Investment Strategies in Cryptocurrency, Part 1: Fundamental Analysis
Prefer a video? Watch here: https://youtu.be/JEf-q8wubS0
What’s the best investment strategy for cryptocurrency? Is there a one-size-fit-all strategy that everyone uses? Is it completely different than the strategies used in other asset classes? In this post, we will explore a few of the methods that are helping individuals and institutions in the cryptocurrency asset space. So, whether you’re an individual trader or working for a hedge fund, this article can shed some light onto a way to improve your current cryptocurrency investing style. This is a good article for investors of traditional assets or blockchain enthusiasts who are just starting to trade tokens.
Investment strategies can be divided into two very different styles. The styles are very different in practice, but overall they both attempt to evaluate the value of the asset today, using information that is readily available. Fundamental analysis calculates value of an asset using both tangible and intangible data, such as price ratios and performance metrics. Technical analysis calculates value using price and trade data.
There is a long standing battle between the users of fundamental analysis and technical analysis in the investment world. We will not attempt to tell you which one is best. Our goal in this article is simply to give you a few ideas on each so that you can improve your own trading strategies. This is an introductory piece, and a good overview to use to evaluate whether the you want to add more fundamental analysis or technical analysis to your trading philosophy. We will discuss the fundamental side of analysis in the first of this two-post series.
So what, exactly, is fundamental analysis? Investopedia defines it as a method of evaluating an asset in an attempt to measure its intrinsic value, by examining related economic, financial and other qualitative and quantitative factors. Several of the wealthiest investors in the world swear by fundamental analysis as the secret to their fortunes. Have you ever heard of a guy named Warren Buffett? He is one of the richest men in the world, and the best known fundamental investor. Another very significant investor using fundamental analysis is Carl Icahn, one of Wall Street’s most successful investors.
Neither of these men start their investment analysis with a stock chart. No, they prefer income statements and balance sheets to analyzing stock price history. Warren Buffet attributes much of his success to the seminal book on fundamental analysis, “The Intelligent Investor” by Benjamin Graham. While there isn’t a similar book for the cryptocurrency assets yet, there’s still much to be gleaned from the methodology presented in the book.
Fundamental analysis is a tool with significant history in the stock market. One of the pieces of data used are company financials, i.e. the income statement and balance sheet. Using these two items, investors can analyze profit ratios, look at the company’s debt, analyze the effectiveness of cash invested relative to the returns, and all sorts of things. Quarterly earnings are used as a predictor of total annual profit and, thus, the intrinsic value of the company today.
Fundamental investors don’t completely ignore stock price. They use price to calculate price to earnings ratios, among others. These ratios help fundamental investors compare companies in various sectors and industries. Other tools of the fundamental investor include equity analysts ratings, industry outlook, and a number of other pieces of information, beyond stock price, to estimate the true value of the company.
How can cryptocurrency investors use fundamental analysis? That’s a great questions! After all, cryptocurrencies don’t have many of the financial reports used in analyzing public companies. Here are a few of our favorites…
The market cap of a cryptocurrency lets you know the overall cash value of the total amount of crypto that exists. This amount is calculated by multiplying the trading price of the cryptocurrency times the total number of coins/tokens that exist. At the time of this writing, Ethereum has a total market cap of $22,357,797,014. This was calculated as follows:
Coins in Existence = 101,821,914 ETH; Price = $219.58;
101,821,914 ETH * $219.58 = $22,358,055,876.12
The market cap gives you a good indication of how much the currency is in use relative to other coins and tokens. You can use it to understand the percent of the coin that is owned by the creators or any other ownership blocks that might influence the future price. Knowing the size of the market is always a good place to start. I typically use Coin Market Cap for this information. (https://www.coinmarketcap.com)
Daily volume metrics are also provided on the market cap websites. The daily volume is the amount of the cryptocurrency that has been traded in the last 24 hours. The daily volume of a cryptocurrency can be a great indication of which assets are “in play”, or the focus of investors at the moment, and thus likely to see significant moves in the near future. One of the dangers to be aware of is the possibility of companies or individuals participating in fraudulent activity to create fake volume and appear more active. Coinmarketcap.com has been accused of displaying incorrect volumes due to traders simply buying and selling cryptocurrency at the same price (called “wash trading”), as a means of boosting the volume figures for their coin/token. There have also been pump and dump schemes in crypto, whereby traders attempt to push a price higher on fake news and volume. Here’s another great resource for clean market data for cryptocurrencies: https://onchainfx.com/.
