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.

Diversification | What it really means

According to Wikipedia, “diversification is the process of allocating capital in a way that reduces the exposure to any one particular asset or risk.”

Investopedia has a slightly different take, saying that “[d]iversification is a risk management strategy that mixes a wide variety of investments within a portfolio.”

To many, diversification means investing in the market in general. You can do that by investing in a broad market index, such as an ETF that tracks the S&P500 index. There are also the Russel indexes. Basically, if you own the market, you get the market return.

The Contrarian View on Diversification

But diversity does not necessarily have to mean more. The goal of diversification is not to get the market return but to reduce exposure to a particular event.

What you are trying to achieve by being diversified is to make sure not everything you are investing in moves in tandem. By doing so, you embed optionality into your portfolio.

If you accept this reasoning, you will also agree that a portfolio of 5 stocks can be seen as being diversified if those 5 positions are not affected by the same factors.

Think about it this way: Which of the two portfolios is the safer investment strategy?

  • Portfolio A: A basket of common stock of the 20 biggest financial institutions in the U.S.
  • Portfolio B: A basket of 5 stocks each in a separate industry.

Longevity as an Investment Criteria

In the world of startups and new ventures, the central theme seems to gravitate towards growth and scaling. 

When it comes to growth and scaling, learning how to manage an organization that is constantly getting bigger becomes the biggest challenge. 

However, when you look at the oldest companies in the world, these are all small operations in industries that have hardly changed much throughout the lifetime of those companies. 

Build to Last

Two of the oldest companies in the world are a:

  • Japanese Ryokan 
  • German Brewery

When founders start new companies, most of the time their vision is to disrupt an industry. 

But what if the objective would be to create something that was built to last? If you want to build an impenetrable fortress, you don’t want it to be ever-expanding, would you?

So, here’s a question: What if you were asked to build a company and there would only be one constraint: The total size of the organization would not be allowed to exceed 8 people.

What would you build?

The Columbo Method of Equity Research

Remember detective Columbo? He was a phenomenal character played by Peter Falk in a 1970s TV series called…you guessed it…Columbo. Detective Columbo was a scruffy and simplistic character, dressed in his signature beige raincoat and crumpy white shirt with a loosely knotted tie.

Colombo is no normal detective series, though. As is you would expect, Columbo’s job is to solve murder mysteries. However, the episodes don’t play out with Columbo delving into each case and eventually discovering who is the murderer, in a sharp twist near the end. Columbo is a detective series without the mystery.

In the case of Columbo, each of the 69 episodes begins with the scene of the murder. So, as a viewer, you know from the beginning who the doer is. The rest of the episode is a mental wrestling match between the murderer and lieutenant Columbo.

The Colombo Technique of Investigation

In each Columbo case, the murder is committed by someone close to the victim. This allows Columbo to approach the suspect as a witness or someone who can help Colombo in piecing together the pieces of the puzzle.

To the assailant, Columbo seems totally incompetent. The scruffiness of his hair and clothing give the impression that he slept in his clothes. He constantly scratches his head and he asks the assailant for help. His questions are simplistic and make him look like he’s totally out of his dept.

But Columbo is playing a part. He’s playing dumb. The perpetrator grows confident and starts to get comfortable, even annoyed. The trap is set. In the final minutes of a Columbo episode, the perpetrator has made a mistake and Columbo wrestles him down for the tap-out.

Stock Research and Colombo 

So, how does this relate to equity analysis? In stock research, there is no crime, there is no murderer. As an analyst, you have a stock and you build your opinion based on fundamental analysis.

But therein lies the caveat. You see, it is you who is the perpetrator because once you start your analysis, you start to for opinions. You will start subjecting your mind to all forms of mental biases. You become overly optimistic. You get anchored. You will start to look for confirmation in the data.

“But that’s me, I’m paranoic. Every time I see a dead body I think it’s murdered. Can’t imagine anyone murdering themselves.”  

– Lieutenant Columbo

As an analyst, you have to put on your mental raincoat and find your inner Columbo. You have to take a step back and start to ask yourself the simple question. The overly naive and borderline stupid questions. You have to confront yourself and find start to look for loopholes in your story.

Just One More Thing…

Lieutenant Columbo bombards his suspects with questions. He’s relentless. He keeps coming back with a question. He’s apologetic, he excuses himself. He just can’t help himself, he says. But he keeps coming back for “just one more thing.” 

