Financial Engineering…?

So, normally when people use the term financial engineering what they mean is that a company used leverage or some other type of financial instrument to optimize it’s capital efficiency.

I don’t really get why we use the term financial engineering to describe increased leverage. By definition, if you are overleveraged, you are at higher risk of blowing up.

You see, engineers are the group of people that make trains and cars and airplanes and what not. When an engineer engineers something that people use, say a bridge, they are inclined to overcompensate. Because they need it to be, you know, safe.

Back in the days of Andy Grove, Intel made sure to always have cash on its balance sheet that could cover 2.5 years of selling, general and administrative expenses. Now, that is what we should be calling financial engineering.

The Value of Luck

Few people are as good at framing ideas as Rory Sutherland. In a talk he gave at the SprintAd-dagen in March of 2019, Rory opened up with the following thoughts on the role of luck and experimentation under capitalism:

“You’ve got to leave enough money free and you got to enough eccentric things to give yourself the change to be lucky…

One of the reasons that a lot of people don’t like capitalism is that some of the people who do very well under capitalism are actually total idiots. They happen to stumble into a business at exactly the right industry at the right time. They got lucky.

And even spectacularly intelligent people, I think we can argue…I don’t think there is any argument that Gates and Jobs are hugely intelligent….they were both spectacularly lucky as well as being hugely intelligent…partly by accident of their birth.

If you notice, a lot of those people, Ellison, Gates, Jobs – the giants of the tech industry – were all born within about 18 months of each other. And there was a tiny moment where you had to be young to make it in tech. Five years earlier and they would have ended up working for IBM. Five years later and it would have been to late.

One of the important things about capitalism, interestingly, is that it is a mechanism for rewarding people simply for being lucky. And the strangest thing about that is that it is precisely that, that makes people so angry about capitalism.

But if you don’t have a mechanism that rewards luck, the majority of great discovery don’t get banked.

If you look at the history of science, there is probably as much you can attribute to lucky accidents… Penicillin, Viagra, for example…the two wonder drugs. Those were both a product of completely lucky accidents.

The discovery of vaccination was just one man that happened notice that milk maids didn’t get smallpox. It’s just those tiny things that can have huge effects and we need to leave enough space to actually be lucky.

And the very strength of capitalism is precisely that it rewards ideas that at first make no sense.“

Rory’s full talk at SprintAd-dagen

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Drowning in Data

If you agree with the proposition that more information leads to more efficiency in pricing in the markets, that should probably lead to the conclusion that markets have never been as efficient. We’ve simply never had this much data and data has never been as accessible as it is now.

Gone are the days when Warren Buffett could comb through Moody’s manuals to find net-nets. Now, data-rich stock screeners are readily available to anyone. On top of that, there are armies of hedge funds other quantitative investment shops out there, crunching data and trying to advantage of any arbitrage opportunity they can find.

A Valuable Lesson of VAR

Had you argued this to me about a year ago, I would have wholeheartedly agreed. Today I’m not so sure. And here’s the reason why.

You see, I’m a football fan (soccer) and recently they have implemented something called VAR into the game. VAR stands for Video Assistant Referee. It basically means that during a game there is now an additional assistant referee who reviews decisions made by the head referee with the use of video footage and analytical technology in real-time. He is then able to communicate with the head referee during the game.

The objective of the VAR implementation is to minimize human errors causing substantial influence on match results. Previously, the referee had to make split second decisions on incidents. Now he or she can utilize VAR, which means better data. The VAR can analyse incidents by replaying it from different vantage points and use graphics to determine rulings such as offside. Sounds great, doesn’t it.

The Interpretation of Data

The really interesting thing about VAR, is that after its implementation there is still a fair amount of dispute regarding key referee decisions. Even with the additional data provided by VAR, pundits are still arguing whether decisions on offsides, penalties and such where correct or not.

It seems that more accurate data by itself doesn’t necessary lead to better decision making. The data still needs to be interpreted. In that sense, it’s not just a question of decision being subject to human error or not. Sometimes, different people will perceive the same data differently. It is in some way a matter of opinion.

Financial Data and Insights

If we apply this to the investing world, it is safe to say the following:

If you would show two analysts the same financial and operational data two competing companies, it is entirely plausible that the conclusions that those two analysts might draw from the data would be diametrically opposed.

The interpretation of the data will be subject to frameworks the analysts used to draw insights out of the data. Insight, per definition, is the power or act of seeing into a situation. But insight, is in the analyst, not insight the data.