One of the most simple, yet profound, pieces of advice from Warren Buffett is to invest in things you know. He tends to stick with companies and assets that he’s familiar with. Sure, it might limit his scope. However, it allows him to be an expert investor on a few specific areas. It’s possible to follow that same principle in the cryptocurrency markets. There are hundreds of coins/tokens and offerings to choose from. Leveraging substantial industry knowledge can give you an edge in finding the best investments for your portfolio.
If the thought of reading a white paper puts you to sleep, you’re not alone. However, there’s so much information in a white paper that it should not be overlooked. Sure, it’s written like a piece of academic research, but it gives you all sorts of fundamental goodness. The white paper typically provides a history of the cryptocurrency, explains its reason for existing (what problem it solves), explains the way revenue will be produced, explains the volume of the currency that will be released and at which stages, and then provides information on the management team. That’s a lot… too much to ignore! Let’s break this down a little.
It’s important to have an idea of the use for the cryptocurrency. Does it solve a real problem? Does the industry it improves acknowledge the existence of said problem and want to actually fix it? The answer to that question will give you an idea of the likelihood of adoption, or actual usage of the coin/token. ERC20 utility tokens allow the buyer to invest in a token, not a company. The token may actually be used to pay for a future service or product. The value of the token tends to be based on the demand for that service increasing or decreasing. As such, a proper understanding of the use-case for the token can be more important than the company that is issuing the token.
Security tokens derive their value from a company’s value or some external, tradable asset. Security tokens can even represent an equity stake in a company. As such, they require a different set of questions for fundamental analysis. How will the asset create revenue? That future revenue gives the fundamental investor an idea of how to value the token today, using the present value of the future expected revenue. To calculate this, investors discount the annual profits of the company by a discount rate that accounts for their desired return on capital. After discounting each year’s profit, investors add up the sum of all future years to arrive at the present value of the company.
Knowing the total number of tokens outstanding helps the fundamental investor understand supply and demand. For instance, if the executive team intends to release more of the tokens later, there’s a large chance that the price will decrease in the future. More tokens doesn’t always mean a larger market cap. In fact, it could simply mean that all the tokens in circulation become devalued in order to maintain market cap parity, or equality with the market cap prior to the token release. If the token is largely owned by a small number of investors, there is a risk that they will flood the market with additional coins at some point, once again depressing the value of the tokens in circulation.
The management team is one of the most influential data points in the early life of a token. Have they had success in a similar venture before? Do they have an intimate knowledge of the industry the token focuses on? Do they have the professional network to widely influence the rate of adoption of the token? Has the team acquired early traction using scrappy growth hacking techniques? This is how Airbnb, Paypal, Uber, Facebook, etc. succeeded. All of these concerns matter, and the white paper is a good place to begin your research on the management team.
This is just a sample of the information provided in a white paper. As a fundamental investor, the answers to the questions proposed will help you determine the overall value of the coin. I research white papers at https://www.whitepaperdatabase.com.
The cryptocurrency space has found use of a few quantitative methods, many of them used in traditional finance, for calculating value. We will cover these in depth in a future post. For now, we will just provide a brief overview. One key fact to remember before starting is that a model is only as good as its inputs. Many of the inputs are more subjective than objective, depending on the trader’s own views of the market.
ABSOLUTE VALUATION METHOD
An absolute valuation method calculates the total value of an asset using inputs specific to the asset itself. The method that some cryptocurrency investors are using is the Equation of Exchange Monetary Model. This macroeconomic model uses money supply, velocity of money, the price level, and an index of real expenditures. Moving the variables around to give a value for the money supply of a currency yields the equation:
- M is the nominal money supply
- V is the velocity of money, or the rate of spending
- P is the price level, and
- Q is an index of real expenditures
As stated earlier, we will dive into the pro’s and cons of this method in a later post. To read up on it now, take a look at this post: https://medium.com/@cburniske/cryptoasset-valuations-ac83479ffca7
RELATIVE VALUATION METHODS
Relative valuation methods attempt to calculate an asset’s value by using metrics to compare the asset to other assets. In the stock market, you might use metrics like price to earnings ratios, which we mentioned earlier. In the cryptocurrency world, there are a few other metrics to consider.
The first method to consider is the network value to transactions ratio (NVT). This metric looks at the cryptocurrency’s market cap relative to its daily volume of on-chain transactions. The NVT allows traders to compare how the market values one unit of on-chain transactions per network. In theory, the lower the market to transaction value, the less the market is valuing the cryptocurrency.
