Author: Adam Smith

It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.

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.

Real Value | A Dan Ariely Documentary

Real Value, a economics documentary by the legendary Behavioral Economist, Dan Ariely, is a available in full length on YouTube. Ariely is know for his ground breaking work on experimental economics, covering fascinating and unconventional economic topics such as pain, attraction and cheating.

The Net Benefits of Gaming

Is the video game industry a net benefit or a cost to society? Does it do more harm than good? If you were to perform a cost-benefit analysis of the video game industry you would go about trying to quantify the economic benefits (job creation, research and development, etc) against the societal costs (addition, power consumption, etc).

From a qualitative perspective, I would image that the effect of the video game industry on societies would be somewhat similar to wars. Wars have a huge cost to society. They take up huge resources both in terms of labor and capital but more importantly is the destruction of human lives and the irreparable damage it can leave on its participants.

Wolfenstein 3D" Graphics Compared to "Wolfenstein: The New Order ...
Castle Wolfenstein (1981) vs Wolfenstein: New Order (2019)

At the same time, wars have been known to accelerate the advancement of certain technologies and scientific discovery. Often, these advancements will have applications far beyond than just some wartime utility.

In the same vain, there are undoubtedly victims of the video gaming industry. Games are hyper-optimized to reward the user of playing and video game addiction is well recorded academically. Countless hours are spent daily on video games, that could otherwise have been deployed to more productive uses.

Yet, the video game industry is also a hotbed for technological advancement. There are countless examples of technologies that were originally developed for the gaming industry, which subsequently found application elsewhere. Slack – a public company with a $16 billion market capitalization as I write this – was originally developed as an internal chap application for a gaming company.

Cost-Benefit Analysis of the South Korean Digital Game Industry

In this cost-benefit analysis of the South Korean Gaming Industry, the researchers attempted to estimate the economic costs and benefits of the digital game industry. Addiction to digital games induces economic costs such as increase in crime, facilities investments for curbing addiction, increase in counselling costs and other welfare losses. The digital game industry in South Korea which is known to have one of the highest rates of game addiction.

The annual cost of game addiction is estimated to be approximately $3.5B while the annual benefit is approximately $24.3B ($3.7B for addicted user market). The proportion of the total costs to total benefits from the game industry is an alarming 14% (95% for addicted user market).

What is Inflation Anyway?

I feel like we have made inflation deceptively simple. We have this exact number for it. The Bureau of Statistics will declare something like “last month, the inflation was 2.46%, annually adjusted.” It will do so with an number that is so precise that at will have at least two decimals, implying the surgical accuracy employed to get to that particular number.

We don’t seem to ask ourselves how we come up with these number, do we?

Do We Even Know What Inflation Is?

The great Milton Friedman did not have even a shadow of a doubt: “Inflation is always and everywhere a monetary phenomenon.” Well, here is what the equally great Robert Solow said about Milton Friedman: “Another difference between Milton [Friedman] and myself is that everything reminds Milton of the money supply. Well, everything reminds me of sex, but I keep it out of my papers.”

In Japan they have been expanding the money supply for decades. They can’t seem to produce inflation, no matter how hard they try. If we ask the European Central Bank what inflation is, they say something like “inflation occurs when there is a general rise in prices.” (They will also ask if you have seen the inflation monster and offer you to watch a cartoon about price stability).

If inflation is just general rise in prices, then why do prices rise or fall? Most would say, because changes in supply and demand. Don’t prices of products and services tend to drop over time? How do we even measure this?

How to Measure Inflation?

This seams to me an exceptionally tricky undertaking. If inflation is supposed to measure changes in the price of the stuff we buy over a period of time, what happens when we start buying different stuff over time? Our behaviors and preferences are constantly changing? Imagine a lab scientist that has to test his experiment on rats one day and then repeat the experiments with hamsters.

Do you see the problem here? The stuff we buy is not constant. Take mobile phones for example. How can you realistically measure the inflation in mobile phones from one year to another? Or even, how do you compare the price inflation of mobile phones to a period 20 years ago, when there were no mobile phones?

What about all the stuff we don’t pay for yet derive some benefit from? How do you factor in the change in cost of consuming Google searches into any inflation measurement? Should you measure the increase and decrease in paid ads displayed with organic searches? 

And there there are substitute products. If pork rises in value, relative to beef, you might be inclined to consume more beef and less pork. But the baskets of goods and services will take that into account.

So next time, when you see an inflation number with a couple of decimal points. Ask yourself how it was measured and how accurate that measurement could be.