Generic vs Brandable Domains

I recently listened to a podcast on Domain Wire with SparkToro’s Rand Fiskhin (better known as the founder of the SEO analytics company MOZ). He also wrote the book Lost and Founder.

You can listen to the Domain Wire podcast episode here. Below are interesting transcripted bits from the interview.

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A Brief History of Domain Names

Asked about the history of domain names and on the importance of domain names, Fishkin said the following:

“In the early years of SEO and Google, and of search engines being the primary way of how we find everything, there was a good 10-15 year period, at least, where keywords (the words and phrases that people search for and how Google makes associations between those words), using those keywords in domain names could actually have a really positive beneficial impact.

These were sort of the gold mine days of these semi-ridiculous domain names. You want to rank for “best auto dealer Seattle”? Well, you should register best-auto-dealer-seattle.com.

And that ended somewhere between seven or eight years ago. It started getting much less powerful. And about three or four years ago it really dropped again. And today, it is very minimally beneficial. And I would actually argue that you lose out, even just in terms of just SEO.

You really lose out when you compare the value of a domain name like that, compared to something that I would call Consumer Brandable. A domain name and a business name associated with that domain name that people can say, speak, hear, remember, build an association with.

Keyword rich domain names are just not those.”

Is there still value in the one word exact match domain words (like clothing.com)?

Fishkin: “I personally wouldn’t do it. I would be much more inclined today to say… Look, there are people today who would invest in clothing.com. They think it has value. They think they could build a brand around it.

I would absolutely say that a short, pronounceable word that has no meaning but could be a memorable brand, is far better. So I would take Zappos over Shoes.com any day.”

What about actual words that are not the actual keyword that you are targeting?

Fishkin: “It’s plausible, but I think it is actually really challenging. I’ve seen a lot of challenges around this re-branding of a name that means something else. I don’t know if you remember, but Jonathan Sposato here in Seattle where I live, he was the founder of picnik.com. They struggled for years.

Picnik was a photo editing, storage and manipulation website. Sort of in the early days of Instagram and those kind of things. Picnik was a big player. They were bought by Google and probably integrated into Google Photos eventually.

The struggles over the years to get that domain name to mean the right thing to the right people. And to get over the cognitive dissonance between the slightly misspelled version of the word with the K at the end.

Lemonade (the insurance company) is I think a little bit more like Amazon where it can be brandable. It is definitely doable. I personally would not choose it, because I would not want to deal with the baggage and challenge of association. But I think a decent brand builder could use it.

The bank in Portland, Simple. They have been moderately successful I would say, building up a brand around it. It helps that the word is a adjective rather than a noun.

For you to rank you need to outrank the other meanings of the word

Fishkin: “Right. You have to get some serious traction and then outrank a lot of other things. There is almost certainly going to be other brands that also use the term simple. The same thing is true with Lemonade, right? You’ve got to outrank a Beyonce album?! Oh, man.

For that reason alone, I wouldn’t take Lemonade.com. Especially because there would be the natural and perhaps very reasonable accusation that you were trying to [piggyback of the album]. Especially so close to that albums release.

If it were talking 10 or 15 years on, its a different story. If you want to registered Thriller.com today, I don’t think anybody is going to complain that you are stepping on Michael Jackson’s toes. But if you registered Lemonade.com today, I could see a lot of Behive fans being…

The value of anchor text and exact match domain names?

Question: What about the value though, if I do have that exact match domain name – lets say I was selling shoes on Shoes.com – the anchor text that people would use to link to the website is shoes.com. Do you think that still has some value?

Fishkin: “Some, but it is declining every year. And it is much much smaller than it used to be. The really interesting thing today is that Google has got this system that has structure whereby the algorithm builds entity association with keywords and phrases.

I registered SparkToro.com and over the last couple of years, Google has come to associate SparkToro.com with audience intelligence and market research. all the things that the company does. So, the words and phrases that whatever press and reporters cover us with. And every journalist mentions.

I’m on you podcast and you are going to say something about that Rand Fishkin is the founder of SparkToro an audience intelligence software platform. I hope you are going to say that. In the text on theweb page that this podcast lives on.

From that, and hundred of thousands of others, Google is going to build up this entity to keyword association database. They know how to associate, whatever it is, Barack Obama with 46th President. They know to associate Harrison Ford with Indiana Jones. They to associate Andrew Altman with Domain Name Wire Podcast.

