Not all Crypto is Created Equal:

Identifying Standout Digital Asset Investments

Dragonfly Roundtable #2

Following on from our first Roundtable, in which we explored the role of digital assets in a multi-asset portfolio, Dragonfly Digital Asset Management hosted another successful event on 15th June 2023. We discussed how the world of Crypto is, actually, not that far removed from the world of Equity investment and how much of it can be reassuringly familiar for traditional investors.

Just like the early days of the internet, there have already been some spectacular winners in the sector as well as businesses which never really took off. As then, it’s all about gaining traction and having the most competitive product / market fit.

For traditional investors, Digital Assets can seem bewildering. Many want exposure to Web3 companies and the incredible technological potential it promises, but are unsure how to invest in the sector.

The first thing to get out of the way is that, despite their name, Cryptocurrencies really do not have that much in common with fiat currencies. It’s for this reason that many investors prefer to call them Digital Assets. While Crypto can be used as a medium of exchange and a store of value, the value of most tokens is only as good as the underlying asset, the team, the technology or the business strategy, just like traditional shares!

Why are Tokens Analogous to Shares?

Like shares, Tokens give investors exposure to the underlying protocol.

• Shares and Tokens represent ownership of a project, and appreciate in value as the business grows. While traditional shares represent ownership in a company, crypto tokens can represent ownership in various entities such as decentralised applications (dApps), protocols, or even specific assets like real estate or art.
• The value of crypto tokens, like shares, can fluctuate based on supply and demand dynamics in the market. Both can be bought, sold, and traded on various platforms, such as cryptocurrency exchanges or traditional stock exchanges. Investors in Crypto talk about “Tokenomics” which encompasses various factors like token supply and distribution mechanisms that affect the value of the protocol.
• Crypto tokens and traditional shares may entitle the holders to dividends or other types of rewards. With traditional shares, dividends are typically paid out as a share of the company’s profits. In the crypto world, some tokens offer rewards or a share of transaction fees generated within a specific blockchain network.
• Both crypto tokens and traditional shares can grant holders certain governance rights within their respective systems. Traditional shareholders have voting rights in corporate matters, such as electing board members or approving major decisions. Similarly, some crypto tokens provide holders with voting rights to influence protocol upgrades, changes in network parameters, or funding decisions in decentralised autonomous organisations (DAOs).

Like Shares, Tokens are issued to support and grow the business:

• Fundraising: One of the primary reasons for token issuance is to raise funds for a project or company. Through initial coin offerings (ICOs) or token sales, companies or startups offer tokens to investors in exchange for funding. These funds can be used for product development, marketing, team expansion, or other aspects of the project.
• Incentives and Rewards: Tokens can be used to incentivise users, contributors, or service providers within a network. In blockchain networks, tokens may be distributed as rewards to those who validate transactions or secure the network through mechanisms like proof-of-stake or proof-of-work. They can also be given as rewards for specific actions that contribute to the growth or success of the platform.
• Ecosystem Development: Projects may issue and sell tokens to finance the development and growth of their blockchain-based products and services. Also, by distributing tokens to developers, partners, or early adopters, they incentivise their participation and contribution to the project’s ecosystem, such as building applications, creating content, or promoting adoption.

How Are Leading Projects Making Money?

Source: Token Terminal

Protocols work just like traditional “real” world businesses! As the above table shows, the model for protocols is really no different to traditional companies — in this case, Uber.

The main issue for investors is that, as with any nascent industry, underlying traction is fast-changing and input variables determining value capture are subject to huge change! Most protocols are currently building out their platforms and networks and, at this early stage, profitability is, rationally, a second order priority: TAM, cost reduction benefits, land-grab strategy, network effects/exponential growth, team calibre, tokenomics are some of the considerations we need to consider when assessing the value of the token.

Valuing Crypto Assets: Taking a 360-Degree Multidisciplinary Approach to Identifying Standout Digital Assets

For the traditional investor, the tools we use to analyse and value Crypto will also be familiar.

Like stocks, the success of digital asset businesses depends on a number of factors:

• Business Growth
• Active Users growth
• Development growth
• Applications / Features growth
• Industry Leadership
• Team Calibre
• Strategic Vision Execution
• Strong Partnerships & Clients
• Innovation
• Robust Technology
• Tech Upgrade Delivery
• Ease of Use

At the end of the day, the industry is fast-moving, innovative, and the “customer is always right”! So you can’t just focus on the tech!

