With the Dow Jones reaching all-time highs, the S&P 500 achieving substantial year over year gains, and political uncertainty roiling markets, one would think that the financial sector would have enough to preoccupy it. However, in a world where unprecedented innovation and disruption are consistently opening new avenues for profit, such a focus on traditional indicators can leave Wall Street and risk-seeking investors blind to emerging opportunity.
Ever since the first Bitcoin bull market of 2013, which saw the coin achieve a price of $1000 from mere cents, the cryptocurrency world has captivated tech and finance enthusiasts alike. 2017 has seen another crypto boom with the rise of Ethereum -- the decentralized smart-contract platform counterpart to Bitcoin -- along with a plethora of alt-coins with intriguing business use cases. Cryptocurrencies, using the underlying Blockchain technology, are able to harness the powers of a world-wide distributed network to practically automate any task in a low cost, efficient environment. As automation becomes the norm, the demonstrated success of cryptocurrencies, along with the creation of new coins, marks the emergence of Blockchain as a technological force that has the potential to disrupt many industries.
While I could dedicate multiple articles to (and perhaps write a research paper on) each of these revolutionary cryptocurrencies, the purpose of this piece is to dive into the next generation of portfolio management. Long gone are the days where "portfolio diversification" is limited to alternative assets such as Real Estate and Commodities. Investors now have access to hundreds of different cryptocurrencies that can provide an uncorrelated hedge against traditional asset classes.
While it is true that the value proposition behind these sky-high valuations is difficult to see at first, you could make that same argument for today's traditional asset classes. Gold, a safe haven in financial markets, is a precious metal that doesn't really enhance our daily lives yet has held high valuations throughout human history. Snap (NYSE:SNAP), a tech/social media company that currently operates at an enormous loss and seemingly provides no material value, entered the market with a $24 billion valuation. Why? Limited supply and the network effect.
Adhering to the foundations of any economic theory, supply and demand drive the price of any asset. As gold is an inherently rare metal that has been deemed attractive by society, its value adjusts accordingly. Similarly, most digital assets are deflationary by nature and are strictly limited to a finite supply (total bitcoin supply is approximately 21 million, for example). The total supply for any coin is hard coded from the beginning and can only be altered in the event of a Hard Fork. As the underlying network matures and becomes applicable to our everyday lives, demand for the coin increases while the supply adjusts accordingly.
Just as we have seen with the rise of social media, when a technology or product garners enough interest its byproducts increase in value. Facebook, for example, profits largely off the user data it can accumulate as a result of the enormous network it has established across the globe. This same network effect is the foundation of the cryptocurrency market with one significant difference: decentralization.
Without going into the specifics of Blockchain, the technology is built on the premise of decentralized processes that require it to have an expansive and supportive network to achieve stated goals. As the underlying network proves its worth and sees widespread adoption, the network token or coin increases in value. However, instead of one central institution profiting off this, anyone with access to the internet can partake and share the spoils while also using the network to enhance their quality of life. If crypto assets can exhibit both these qualities, while providing industry revolutionizing solutions, why should they not be valued accordingly?
In terms of building a crypto-folio, Bitcoin and Ethereum will always be heavily weighted due to their first movers' advantage and established names. However, there are some intriguing alternative currencies that provide examples of how blockchain could revolutionize various industries:
- Siacoin: Sia's Blockchain based cloud storage platform looks to compete with blue-chip companies such as Amazon Web Services by disrupting the enterprise cloud storage market. They provide a much cheaper and more secure network through the use of Blockchain technology. In a market where heavyweights can charge sky high prices, Sia estimates a price of approximately $2/TB. By incorporating distributed ledger technology into its platform, Sia is also able to protect the data by breaking it up into pieces and storing it on a decentralized network among multiple computers, as opposed to a centralized location that can be hacked.
- Civic: Civic tackles one of the most important problems of the 21st century: Identity Verification. As they state in their Whitepaper "It is estimated that in 2016 alone, 15.4 million adults in the U.S. were victims of identity fraud resulting in a loss of $16 billion, while globally almost 1.1 billion identities were stolen last year." Imagine a world where the most personal information could be verified and sent to any institution instantaneously, yet still have the unbreakable security of the Blockchain. This is what Civic is striving to create with their identity verification services ecosystem. The Blockchain's capabilities enable Civic to facilitate identity verification between parties in a low cost, highly secure setting. No personal information is ever stored besides with its owner and thus worries of theft are greatly minimized.