From that entity association build-up comes much of the value. In fact, sometimes even greater value then what you saw ten to fifteen years ago with anchor text and exact match keywords. And using shoes.com to link to shoes.com, which told Google that shoes.com was all about shoes and gave them a rankings boost.

It’s not to say that this is completely gone. There is still a fragment of that value left. It is just that you can achieve a lot of the same algorithmic input and value from essentially the entity graph then the anchor text.”

More about Domains and Brandable Names

Leverage does not get the Credit it Deserves

First of all: Yes, there is a pun in this title and it is intended. But as with most jokes, there is a truth to it. The use of the term leverage in daily conversation, will usually care a negative connotation. Leverage gets a bad rap, you could say. 

The cause of this, I guess, is because most people will associate leverage with debt. And although debt is definitely a form of debt, not all leverage is debt. In the world of engineering, the term leverage simply means the exertion of force by means of a lever. 

The Law of the Lever, which was proven by Archimedes using geometric reasoning, shows that if the distance a from a fulcrum to where the input force is applied is greater than the distance from the fulcrum to where the output force is applied, then the lever amplifies the input force. “Give me a place to stand on, and I will move the Earth”, Archimedes is famously quoted. 

Leverage and Investing

When we think about investing and business in general, leverage tends to mean financial leverage. But not all leverage is created equal. There are many types of leverage and those different types of leverage have different kinds of qualitative attributes.  

Many investors use leverage and there are probably more types and forms of leverage at your disposal than you can imagine. Savvy investors and entrepreneurs excel when it comes to creative use of leverage. 

Different Types of Leverage 

Once you start looking for leverage, you will start seeing it everywhere. Operating leverage, for example, is a generally under-appreciated form of leverage. Many of the most successful businesses in the world have been able to use operational leverage on favourable terms. Operational leverage is a necessary ingredient in any venture trying to scale fast. 

When we think of Financial Leverage, we tend to think about loans. But there are other forms of financial leverage, such as derivative instruments. 

Operational leverage

  • Other People’s Assets (think marketplaces and aggregators)
  • Other People’s Money (think asset management companies) 
  • Negative Working Capital (think insurance float) 
  • User-base leverage (think new products to your existing user base)

Financial Leverage

  • Debt
  • Unsecured Notes
  • Margin Loans
  • Options
  • Futures
  • Forwards
  • Warrants 

The Beauty of Non-Recourse Leverage

Determining whether leverage is recourse or non-recourse is crucial to any reward/reward assessment. The beauty of non-recourse leverage is that it is asymmetric. If you invest in a stock, the most you can lose is the money you put up. The upside, however, is infinite, theoretically speaking. If you start a limited liability company, your theoretical upside is infinite, but you can only lose the equity you put up (unless you are providing personal collateral). 

Non-recourse leverage often comes at a price. If you buy a call option, you have to pay for it. The further out-the-money it is, the cheaper the price. Unsecured loans are more expensive than secured loans. Etc, etc.

Finding a mispriced, perpetual, non-recourse option on something is the holy grail of fundamental investing. This is how the best investors and most savvy business people create wealth for themselves.

Read more on Leverage and Optionality

Will there ever be more than 21 million Bitcoin?

Anthony Pompliano is the host of the Pomp Podcast, where he talks about all things crypto and Bitcoin. He is also widely followed on Twitter. On Twitter, Pompliano often makes proclamations about banks and central banking. One of his most know catchphrases is “Long Bitcoin, Short the Bankers“.

Incidentally one might make the case that Pompliano is indirectly participating in the banking industry through Morgon Creek Capital, which is an investor in Blokfi.

This morning BlockFi announced that they have raised a $50M Series C round of funding. The investment round was led by my partners and I at Morgan Creek Digital, alongside an amazing list of co-investors like Valar Ventures, CMT Digital, Castle Island Ventures, Winklevoss Capital, SCB 10X, Avon Ventures, Purple Arch Ventures, Kenetic Capital, HashKey, Michael Antonov, NBA player Matthew Dellavedova and two prestigious university endowments.

I will be joining BlockFi’s board of directors as part of this investment.

Pomp Newsletter, August 2020

What does BlockFi do? Well according to the newsletter:

“For those that are unaware, let me break down what BlockFi does today, why I think this business can be one of the next multi-billion dollar fintech giants, and where they are going next. Today they have the following products:

  1. A lending product that allows an individual or organization to deposit crypto assets and take US dollar loans out against the collateral. This is popular for people who want USD liquidity, but would rather not sell their Bitcoin or other assets.
  2. An interest-bearing account where users can deposit Bitcoin, Ether, or stablecoins and earn up to 8.6% APY interest.
  3. A cryptocurrency exchange that has no transaction fees.“

Sounds like a bank. Quacks like a bank. Must be a bank.

