further increase in price. This means that the market will tend to be extremely irrational and all emotions of traders would be magnified exponentially as there is no true way to evaluate the intrinsic value of the investment.
Ideally we would tend to be very careful and selective when everyone is optimistic and cautiously optimistic when everyone is pessimistic about the market.
Dead market capitalization:
This concept is unique to virtual currencies. In virtual currencies you don’t have intellectual property as everything is open source. So the value of an investment is basically the cash it has on hand plus the adoption it has. It means that when you buy the investment anything you buy above the cash it has on hand is the price of the adoption. You cannot count the product as it is open source and anyone could copy it. The reason this usually doesn’t happen is mostly because if people have to choose between 2 identical products they would choose the one with the higher adoption. So if you buy ETH which is worth roughly $20 billion and has around $250 million in cash you are paying for the adoption around 100 times the cash. When you participate into an ICO you are usually paying very close to the cash on hand minus a small premium for the founders. Of course at that point you don’t have the adoption so you have to carefully balance how much you want to pay for the adoption when you make an investment.
Discounting:
One of the hardest things in investing is when to sell. This is magnified exponentially in the world of virtual currencies as there is no specific reference to determine how expensive related to fundamentals an investment has become since you don’t have anything like revenue, profit, etc. One of the few parameters you have is the discounting. It basically means how much people are already discounting future success. Let’s say that a specific virtual asset has increased in value 10 times because people believe that there are 90% chances that it’s going to be very successful (Of course the hard part is to estimate that 90%). It’s probably better to sell right away as if people are expecting the chances of success to be around 90% why take the risk and wait and maybe actually it won’t be successful or it would take a very long time? You want instead to purchase something most people don’t really believe has chances of success so they are discounting failure and you hope that their views are exaggerated and that potentially the product will be successful or even simply that the sentiment will change towards discounting success at which point you can sell without even having to wait for the event to actually happen.
Risk reward ratio:
We believe the risk reward ratio is the main criteria for deciding on investment. This requires intellectual honesty in the sense that you have to clearly decide in your mind what you think is the risk and what you think is the reward. You also have to keep your emotions in check and realize that the more the price goes up the more the risk increases and the more the reward goes down. It also means that a very good business may not be a good investment and an average business may be a very good investment according to the price paid.
Concentration:
We believe in concentration amongst a few best investments. We don’t believe into buying very small amounts of everything. This would mean that the insight of the manager has almost no value as anyone could just buy small chunks of everything randomly and end up with a very similar performance as the manager that does 100 investments with 1% exposure each.
Weak opinions:
We believe our opinions should never be strong. Unlike stocks or normal businesses where the fundamentals are the key to what is going to bring sustained revenue and profitability in virtual currencies it’s mostly a self-fulfilling prophecy. That is, simply because something gets adoption it will get more adoption because of the network effect. That means that having strong opinions is going to be a very weak strategy. We prefer to have weak opinions, constantly monitor the markets and readjust our opinions without any ego or predetermined ideas.
Cost of missed opportunity:
Unlike the attitude of traditional value investors we consider that in this market the cost of missing an opportunity is much higher than the cost of losing one’s investment in a specific asset (assuming a healthy diversification of the portfolio). It’s not uncommon to see performances of 100 times or even 1000 times in short periods of time.
A new type of macro analysis:
Usually macro analysis is only useful at a macro level like for example trying to predict how the overall economy is going to do based on specific factors and catalysts. On the other hand micro analysis is useful for the analysis of the fundamentals of individual stocks. In the area of virtual currencies this model is turned upside down in the sense that every single currency’s potential is more like a market on its own and it’s all about trying to determine which factors and catalysts can determine the success of the virtual currency much more than it is about looking at the fundamentals. In some way the right approach is to look at every single virtual currency from a macro point of view just as if we were trying to predict how a specific economy will do in the future based on specific cues.
Intellectual honesty of the developers:
When we refer to the idea of intellectual honesty we mean that the person expressing an opinion is truly expressing his true belief and is not being biased by his personal gain or preferences.
We believe it is preferable for the investor to invest in a currency in which the developer has intellectual honesty. Let’s look at some examples:
– Gregory Maxwell or Luke Jr: people with excellent credibility and skills (Gregory Maxwell the de facto leader of bitcoin core and Luke Jr the creator of SegWit) could any day decide to launch their own ICO and raise hundreds of millions of dollars easily. They however are not doing it, Luke for example maintains his open source implementation of bitcoin Knots for which he probably receives no compensation at all.
– Peercoin: price has been stagnant for years now but the team has never made compromises on the quality of their product. It is the first proof of stake coin and Sunny King (its creator) not only invented proof of stake but also launched the coin in a completely fair way with no ICO and no pre-mine. They have never tried to generate excessive hype and didn’t try “tricks” designed to artificially increase scarcity by locking coins in order to make the price rise like for example the idea of master nodes.
- Namecoin: the second coin to ever be launched after bitcoin. Its goal is to create decentralized domain names. They recently have been invited by ICANN. Maybe one day it will be incorporated in the standard domain name extensions we know. In the meantime no hype at all.
–EOS: I’m using this one as a counterexample. It is the 3rd project for the developer (the first two were BitShares and Steem), it almost seems the project has been designed to produce as much hype as possible during the fundraising in order to collect as much money as possible. From releasing the token during the presale itself to extending the duration of the fundraising for a full year.
However because we have weak opinions we are also very careful about dismissing something just because of one element. For example so far peercoin and namecoin have been terrible investments maybe because of the lack of funds which didn’t allow them to create awareness through marketing (in our opinion hype is bad before or during ICO but it’s good after the ICO as virtual currencies are mostly self-fulfilling prophecies).
Some criteria however can be useful to determine how desperately the developers are trying to raise money. I will argue that any blockchain that releases a temporary token on ethereum before they launch is simply doing it in order to raise more money from the short-term speculators. We can appreciate that for example Tezos and Polkadot will make their investors wait until their block chain is complete.
We are not trying to be excessively moralistic here, it is understandable that some developers may want to raise as much money as possible for the project but we also understand that if too much money is raised that will limit the upside for the investors. So in this case we chose to be opportunistically moralistic simply because we believe that when the developers behave in a more ethical way towards the investors this will tend to increase the investors returns.
