Category: economics

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.

If you’ve seen one financial crisis, you’ve seen one financial crisis

The title of this post is a quote from former Fed governor Kevin Warsh. It’s reminiscent of the line from Tolstoy’s Anna Karenina that says happy families are all alike but every unhappy family is unhappy in its own way.

At the same time, our behavior is highly mimetic. Not only do we base most of our learning on imitation, but we are constantly searching for clues by comparing the current to the historic. I do this myself, literally all the time. 

When I’m looking at potential investments or trying to value stuff, I find myself searching for historical comparisons. When looking at XL Media, I immediately connected it with American Express and the famous Salad Oil Scandal. When I looked at CentralNic, I started drawing comparisons between the domain industry and cable industry in its early days.

Performing these mental model checks and looking for similar histories, is the default setting, in my experience. It seems to happen almost automatically. I need to force myself to not do it. It is in our nature. It’s a survival thing (see, I just looked for a comparable mental model and found evolutionary theory…).  

What’s obvious is obviously priced in…

The title of this post is a quote from a famous bond investor Jeffrey Gundlach. Gundlach is the manager of DoubleLine Capital, a huge bond fund, which has earned him the nickname the Bond King. 

It is clear to me that information that is obvious, should be priced into the market price of a public asset. This is logical. But if you abide by this logic, you should also agree with the statement that everything that is not obvious, is not priced in. 

By this logic, you would also have to assume that, unless every possible event is inherently obvious to market participants, the price of a public security is inevitably always wrong, since it does not account for the obvious. 

In the same vein, being a contrarian is a valuable stance, but only if there is an non-obvious truth that the market isn’t accounting for. Successful contrarians, try to approach the world from a different perspective. But they only act on it when they feel they have discovered an under appreciated possibility. 

The key is that thinking contrarian is a process, being contrarian is an action. You don’t always think contrarian, but only sometimes be contrarian.

The Efficient Market Paradox

Two economists are walking down a street, discussing the Efficient Market Hypothesis, when one of them suddenly stops in his tracks. He points to the street and says “look, there’s a $10 bill!”

The other economist looks at him with a mixture of amazement and disgust as he replies in a reprimanding tone: “Obviously, if there was a $10 bill there, someone would have already picked it up.”

What this joke illustrates is the inherent paradox of the Efficient Market Hypothesis. For markets to be efficient, they are active participants. For participants to be active in a market, there needs to be an arbitrage. In a perfectly efficient market, the arbitrage is competent away by the activity of the participants. 

The Markets are Mostly Efficient

No market is perfectly efficient. New information is constantly entering the collective perception of the market. Once information becomes obvious, it will obviously be priced in, when markets are efficient. 

WIth the internet and other technological advancement in data gathering, analytics and distribution, markets have undoubtedly become more efficient. In the early value investing days of Warren Buffett, he would read through Standard and Poor’s manuals, making mental calculations of stock’s intrinsic valuation. Nowadays, this information is readily available and calculated, practically in real time. 

In a podcast interview on the Invest with the Best Podcast, Michael Mauboussin, presented a fascinating statistic:  

“I think that one of my other favorite statistics in the paper is that in 1976, there were less than 1 CFA charter holder, for every public company in the United States, and today there are 27 CFA charter holders for every public company in the United States. So a lot more eyeballs on the companies that are out there. And maybe there is clearly more dispersion in smaller midcap companies. But look, the world is just a super dynamic place. You see these value changes are quite dramatic. You think about 2020 and hardly anybody had any idea what was going to go on. It was really hard.”

Degrees of Market Efficiency

It goes without saying that there are different degrees of efficiency. When you invest in big S&P 500 stocks such as Apple, Amazon or Netflix, you should be aware that there are hundreds of analysts that cover those stocks. You have to ask yourself what kind of an edge you have over those market participants. 

At the same time, there are plenty of markets and asset classes that are less efficient. There are many publicly traded stocks that don’t have a single analyst covering them. Outside of the stock markets there are all sorts of asset classes and markets where an individual can develop expertise and investment edge. Internet domains, for example, is an asset class that has a very vibrant secondary market and dedicated investors. 

There are plenty of $10 bills out there, waiting to be picked up.

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.

How to Value Your Job

The worst career advice that you get from people is when they say stuff like “you need to take control of your career, you need make sure you get what is coming to you, no one is going to care about you the way you do, so you need to make sure you fight for all of this stuff”, etc, etc. Those are all terrible advises. 

Your job, whatever your job is, is to add value to your employer. It is not your job to try to extract value from your employer and try to get as much of it into your pocket. Rather, your job is to add as much value as you can for the employer and then you can capture some of that value. 

Contrary to what most people think, being underpaid is a very powerful position to be in. Because, if you are adding more value than you are costing then it means also means that you are a very valuable employee. And if your employer is rational, you are going to be treated well.

Nobody has ever gotten fired for creating too much value for their employer. And nobody keeps a job very long if they are getting paid more than they are worth. 

This text was adapted from a podcast interview with legendary investor Bill Miller on Master in Business. The whole podcast is well worth the listen