How to Create Bitcoin

I myself am a customer of BlockFi as I have a deposit there. I’m actually a quite content customer. I should also note that I have nothing against the banking profession or of Anthonly Pompliano being one. It’s an honorable profession in my opinion.

Anyways, the cryptocurrencies that I have deposited at BlockFi, as highlighted in the newsletter, carry interest. Interestingly, the interest rates offered through BlockFi are considerably higher than interest rates shown offered by banks.

It’s worth wondering how BlockFi pays its customers interest. There are a number of ways BlockFi can do this. One way would be to just buy cryptocurrencies and pay the customers. However, although this might be good for customer acquisitions, it does sound pretty costly.

A second way, would be to lend out the deposits. The problem here is that if you are accepting deposits by paying up to 8.4% interest, you have to find lenders that can pay even higher interests, to get a positive spread after factoring in delinquencies.

As described in the newsletter, BlockFi has a lending program whereby lenders have to deposit crypto as a collateral. It might come as a surprise that the collateral required to get a loan at BlockFi is double the amount that is being lent. Alas, we can assume that BlockFi is not in much need of writing off bad loans.

Bitcoin Printing

A third way for BlockFi to pay out interests would be to simply add the amount to their clients statements. After all, this is what banks to and banking is all about. The location of the so-called money printing does not happen at the central bank level but at the banks they service.

So what happens if BlockFi or any other banking institution built on top of Bitcoin does this (NB: I have know idea if this is the case, I’m just theorizing here)? Now there are more Bitcoins in circulation that have been created.

The question I ask myself is this. Even if the supply of Bitcoin is fixed, what is to say that the circulation of Bitcoin cannot be increased when lending and other banking related institutions, such as BlockFi, become more widely used?

How does BlockFi custody assets?

This question is answered on the BlockFi website:

When clients send crypto to their BlockFi account or purchase additional crypto within the BlockFi Interest Account, that digital asset is replaced with an obligation to return the same amount of that crypto plus any interest earned. In order to pay our clients crypto interest on a monthly basis and to meet withdrawal requests on a timely basis, we engage in a number of activities, including (1) keeping a material amount of digital assets available for withdrawal with third parties such as Gemini, BitGo, and Coinbase; (2) purchasing, as principal, SEC-regulated equities and predominately CFTC-regulated futures and (3) applying risk management to the lending activities in the institutional market. The credit risks to these institutions are mitigated by credit due diligence and/or collateral (such as cash, crypto, or other assets).

Digital currency is not legal tender, is not backed by any government, and the BlockFi Interest Account is not a bank account nor a brokerage account, and is not subject to FDIC, SIPC, or other similar protections. Interest rates, withdrawal limits, and fees are subject to change and are largely dictated by market conditions. This is not a risk-free product and loss of principal is possible.

Value vs Growth

If you follow the financial media and the media coverage around stock markets on topic that repeatedly pops up is the Value vs Growth debate. Apparently, Value has underperformed Growth for many years now and some have even gone so far as to declare Value Investing dead.

Why Value Investing is indeed Dead

I also think that Value Investing is dead, but not for same reasons that the pundits do. The general conception of the value is dead logic is that:

  1. The market is much more efficient now and the competition within value investors is fiercest. This drives away any pricing opportunities sooner that it used to be.
  2. The internet and globalization has created an environment with more extreme scaling effects and power laws. This results in winner-takes-it-all situations where one or two players dominate the market and take in all the profits.

The conventional value invest retort is that value is relative to price. That is, that a good company is not a good investment at any price. Value investors also tend to believe that the move into passive investing has favored companies that are considered growth companies at the cost of companies that would be considered value stocks.

What is the opposite of Growth Investing?

My logic for declaring Value Investing dead, is that Value Investing never existed in the first place. Value Investing and Growth Investing are both fundamental investing methodologies. Both strategies are looking at fundamental factors (revenues, earnings, cash flows) and estimating the current value from those factors.

But is value the opposite of growth? If Growth Investing is about discovering and investing in companies that are growing fast and that this growth underestimated in the current value of the stock. You could say that growth investors are of the opinion that the market over-discounts the value of future profitability of high quality growth companies.