Universal Basic Income and Inflation

Imagine if the government would decide that everybody would receive a monthly check of $4,000 as a Universal Basic Income. Now imagine that you are in need of a good plumber. How much do you think the plumber will charge:

  • Less than before UBI.
  • Same as before UBI.
  • More than before UBI.

If you think that the plumber will charge less than he did before UBI, you are probably overestimating the compassionate nature of plumbers. If you think a plumber would charge the same as before, you are assuming that plumber will disregard the effect of extra monthly $4,000 to their life.

My assumption would be that most plumbers are not plumbers of passion. Rather, they entered into plumbing because it paid well. The reason it pays well is because nobody aspires to be a plumber. But there is a price where the occupation of plumbing attracts enough of people to satisfy the need for plumbing.

My guess would be that many people would of alternative uses of their times when presented with Universal Basic Income. But the jobs aspire to leave behind would still need be done…just at another price.

The Joys of Compounding

On January 18, in 1963, a 32 year old Warren Buffett sent his annual letter to the limited partners of the Buffett Partnerships. The compound annul return for the limited partners that had been there from the start, five years ago, the return was 21.1%. The cumulative return for limited partners over the five years was 215.1%.

Gross of the management fees that he took as the general partner, Warren Buffett had compounded capital at 26% per year. In the letter, Buffett wanted to better educate his partners of the powers of compounding. In a section that he called “The Joy of Compounding”, he writes the following:

I have it from unreliable sources that the cost of the voyage Isabella originally underwrote for Columbus was approximately $30,000. This has been considered at least a moderately successful utilization of venture capital. Without attempting to evaluate the psychic income derived from finding a new hemisphere, it must be pointed out that even had squatter’s rights prevailed, the whole deal was not exactly another IBM. Figured very roughly, the $30,000 invested at 4% compounded annually would have amounted to something like $2,000,000,000,000 (that’s $2 trillion for those of you who are not government statisticians) by 1962. Historical apologists for the Indians of Manhattan may find refuge in similar calculations. Such fanciful geometric progressions illustrate the value of either living a long time, or compounding your money at a decent rate. I have nothing particularly helpful to say on the former point.

The following table indicates the compounded value of $100,000 at 5%, 10% and 15% for 10, 20 and 30 years. It is always startling to see how relatively small differences in rates add up to very significant sums over a period of years. That is why, even though we are shooting for more, we feel that a few percentage points advantage over the Dow is a very worthwhile achievement. It can mean a lot of dollars over a decade or two.

– Warren Buffett, 1963 Letter to Partners

Here’s the accompanying table:

Compounded Value of $100,000 at different rates and durations
Compounded Value of $100,000 at different rates and durations

All of Warren Buffett’s annual letters to partners are a treasure trove for any aspiring investor. You can find a compendium of the Buffett Partnership Letters over at CSInvesting.org.

Investing in Crypto from a Portfolio Perspective

The appeal of cryptocurrencies and digital tokens is for many the possibility of a home run. But betting on one outcome will make your outcome binary. You are either right or you are wrong. In an investing subject that has such high uncertainty of outcome, as blockchain and cryptocurrencies undoubtedly have, trying to determine who the most likely winner is, might not be the optimal investment strategy.

An investor in the blockchain space, even if that investor would be 100% convinced that distributed ledgers will disrupt the finance industry, will face three major problems:

  1. We don’t know who the winners will be
  2. We don’t know what the winner will be
  3. The last mover advantage

We don’t know who the winners will be

Industries tend to consolidate over time. This has been as true with banking and auto manufacturing as it has been true with breweries and paint manufacturing. Online, the power laws of industry consolidation have been even stronger. In the online world, the winner takes it all. The network effects of digital products such as search engines and social networks are so strong that they tend to create natural monopolies. 

There have been thousands of cryptocurrencies and altcoins created so far in the relatively short history of blockchain. If the network effects of cryptocurrencies are anything like in industries that the internet brought us, most of these currencies are destined to die.

We don’t know what the winners will be

One of the biggest allures of blockchain disruption is that distributed ledgers will significantly alter the way humans organize themselves and their endeavours. Some will even go so far as to say that the concept of the company as a way for people to organize their efforts will become obsolete. 

Yet, even though the formation of Bitcoin and other cryptos, such as Ravencoin, have been without the ownership and organization structure of a company, most organizations that are developing products and services on blockchain technology are formed through a corporation. 

