What Should Traditional Investors Make Of Cryptocurrencies?

Includes: BTC-USD
by: Vishesh Raisinghani

I'm a value investor and former crypto skeptic.

There's more to these seemingly bizarre assets than meets the eye.

Research will reveal the opportunity to buy tokens with real utility where loyal users are locked in and network effects drive value.

Here’s the thing - my driver’s license says I’m in my mid-20’s, but psychologically I feel like I’m older than John Bogle. I’m an old-school value investor whose first investment was a British semiconductor design company (ARMH) and whose biggest holding is an Indian plastic products manufacturer (Essel Propack - listed in India). I’ve also done two levels of the CFA exam and can’t buy a stock unless I’ve run a comprehensive DCF valuation on it.

So, when I first heard about Bitcoin back in 2012, it was a shock to the system. I wasn’t inclined to take this thing seriously. After all, the stated ambition was to replace fiat currencies everywhere! In my mind, that’s ludicrous. I’m not alone - everyone from Warren Buffett to Robert Shiller has dismissed Bitcoin (BTC-USD) and all other crypto assets as nothing more than a spectacular display of excess capital and human irrationality.

However, in the spirit of keeping my mind open to new ideas I started to look more closely at the cryptoverse around the start of 2017. I’ve been converted and am now a crypto investor. Here’s why:

Don’t Underestimate Network Effects

Network effects are a lot more powerful than people realize. There’s a reason Chinese parents pay foreign tutors to teach their children English. There’s a reason international trade is dominated by the US dollar and it’s the same reason you can’t let go of Facebook (NASDAQ:FB) even though they admit their tools are tracking your deepest secrets. All these platforms have more utility with every additional member. The rate of value grows exponentially along with the number of people who subscribe to the platform.

These network effects are measured by Metcalfe’s Law, which was initially designed to explain the value of fax machines and telephones. If Metcalfe’s Law seems too optimistic, perhaps Zipf’s Law could be better suited to crypto valuations. Either way, there’s no doubt that if a significant portion of the world’s population buys into cryptocurrencies and tokens, the value is created organically.

Image result for network effects Source: Network Effects: The Power of the Platform

Underestimating this fundamental law is the reason value investors have often missed out on big tech opportunities such as Facebook and Apple. It’s what makes Apple’s iMessage platform and Facebook’s apps as addictive as cigarettes.

That’s not to say all cryptocurrencies are valuable simply because some people are invested in them. On the contrary, nearly all of these crypto assets will fail. But the few that survive will be worth astronomical prices and have a significant impact on the world in a decade or so.

Digital Currencies Were Always Inevitable

Let’s face it, traditional finance is ripe for disruption. In the current environment, normal savers can’t find decent interest rates on their savings. Small and medium-sized businesses can’t get bank loans to finance their growth. Cannabis retailers and adult entertainment producers can’t get decent rates or chargeback protection on their credit card payments. Currency exchange is needlessly expensive and sending money abroad could take days instead of seconds. Most new and exciting companies are staying private for longer, which means only VCs and angel investors can capture all the alpha. Meanwhile, public markets are so efficient that generating alpha by stock-picking is a dying endeavor (I am well aware of the irony of saying this on ‘Seeking Alpha’).

As an ordinary investor or consumer, you are locked into a financial system that treats you poorly. This is a system ripe for disruption from Fintech and Crypto startups across the world.

Think Tokens, Not Currency

The biggest issue most investors have with these crypto assets is defining them properly. If they are currencies, what about the rampant deflation? How do you value something that gives no dividends or interest payments? When there’s no company or managers, how do you judge leadership or governance standards?

All those are valid concerns and they apply to nearly every scam ICO or inflated cryptocurrency on the market today. However, there are rare crypto assets that are more like useful tokens that can be utilized within an ecosystem.

This isn’t a new concept at all. At least seven cities across the world have their own currencies to sustain their local economy. Tokens are used in online games, theme parks, and casinos. If you think about it, your Apple or Amazon gift card, card cashback, and airline miles are also a sort of token.

Tokens are essentially anything that trap value for utilization within a specific ecosystem. With this framework you can judge whether a specific project based on how many people are likely to find it useful enough to buy into the ecosystem.

Crypto Has Reincarnated Alpha

According to Bain’s Private Equity report 2018, private equity funds across the world have managed to outperform the S&P 500 by 200 to 300 basis points in the past year. In fact, if you look back at the history of PE investments, the best performing PE funds have outperformed the public markets by hundreds of basis points compounded annually. Even in the most recent years, PE funds can expect a 3x to 5x return on some of their investments while most of them return 1x.

For much of the past decade, accredited investors needed $5 million just to buy into a PE fund. For the average non-millionaire investor, well-known startups like Uber, Airbnb, and Twitter have been private companies for so long that by the time they hit the market they stop growing. Average investors simply cannot get their hands on startups and exciting emerging technologies.

However, with crypto assets every new token sale represents a stake in an unbelievably small startup with global ambitions and interesting technology. Anyone can buy in from anywhere, which means average investors can finally play the VC or PE strategy on smaller scale. Bitcoin isn’t the only crypto asset that multiplied tremendously. Most alternative coins and tokens in the crypto market are up 100x or more from when they were first launched. Again, many of these are scams and these investments are tremendously risky, but it turns out some of the projects have a legitimate purpose and could offer lucrative risk-adjusted returns. For example, Basic Attention Tokens (BAT-USD) are used within a special browser to pay content creators, Storj (STORJ-USD) offers a decentralized cloud storage solution, and Iota (IOTA-USD) acts as currency for internet-enabled machines of the future. These tokens are trying to solve a real problem with this interesting new technology, which gets lost in all the hyperbole of this market.

Chart Bitcoin Close Price data by YCharts

Although this market isn’t for everyone and comes with a tremendous amount of risk, the same can be said for leveraged forex trades and shady derivatives that are accessible to nearly everyone.

Smart Money Is Coming In

George Soros, the Rockefellers, and Tim Draper have all either invested or are expected to invest in cryptocurrencies soon. Barclays and Goldman Sachs are planning crypto trading desks and Fujitsu and Bosch are directly invested in certain crypto tokens.

Coattail investing and following the smart money is a time-honored technique on Wall St. Now, the writing's on the wall and it seems a lot of big players are going to get a stake in this emerging technology before the average investor gets over their fears.

Final Thoughts

I agree with IMF chief Christine Lagarde’s view that if you keep an open mind and look closely at the cryptoasset market, you’ll come away with a very balanced view of a technology with immense potential and a lot of hurdles.

There’s no doubt the cryptocurrency market is fraught with risk. Some crypto-investors come across as outright anarchists who don’t understand fundamental economics and the developers seem to have the most ludicrously ambitious goals. But the opportunity to stake your claim in a world-changing technology is real. You just need to work really hard to sift through the noise.

For traditional investors, a closer look at the underlying technology is justified.

Disclosure: I am/we are long ETH-USD, IOT-USD, BAT-USD, OMG-USD. 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.