The opposite of Growth Investing would be to discovering and investing in companies that are deteriorating but that this deterioration is overestimated in the current value of the stock (and/or higher up in the capital structure). The opposite of Growth Investing, in my humble opinion, is Distressed Investing.

Distressed investing is Value Investing. But Growth Investing is also Value Investing, because all Value Investing is just Fundamental Investing.

How did Grayscale grow its AUM so fast?

When I write this, Grayscale Investments has about $9.8 billion in Assets under Management. This undoubtedly makes Grayscale one of the fasted growing asset management companies in history.

Established in 2013 by Digital Currency Group, Grayscale operates trusts that allow investors to invest in various cryptocurrencies. Trusts are open-end, which means that the number of units will change as investors move in or out of the funds.

The units in the Grayscale Bitcoin Trust (GBTC) and the Grayscale Etherium Trust (ETHE) are that are quoted on the OTCQX market. Both trade at a significant premium to the net asset value (NAV) per share. That in itself is intriguing, since Grayscale charges a 2% management fee on assets.

Why does the Grayscale Bitcoin Trust exist?

The Grayscale Bitcoin Trust is passive, as opposed to being an active fund. The investment policy is simply to hold Bitcoin. Passive funds are usually set up to track and index or some other benchmark. So you might ask yourself what is the point of setting having a fund that only holds one asset?

Why would somebody buy this as opposed to buying the underlying asset directly? How come that investors are willing to buy Grayscale Bitcoin Trust units at a premium to Bitcoin per unit and pay Grayscale a 2% annual fee, instead of just buying Bitcoin directly?

The answer is two-fold:

  1. Most institutional investors are simply not allowed to invest directly into Bitcoin. They have a strict mandate on what they are able to invest in. So, they can’t, even if they want to, get exposure to Bitcoin unless it is through a security, such as a trust unit. Eventually, we can expect the Grayscale Bitcoin Trust to convert into an ETF and the management fee to go down.
  2. Most investors into the Grayscale trust are not buying investing through the open market. They participate in something called an Offered Product. Accredited investors participate in the Offered Product and receive an allocation that values the trust units they receive on a NAV-basis, or Bitcoin per share. By participating in the Offered Product, they are also bound to selling restrictions and subject to significant limitations on resale and transferability.

More on Cryptocurrencies

The Value of Making Up Brand Names

In a recent episode of the Invest Like the Best podcast, Patrick O’Shaughnessy asked Rich Barton about his thoughts about coming up with brand names. His reply is a great guide on the value of brand names. 

Here is the gist of what Rich Barton said (this is paraphrased as I didn’t have much time to transcribe, but you can find the section on minute 56 in the podcast):

Rich Barton: “I love to make up words for companies. I love to make up brand names. It’s just a classic example of thinking long-term versus short-term. 

If you are thinking short-term, you think of the easiest most recognizable words. Put a dot com after it and that’s the name of your company. Blood.com. I don’t want to insult anybody by giving you the name of a real company. But a lot of companies have done that. And that’s great. The SEO is really great in the short term. Everybody knows what you do. It’s easy. 

What’s harder is to make up a word. But if you can do it and fill that empty vessel of a word with meaning and emotion, then long-term you will have invented something that actually enters the language.  And it is yours. It’s much better in the long-term. 

So, my rules of making up words – and I don’t think that every company should do it, but most I think) – but when I’m thinking about consumer brands, which is kind of my space. 

I have a few rules. 

  1. The first one is High-Point Scrabble Letters. For the Scrabble players out there […] you know that the highest point Scrabble letters are z and q. Those are 10. Why is z worth 10? Z is worth ten because Z is the least used letter in English. Which means that when you see it on a page, it stands out and is memorable.  
  2. Two syllables is good. I think fewer syllables is better. I think the sweet spot is two. Expedia was too long. It had the X which was great. It kind of invoked speed and expedition. But it was four syllables and was just too long. 
  3. Does it make a good dog name? That is rule number three. 
  4. Something interesting about the letters. Palindromes are really interesting. Double letters are interesting. Zoom is a really terrific one. They actually repurposed an existing word and then refilled it with a new definition. Zillow filled all of these goals so maybe I’m doing a kind retrofit. 

When people call me and ask me about making up words, then this is the checklist I go through.

Are you looking for a brand name? Make sure you have the .com domain ending. Check out available .com domains for memorable and readable names at Dragon Value.