Copying Top Investors and Their Portfolios

When it comes to investing, being a small fish in a big pond isn’t all that bad. Consider the following:

  • All institutional investors need to file a so-called Form 13F. They basically have to tell the Securities and Exchange Commission what they are investing in. Better yet, all this information is made public. 
  • What makes an institutional investor institutional, is that fact that they have clients. An institutional investor manages and invests money on behalf of their clients. And how do they get money from others to manage? Just like any other regular company…by selling. They literally tell how they invest and how they plan to invest. 
  • Some investors, like Carl Ichan, Bill Ackman and Dan Loeb are activist investors. How do they get active? By publishing to the public detailed reports on what they think the value is of the companies that they turn active on and how they think the company needs to do in order to achieve those valuations. 

All of this information is readily available for you as an investor. Big investors with small armies of stock researchers and equity analysts are publishing research in droves and filing disclosures on their positions every day. 

All of this information is available to you for free. 

How Scuttlebutt Investing Works

The Scuttlebutt method of investing is fathered by the legendary investor Phil Fisher. Fisher is likely most known for his bestselling book Common Stocks & Uncommon Profits.

Scuttlebutt investing, as the name indicates, begins with a story or some other anecdotal data point, that triggers interest. It might be a product you love, a competitor you hate because of her competence.

How to Practice the Scuttlebutt Method

This is just the starting point, though. You have a hunch. You might be on to something, but what’s the next step? Do you check the performance of the stock price, do you download the financial statements and start crunching numbers?

If you are a Scuttlebutt Investor, your research would be very hands-on. You might visit retail locations or even manufacturing facilities. You would get feedback from customers, resellers or even competitors. You would try to understand the competitive dynamics of the market, performing the Silver Bullet Test on the people you would talk to.

Following up with Fundamental Research 

The Scuttlebutt Method is great to validate investment ideas and building an intuitive understanding of the operational and brand-related qualities of a potential investment. Nonetheless, once you have strengthened your conviction about a certain stock, what you want to do is to cross-validate your finding with a fundamental analysis of the financial statements of the company.

This will give you a clearer picture of the business model and allows you to compare your scuttlebutt data points with the overall financial and valuation picture.

Discount to Net Asset Value | Protect Your Downside

One way to value a stock, especially those of companies that own various subsidiaries or a portfolio of assets, is by analysing the company’s discount (or surplus) to Net Asset Value.

Conglomerate Discount – The Case of Exor

We recently took a close look at Exor N.V., the holding company that controls such publicly traded companies as Fiat Chrysler Automobiles, Ferrari and CNH Industries. Conglomerates like Exor are interesting to analyse as they tend to trade a steep discount on the mark-to-market Net Asset Values (or market-adjusted book value).

In the case of Exor, the company trades at about a 30% discount on the market value of assets on the balance sheet. 

Point of Maximum Pessimism – The Case of Dundee Corporation

If you are a Contrarian Investor, you are trying to go where other investors feel extremely uncomfortable to be. You are trying to go where others are running to the exits, but at the same time, you don’t want to be too early. 

One of those situations is materializing at a Canadian Asset Management Company called Dundee Corporation. After a series of unfortunate events (and decisions), the market capitalization of Dundee is gone from about a billion dollars to about $74 million. 

The company trades at a steep discount to book value, but for good reason. The company has been haemorrhaging money as failed investments have sucked up cash and destroyed shareholders’ capital. 

But investors may have overreacted. Even though the company is taking drastic steps to turn the business around, Dundee’s stock is trading at about a 70% discount to book value. If the company manages to stop the bleeding, a significant re-rating might be in the cards. 

The Fundamentals are in the Footnotes

The whole point of fundamental research or value investing or whatever you want to call it is to get an edge by looking a little deeper than others are looking. This is why you won’t get very far by using stock screeners.

Stock Research on Onverstock.com 

We recently published a stock report on the Fundamental Finance Playbook about Overstock.com. The article is a deep dive into the current status of the company’s online retail business. We try to figure out if the business is, in fact, in a turnaround as management claims, or if the company is at risk of running out of cash.

Previously, the management had stated that they were trying to sell the online retail business but so far nothing has materialized. During our research phase we noticed that during the last quarter, consulting fees on the corporate level had increased significantly. By corporate level, we mean not connected to the operations of the online retail business nor the blockchain ventures.

Overstock engaged Guggenheim in 2018 to explore strategic options for the retail business and find possible buyers. If the consulting expenses are mostly in the “Other” business segment and neither in the retail operations nor the tZero operations, it is plausible that Overstock is already in advance negotiations with potential buyers through Guggenheim.

What that indicated to us, was that there was a possibility that Overstock was already working with Guggenheim Securities, the company that Overstock employed to find buyers, on advanced negotiations with possible buyers. These kinds of transactions usually require heavy due diligence, so it would be quite plausible that costs would ramp up like this.