Some are a combination of both. An example of this is the combination of the XRP cryptocurrency by the company Ripple. Ripple does not own or control XRP, but it owns a significant amount of XRP which it received when the company facilitated the creation of the XRP cryptocurrency. 

So, where will the value capture be? Will it be on a cryptocurrency level or on a company level? Is it better to have exposure to XRP or Ripple? Currently, this is extremely hard to tell. 

Last Mover Advantage

Bear in mind that Google was not the first search engine. Neither Chrome nor Explorer was the first internet browser and Windows was not the first operating system. Facebook was not the first social network. 

In the words of Peter Thiel, “you don’t want to be the first mover into a market, you want to be the last mover.” It is possible that none of the cryptocurrencies and none of the biggest blockchain-focused innovators currently out there are the last movers in the space. Maybe we are yet to see the equivalent of Microsoft, Google and Facebook of crypto and blockchain yet. 

Portfolio Approach

In an essay called Diversification and the Active Manager, Horizon Kinetics’ Murray Stahl and Steven Bregman bring up a thought exercise whereby an asset manager starts out with a diversified portfolio that includes one overperforming stock and simply holds it over a long period of time.

They take Intel and Microsoft as examples:

“From October 1987 to December 1999, the stock appreciated about 173x. Thus, if a 3% position in 1987 were held in a portfolio and not traded away, it would have become a dominant portfolio position by 1999. In truth, the position would have become so disproportionately large that no active manager would have been permitted to maintain it.  

In fact, Intel would be a much better example. Between October 1987 and December 1999, Intel shares appreciated approximately 2,680x. Obviously, a 3% position in 1987 would, as a practical matter, become the entire portfolio by December 1999, irrespective of what performance the other portfolio elements accomplished.  

If one contemplates these facts, the implications can be interesting. It should be self-evident that any portfolio manager who simply held Microsoft and Intel shares would have dramatically outperformed the S&P 500. Again, of course, this would not have been permissible. Nevertheless, in hindsight, this would have been the correct action.”

Building a diversified blockchain portfolio

Aside from basically buying a basket of cryptocurrencies, an investor would also like to have exposure to companies that are building blockchain-related products and services or investing in such projects.

Currently, the number of public companies that have that exposure is limited and many often simply seem fraudulent once you look under the hood. There are however a few stocks that are worth considering to gain exposure to blockchain and cryptocurrencies:

  • Galaxy Digital Holdings (aim to become a merchant bank in crypto and blockchain)
  • Overstock (through its subsidiaries tZero and Medici Ventures) 
  • Hut 8 (cryptocurrency mining) 
  • FRMO Corp (shareholder in Digital Currency Group and a number of mining ventures)

More Thoughts on Crypto

Want to collect interest on your crypto? Sign up for a Blockfi account with this link and receive a $10 bonus in Bitcoin when you fund your account.

How to find a business exit broker

So you have decided to sell your small business or company. The very first thing that crosses through the mind of most people (and rightfully so) is the question: how can I maximize the value of my exit? The key here is getting the right broker for the job. 

The task of finding the right partner to help you sell your business is no easy. There are countless examples of owners that ending up choosing the wrong broker or having a misaligned incentive structure with their broker. As a result, they fail to get the right buyer or fail to close a sale. The repercussions of choosing the wrong broker can be drastic.

However, if you choose the right intermediary for your business exit, there is a possibility of obtaining your exit goals. But how do you get to choose the right broker? Don’t panic because we have got you covered and in this article we are going to give some tips that you should apply when choosing a business exit broker. To start with, don’t try to find an exit broker on google, you might end up regretting after making huge losses. Follow the following tips and you can be sure of getting the right broker.

Look for attributes of a superstar

You just don’t hire a broker without looking for his or her attributes. A good broker that is not going to bring losses should be characterized by the following features.

Specialized experience

Experience is not just experience. When it comes to selling your business. A broker might have been in the game for more than 20 years and still not be the right choice for you. You need to go for a broker who is experienced in your line of your business. For example if you deal with electronics and you choose a broker who has been dealing with real estate for all his life, you might end up making losses no matter how talented he is. Having experience in your industry is vital.

The broker should also have some experience selling businesses and companies in your geographical market as well as within your price range. If the broker does not have this knowledge, it is very possible that his pricing and marketing efforts might fall short of your sales goals.

A verified track record 

The broker you are about to hire should be able to provide you with some reference of customers he or she have served before and they were satisfied with his efforts. If he is not willing to share this kind of information, it might be a red flag that he is not as good as he claims to be.

