Category: Finance

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.

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

Value and Growth are Joined at the Hip

Most people think Warren Buffett is a value investor but if you want to go into the particulars, one could argue that he is primarily a fundamental investor. Buffett famously said that growth and value are joined at the hip. Both are areas of fundamental analysis.

One could also argue that many business owners would not easily understand the question if you would ask if they focus more on growth or value in their capital allocations. Business owners simply allocate capital to the projects with the highest expected IRR, irrespective of any category you might want to fit it into. 

Personally, I really like the framework put forth by the late Marty Whitman. In his opinion, there are are 5 main areas of fundamental finance: 

  1. Value Investing (limited to minority positions in public co’s) 
  2. Distress Investing
  3. Control Investing
  4. Credit Analysis
  5. First and Second Stage Venture Capital Investments

Warren Buffett, as an example, has been active in all of those categories, either directly or indirectly. Henry Singleton, as well, is someone you could not classify as a value investor specifically. He just went where he thought the highest IRR was at any given time.

Why is Chuck Royce such a Good Investor?

The title of this post is a question posed by Tobias Carlisle to his guest Micheal Green of the Logica Fund, on his The Acquirers Podcast. Micheal’s answer to this question was pretty interesting, to say the least, and beautifully formulates the investment framework of Chuck Royce and the Royce Funds.

Michael Green: “First of all, Chuck has just an incredible mind and an incredible awareness of the embedded optionality in securities. And so, his philosophy as it relates to securities selection at Royce [Funds] was that he focused on small cap stocks, but he required that they have very low levels of leverage. And the reason why he did that…I think he intuitively knew this but I don’t think certainly he was explicitly modelling it in the same way I would be forced to do.

When he recognized this, that they had option-like characteristics, right, owning a portfolio that has small cap names in it is the greatest potential to exhibit that lottery-like winner capability. And he was very agnostic between value and growth from that standpoint. Always looking for that option-like characteristic. But his simple rule was that the company couldn’t have enough leverage that would lead to aggregation or a shortening of that option duration.

So he was effectively trying to pick infinitely lived option-like assets. And he just did it extraordinary well. I mean, he had seen so many management teams and he had seen so much. I met him in 2003 for the first time and he had been running Penn Mutual Fund which was the core of the Royce universe. Which he acquired for $1 in 1974. People forget how bad things got.

There is maybe a little bit of this feeling in the active manager community today. But he was able to buy Penn Mutual Fund for $1 dollar. Because the owner, it had assets, and it had a bit of a track record. But the owner was incapable of paying directors salaries, registration fees etc. So he bought it for a dollar and then it proceeded to lose money for some time as he paid directors and others. But it turned into this extraordinary vehicle on the back of his talent. 

Tobias Carlisle: My interpretation of the Royce firm is that they seem to have a holding in every single stock I ever look at. A tiny holding. 

Michael Green: So, I think that’s true. I think that is again a reflection of Chuck’s philosophy that each of his securities represents this option like characteristics. A typical portfolio of Royce would have somewhere in the neighborhood of 160 to 300 stocks. There would be multiple portfolios.

Portfolios would typically be launched in a new fund when we thought it was a peak of a market. Which sounds counter-intuitive. Until you realize that what this actually means is that you have launched a vehicle that has an excess of cash in an environment of high valuations. And so as the markets sell off, that cash creates actually an out-performance characteristic.

So when the next cycle emerges, not only did you have cash to deploy at more attractive valuations, but you benefited from the cash component. And I mean, that type of insight. And again, I highly doubt that Chuck modeled it, but he just knew it intuitively. And that’s part of what I referred to with my respect to Chuck. I think he is probably the single finest investor I have encountered.

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.