Fundamental Analysis:

Factors such as the team’s expertise, the project’s roadmap, technological innovation, market potential, partnerships, and community support can contribute to the perceived value of the digital asset. As with the small start-ups of the dot.com age it can be tricky to pin down estimates of financial profitability, especially as, much like the approach taken by companies like Amazon in the 1990s, the priority is to grow and reinvest in the business.

There are some striking drivers of value, and one of the benefits of Crypto is that information on fees, developers and active users are readily available… in real time! This traction is closely mirrored in Token returns: levels of adoption and the size of the user base are closely related to the perceived value of a digital asset as are transaction fees, royalties, or other monetization strategies.

Ethereum growth vs Monthly Contract Deployers

Source: Token Terminal

Ethereum: Market Cap vs Monthly Fees

Source: Token Terminal

Polygon: Market Cap vs Monthly Core Developers

Source: Token Terminal

Like equities, the value of digital assets can be influenced by market sentiment and investor perception. Positive news, developments, or endorsements can drive up the perceived value, while negative news or concerns may have the opposite effect. News of partnerships — especially with established “old-world” companies — has been a major driver for protocols like Polygon.

Themes

We also can compare similar digital asset projects in the market, much as we do within sectors in Equities.

Just like in the stock market, there are a number of themes within Crypto which are essentially driving the growth of a group (or sector) of protocols. Not all of the players are created equal however! We need to identify who is best placed to benefit from a particular investment theme (a decision primarily made by customers!). In old money terms, this is very much like an investor deciding whether Tesco or Sainsbury have the best strategy for attracting customers or the best relationship with suppliers!

Some of the Themes which Dragonfly have invested in over the last year include:

• Ethereum L2 Scaling Solutions: the largest and most thriving ecosystem
• Birth of Bitcoin Ecosystem: New innovation which allows BTC network buildout
• Asian Growth: welcoming regulatory infrastructure and huge untapped capital
• Artificial Intelligence: blockchain efficiencies applied to exponentially growing sector

The Best Bit!

The market is still hugely inefficient! We believe that as more professional investors enter the space, value-based metrics will become an even bigger driver of price performance. At the moment, it is possible to find the sort of dramatic mispricing which is now very rare in the incredibly efficient Equity markets, offering extraordinary opportunities for savvy, experienced players!

Market Cap to Daily Active Users Ratio

Source: Invest Answers

Routes to Adding Crypto Exposure to Multi-Asset Portfolio

By now, many will be keen to know how they can get a piece of this appetising pie. The following are the most common routes to exposure:

• Buy Bitcoin
• It’s the largest, safest network…
• BUT just investing in Bitcoin doesn’t adequately capture the innovation and faster growth of the rest of the sector.
• DYOR!
• Do your own research to identify Crypto winners of tomorrow…
• BUT with approximately 19k tokens in the market, this is likely to be time-consuming and will require a multidisciplinary skillset.
• Buy Crypto Index Fund
• The advantages are low fees and broad exposure….
• BUT such a fund doesn’t capitalise on the huge alpha available in identifying and backing sector winners.
• Invest in a Diversified, Actively Managed Portfolio
• No lockup/liquidity sacrifice, diversified risk controlled exposure, no derivatives risk, in-depth investment research and analysis proven in identifying sector winners.
• Naturally, choosing a competent and experienced fund manager is key!

Whatever route you choose, Crypto is, as we said at the last roundtable, a powerful addition to a multi-asset portfolio. A small investment can mean minimal negative impact on portfolio risk and volatility in down years but meaningfully add returns in good years and over the long term. To put things in perspective, allocating just 3% to Crypto over the past ten years would have 10x a typical multi-asset portfolio’s returns!

Source: Dragonfly Asset Management, simulated performance calculated using historical price data from S&P Global, Ycharts, and DQYDJ

Portfolio incl. Crypto: Weights reflect a typical portfolio with the following allocation: 40% US Treasuries, 30% S&P 500, 20% Nasdaq, 5% Gold, 3% Crypto, 2% Cash

Portfolio excl. Crypto: Dragonfly Asset Management, weights reflect a typical portfolio with the following allocation: 40% US Treasuries, 32% S&P 500, 21% Nasdaq, 5% Gold, 2% Cash

DISCLAIMER: This content is for EDUCATIONAL AND ENTERTAINMENT PURPOSES ONLY and nothing contained in this blog should be construed as investment advice. Any reference to an investment’s past or potential performance is not, and should not be construed as, a recommendation or as a guarantee of any specific outcome or profit.