- Golem: Dubbed the "AirBnB of computing," Golem aims to establish a world supercomputer using distributed ledger technology. As a so-called "ERC-20 Token," Golem is one of the first DApps (Distributed Apps) built on the Ethereum platform. With Golem's shared economy, a machine's unused computing power can be bought or sold in a massive network. The potential target market is vast, with uses ranging from machine learning to the medical field, as practically every profession requires computing power of some sort these days.
While these cryptocurrencies have intriguing potential, it is important to remember that they remain, for the most part, in an early development stage. They have development road maps in place, but there is no guarantee that they will be able to stay on track, or that the projects will reach fruition. There is, without a doubt, an enormous risk associated with crypto assets. Cryptocurrencies are lines of code that exist solely in the electronic domain, unbacked by physical objects or any kind of institutional guarantees. They could literally vanish into thin air in the blink of an eye, or simply become worthless to those who hold them. Additionally, there are coins which are basically scams, or are just issued to follow the hype and money of a hot trend without any true value proposition.
This is where investor due diligence comes into play, similar to any stock selection strategy. From a macroeconomic level, it is quite difficult to predict the landscape in the next few months, let alone years. The rate of global adoption of Blockchain technology and regulatory risk are significant factors that could sway the pendulum one way or another. However, just like we saw with the Dotcom bubble, the technology is here to stay.
As of the publishing of this article, cryptocurrencies have a market capitalization of $150 Billion and have overcome the uncertainty of developer civil wars, the scares of million-dollar hacks, and the intense skepticism of numerous intelligent critics. A majority of the coins are currently highly correlated with the overall market leaving little room for diversification however over time the weaker projects will be weeded out. Thus a micro-economic route is the best way to go, instead analyzing specific projects.
Main factors that are useful to research on include the following:
- Business Use Case
- Does this coin propose using Blockchain to revolutionize existing technology or are they just using buzz words to cash in on a hot trend? (Civic provides one of the most outstanding use-cases in the crypto world). Reading the whitepaper allows you to gain some first-hand insight into the coin's mission and the problem they are looking to tackle. However, with the Initial Coin Offering (ICO) gold rush that has taken place recently, it has become harder to distinguish between well thought out business plans and neatly presented scams. Analyze every whitepaper with intense skepticism and don't be afraid to reach out to the developers or community with challenging questions about their coin.
- Developer team
- Just like a venture capitalist investment, you must attempt to analyze the team behind the product to see if they are in it for a quick profit or an actual belief in their underlying project. Pay attention to their development road maps and their progress to-date. Research the founding developers to gain some insight into their experience and past projects.
- A great source for information is forums, such as on Reddit or Slack channels, where the developers interact with the community and provide updates. Siacoin's developers are well known for their strong relationship with the community and their unrelenting belief in the project's potential.
- If the coin has recently held an ICO or was Pre-mined, look for some insight into what they used the funding for. Excessive marketing costs and large developer holdings can be indicators of a money hungry developer team. A majority of the funds raised should be put towards development expenses and there should be an incentive-laden plan in place for dispensing any coins held by the development team.
- Coin dynamics
- Make sure you identify the total possible supply for the coin before you develop any sort of potential price targets (there is a reason Bitcoin's price is so high -- limited supply). Just like any stock, the number of coins outstanding will have a large influence on the price point.
- A key misconception is looking at the circulating supply vs the total supply. Many coins can be mined (increasing the circulating supply over time) while other coins have been pre-mined but are still held by the developers. Pre-mined or not, with a little research you can determine the total supply of coins that will ever exist for a specific token.
- Technical analysis (TA) has become a heavy topic of interest on crypto discussion boards however it is arguably more of a self-prophecy outlook. While TA has become an integral part of Equity analysis, the Crypto market is a whole new ball game. With countless exchanges across the world it is very difficult to conduct a concise analysis of any coin. Also, as cryptocurrency trade volume is still in it's infancy, all coins are subject to manipulation by big players throwing any technical analysis out the window.
In this article I have touched on the various aspects involved in formulating a crypto-folio, ranging from the risks involved to the analysis required. I am not recommending that you liquidate all your equity holdings in your portfolio. This is merely a new asset class that can provide a hedge against any political or economic turmoil going on in the world. At a current total market cap of $150 billion, cryptocurrencies are still not a mainstream financial instrument within our Global Economy.
If you pinpoint the Global GDP to approximately $80 Trillion, and speculate that the crypto market will one day occupy at least 1% of that, it would be sitting at around an $800 Billion total market cap. There is clearly still room for exponential growth with an equal likelihood of total failure. However, I would argue that the opportunity to take part in a revolution that has the potential to change the course of human history is a risk worth taking.
Disclosure: I am/we are long CRYPTO.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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