But when the broker gladly provides you with a list of customers who were more than satisfied to work with him it is a step towards the right direction. Follow up a few clients who were served and confirm the claims that he is a superstar. If the ones who you contact seem to agree that he is a star, then ask about his weaknesses and see if his qualities are enough to help you meet your objectives.

Connections and Networks

If a broker claims that he will be able to take your business from listing to closing alone without needing any help from anyone that is a bomb waiting to explode to your business. Excellent brokers usually have established connections with able lawyers, accountants as well as other local professionals.

Even if you are going to use your own lawyer, it is still important to confirm that the broker has good relationships with lawyers and other professionals in your locality. This will help you understand if the lawyer has been able to gain respect from them and if he has, then most certainly he is as good as he says.

Truthfulness and Trust

The most common barrier when it comes to selling your business is the pricing. Not many brokers are honest about the real worth of the business. Most of the brokers usually tell the clients what they want to hear. This can result to dragging during the sale of the business.

But a broker who is good and knows what he is doing will tell you up front the value of your business and other sensitive details of your business even though that’s not you might be wanting to hear. If the broker is that truthful and he has all the above qualities, there is a very high chance that he is going to make you profits.

Finding a Broker You can Trust

Now that you are equipped with the traits that you should look for, it is important to understand where to start your search.

Local Referrals

There is no better way of finding an excellent broker than from the local referrals. Do some research and find out whom is doing business listing in your area and then verify his or her qualifications discreetly using some of your industry contacts. Get all the information you need about him or her before considering to hire.

Legal and Financial Advice

There is a very high chance that your lawyer or accountant knows one or two brokers that are very good at their jobs. Keep them in the loop and ask them to help you identify the best broker for the job.

Online Directories

Many online directories are not very reliable but since you already know how to identify a good broker when you see one, you can look for some suggestions from online and assess a few of them before hiring one.

Chambers of Commerce

Most of the chamber of commerce and economic development offices usually possess up to date information about most of the local professional brokers included and they may be able to help you find an excellent broker. Just to protect your confidentiality, frame your questions in a general manner.

Cryptocurrency Mining has to be Profitable

In essence, a cryptocurrency is nothing but a transaction system, a means of exchange. You can argue (as you can with all currencies) that it is also a store of value, but the only reason to store value is the intent to exchange it for something else at a later date. 

Every transaction system has a settlement system. For all digital currencies, the settlement cannot be physical. The main problem with the previous versions of digital currencies has always been that digital things can be copied. Cryptocurrencies solved this with distributed ledger and the mining process. 

The Mining Process is the Settlement System

 In a Proof of Work cryptocurrency, transactions are facilitated through the mining process. So, in the case of proof of work cryptos, such as Bitcoin and Dash, there has to be a mining process. For there to be a mining process, the mining has to be profitable over the long term. 

Think of it this way: If I can buy a Bitcoin for less than the cost of mining a Bitcoin, why would I mine Bitcoin? But if the miners would stop mining Bitcoin and rather buy Bitcoin, there would be no Bitcoin. 

But That’s not how it Works…

The Proof of Work system is beautiful in that way because it adapts over time. If the price of Cryptocurrency falls below the cost of mining, fewer people will mine, which means that the total Hashrate will drop. When the Hashrate drops, the difficulty rate drops, which means that the likelihood of winning the block reward goes up.  

This mechanism means that over the long run, a functioning cryptocurrency should provide proper incentives to the miners, that is mining yields. 

The Dash Example

Dash is a Proof of Work cryptocurrency. The Dash development community has been very focused on payments and on building applications for Dash to become an alternative option to payments. Although Dash seems to be gaining traction on many levels, the price of the currency has fallen drastically over the last 6 months. 

For Dash miners, this means that mining Dash has become unprofitable. In April 2019, one could buy a Dash mining contract from Genesis Mining that would have a current yield (current daily mining output/cost of a day of mining) of close to 100%. 

Currently, you can buy a 12 month Dash mining contract that will cost you $0.27 a day per 30,000 mh/s. The output, however, based on the current Dash to USD exchange rate will be about $0.19. 

So as a potential Dash investor, what does this mean? One of two things needs to happen. Either Dash miners need to leave the mining pool to make mining more profitable or the value of Dash needs to go up and above the cost of mining. 

More Thoughts on Crypto

Want to collect interest on your crypto? Sign up for a Blockfi account with this link and receive a $10 bonus in Bitcoin when you fund your account.