Two Potential Acquirers 

A week after we published, Patrick Byrne, Chairman and CEO of Overstock said in an interview with CNN that the company was in negotiations with two potential acquirers. It remains to be seen if anything materializes from this, but it goes to show that sometimes the fundamental facts are buried in the footnotes.

Stock Report | OTC Markets (OTCM)

OTC Markets (OTCM) is an American Financial market providing price and liquidity information for Over-The-Counter securities. The company was founded in 1913 as the National Quotation Bureau since the company has changed many names. The company operates in the Financial Services space.

Business Segments

The company primarily provides 3 services:

OTCQX

OTCQX is the trading platform that connects clients to broker-dealers, providing liquidity and execution solutions.

OTCQB

OTCQB is the new reporting and market data compiling service. It grants access to various channels like Bloomberg, Thomson Reuters, etc.

OTC Pink

This is the corporate services pack, which helps companies to better engage and inform investors.

OTCIQ

Apart from these primary services, OTCM provides a service to other businesses called OTCIQ. OTCIQ serves as an investor relation portal for the company to monitor security market activity and transmit information to investors.

Management

The top brass of OTCM is highly qualified and rich with experience. The CEO, president and director, Cromwell Coulson took over in 1997 when the private company was nothing more than a publisher of quotations. Coulson and his team have transformed OTC into a publicly-traded company, operating in 3 markets and seeing an annual trading volume of just under $200 billion. 

CFO, Bea Ordonez, has over 20 years of experience in the financial services segment; she is also a member of the Institute of Chartered Accountants in England and Wales. Jason Paltrowitz, Executive Vice president of Corporate Services, has served had held management positions in renowned companies like JP Morgan Chase and BNY Mellon. 

The company’s management is more than qualified and has a great track record; OTCM has not received any warnings or penalties for non-compliance with rules and regulations in the past few years.

Market Statistics

  • Simple day moving averages 50 days: 33.72
  • Simple day moving averages 200 days: 32.1
  • 52 week Range: 25.37 – 40
  • Lifetime high: 39.95

Valuations and Competitors

  • P/E – 25.32
  • EPS- 1.36
  • NOA- $13,972
  • NOPAT- $16,148.19
  • RNOA- 1.15

Business Model

OTCM lacks any direct competitors, and therefore enjoys an almost monopolistic operation. This makes it hard to determine the exact value of the business is the lack of comparison with other publicly traded stocks. News Corp-owned MarketWatch is a close rival of OTCM in the news and press segment. Both companies publish investor reports and function in the financial service space.

However, News Corp currently trading at 12.6 has been in losses for the past 2 years. Its share has shed nearly 22% over the past year and hence can’t be considered as a comparison. On the Exchange side of things, OTCM would be dealing with the likes of NYSE and Nasdaq. Both of these exchanges are considerably beyond OTCM’s reach as of now. Hence OTCM enjoys a niche that is unlikely to change in the near future. This while making OTCM harder to value could also be seen as the advantage of the business having a unique business model.

Key Financials

(all $ figures are in thousands) 

  • EBIT: $19,645 (up 7.32% from 18,304, in 2017)
  • Net income from operations: $16,237 (up 28.8% from 12,599, in 2017)
  • Cash and Cash Equivalents: $28,813 (up 21.66% from 23,683)
  • Total Assets: $41,649 (up 14.6% from 36,317)
  • Total liabilities: $25,240 (up 12% from 22,526)
  • Net cash from operating activities: $22,590
  • Net cash from financial activities: -$15,882

Operating expenses for the company have grown at a steady rate signalling a steady expansion in the business. Net income from operations grew by 19.2% from 2016 to 2017. In 2018 it’s up 28.8%. However, that’s not the whole story because of a one-off item in the company’s gross revenue. In 2018 there was a one-off licensing deal with Bloomberg LP contributing to 10% of gross revenue from licensing, amounting to $2,338.

The model of the company allows it to be heavy on cash almost at all times. Therefore the cash and cash equivalents are larger than all other assets combined. Both the Cash and cash equivalents and the Total assets have increased. The total asset growth is faster than the total liability growth and there has been a sharp spike in the other liabilities item. 

This is causing the growth rate difference between the 2 to seem close however this will not repeat in the next quarter causing the difference highlighted more clearly. One of the most important items to notice in the balance sheet of the company is that its short and long term debt is 0. Being debt-free is always a big positive for any company.

The net cash from investments has been low, signalling that profits are simply being reinvested in the core business. However, the company has stated that it would make further acquisitions in FY 2019. The financing activity in question has been dividend payout and the operating profit has increased by nearly 37% from the previous year.