NVT = Network Value / Daily Transaction Volume
Another relative valuation method for cryptocurrencies is the number of transactions per second. In theory, the higher the number of transactions on a network, the higher its likelihood of widespread adoption. A high transaction speed increases the likelihood of, or even capacity for, mass consumer adoption.
REDDIT/ MEDIUM/ FORUMS/ CHAT APPS
I would be remiss if I didn’t mention the forums and various cryptocurrency communities online that can provide current information to be used in fundamental analysis. Reddit has a countless number of forums and sub-communities focused on cryptocurrencies. Medium has more blogs focused on cryptocurrencies than I could even begin to count. As well, many of the currencies have Telegram, Discord, Riot or Rocket Chat groups that you can join to stay abreast of any news that might affect the value of the cryptocurrency. Even just following the sentiment of the chatter on forums and online communities can give you an indication of the market sentiment of the crowd, and where the value of the currency is likely headed. While too much information can be detrimental to your trading success, not enough can lead to ill informed decisions and a loss of money.
There are two main trading styles of fundamental investors. Once you have looked at the available data and come up with your expectation of the actual value, or intrinsic value, of the currency today, your goal is simply to buy low and sell high. That typically means you implement a buy and hold strategy. Or, maybe you intend to buy the dip. Both strategies focus solely on buying, because at the moment traders can not easily short (sell at a higher price and purchase at a lower price to deliver against the sell) cryptocurrency.
BUY AND HOLD
The buy and hold strategy is the ultimate long-term investing strategy. It assumes that the value of the cryptocurrency will be higher in the future, and therefore it is best to purchase today. Buy and hold investors will have to decide whether to make their full investment immediately, at one price, or to get on a steady buying program to build their position to the ideal size.
One of the benefits of this strategy is that the investor is always focused on buying at the best price for maximum profits. That price is determined by the expected value of the currency. Buy and hold investors tend to have fewer transactions, and thus less money spent on execution. They also have a long-term focus, which allows them to avoid the stress of momentary price dips. It all comes back to the value of the currency, not any white noise from price movement.
This strategy has some downsides as well. One of those is that you might miss the right opportunity to exit a cryptocurrency. Your expected value may be much higher than the market reaches. This will either lead to trading losses, or holding a position much longer than initially planned. Another challenge with this strategy is the increased need for security. Holding on to your cryptocurrency is obviously very important. You will need to choose a wallet that suits your needs. It also helps to use a decentralized exchange, which allows you to remain in control of your cryptocurrency the entire time.
BUY THE DIP
The buy the dip strategy also assumes that the value of the cryptocurrency will be higher in the future. Investors that use this strategy ultimately show the market a full trust in their valuation by purchasing the cryptocurrency when the market goes lower. This is an additional way to buy below the value created from your fundamental analysis.
Buying the dip leads to adding to your position at a lower cost. This ultimately lowers your overall cost basis and hopefully increases your long-term profit in the currency. As long as the price goes back up, or even returns to where it was, there’s money to be made by purchasing when others are afraid. Warren Buffett is credited with saying “Be greedy when others are fearful, and fearful when others are greedy.” The buy the dip strategy is the embodiment of that quote. Drops in price are not stress inducing, they are opportunities to add to your position at a discount.
As with most things in life, there are some negatives with this strategy too. In addition to the security issue we covered in the previous strategy, there is one more thing to consider. Sometimes the price is going down as an indication that something negative has occurred. The future expectation of the value might actually be lower, leading to a justified drop in price. Professional traders always warn against catching a falling knife. Consistently buying the dip might lead to a few “cuts”.
Hopefully you have a better understanding of fundamental analysis. We defined what it is and gave a few examples of information that helps a fundamental investor calculate the intrinsic value of the cryptocurrency. We then covered two main trading strategies for the fundamental investor. In the next post we will continue this series by discussing technical analysis. If you are more prone to using historical price graphs to make trading decisions, this is right up your alley. If you are traditionally a fundamental investor, the next post will give you a few ideas that will give you a new tool for your tool belt.
Thank you for reading this post! Leave a comment below and let me know your favorite source of information for fundamental analysis!
About The Author: Eric Lewis is a self-proclaimed finance junkie with 17 years of trading experience. He began his trading career focused on index option trading at the CBOE in Chicago, where he spent 5 years as a market maker. He entered the energy business after graduate school, focused on structured notes and origination. He then settled into fuel trading, with a focus on gasoline and ethanol. Eric has a weekly podcast on option trading and has turned his focus onto the cryptocurrency trading world. He has a BA in Economics from the University of Texas at Austin and an MBA in analytical finance from the University of Chicago.