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.

https://youtube.com/watch?v=sGkzL0xAWYc%3Ffeature%3Dplayer_embedded

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.

Is the Number of Active Blockchain Wallets a Leading Indicator?

A predictive indicator of how blockchain and cryptocurrencies are progressing in disrupting the world of the conventional finance industry is the number of active cryptocurrency wallets.

What are Crypto Wallets? 

According to Wikipedia, a cryptocurrency wallet is “A cryptocurrency wallet is a device, physical medium, program or service which stores the public and/or private keys and can be used to track ownership, receive or spend cryptocurrencies. The cryptocurrency itself is not in the wallet.“

Today, anyone who is interested in downloading a cryptocurrency wallet to his or her mobile phone will find an exhaustive list of wallets that allow the user to send, receive and hold cryptocurrencies, such as Bitcoin, and Ethereum.

That crypto wallets have gotten so much attention from entrepreneuring blockchain ventures should come as no surprise. Owning the relationship with the wallet user will be immensely valuable for any provider of wallets that can attract users at scale. Hence, there is a race for domination.

How Many Crypto Wallets Are There? 

According to Statista.com, there are just under 35 million active cryptocurrency wallets in use in 2019. This number has grown 5-fold over the last 3 years.

Statistic: Number of Blockchain wallet users worldwide from 1st quarter 2016 to 1st quarter 2019 | Statista

As the user base grows, cryptocurrencies are reaching more mainstream users. At 35 million users, the user base is tiny. Especially if you take into consideration that about 67% of Americans own a credit card and that there are over 1.5 billion credit cards in circulation between Visa and MasterCard.

More Thoughts on Crypto

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Cryptocurrency Mining | A Future Asset Class?

Our interest in the mining process, and in the economics of the cryptocurrency mining process, in particular, was piqued by Murray Stahl and the activities and research of FRMO Corp and Horizon Kinetics into Cryptocurrency. 

Mining as an Asset Class

During the FRMO Corp 2017 Annual Meeting, Murray Stahl gave the following example of the profitability of Bitcoin mining: 

To mine cryptocurrencies, you can buy servers and depreciate them on some sort of reasonable schedule, based on their estimated useful life. If we hold back enough cash to the equal or compensate for the depreciation rate, then the unit value will remain constant. As an example, if you depreciate $100 worth of equipment, and hold back $100 of cash from the mining profits, you have $100 less net equipment, and you have $100 more cash.

The book value will remain the same, and you basically pay out the balance of the profits to the shareholders. In that way, you could have a business in which you’ve created a new security that doesn’t fluctuate in price; it’s just the dividend payout that fluctuates. Sometimes the dividend is higher and sometimes it’s lower; people can live with that. But the accounting value will always be the same. 

That’s a complicated concept to absorb; sometimes I need to explain it five times for people understand, but that’s the way it works. Income is very important in modern-day asset allocation.

Horizon Kinetics has already raised funds for partnerships around cryptocurrency mining (or rather Consensus Money Seigniorage, as we believe they would rather call it). Furthermore, based on various statements made by Murray Stahl and his partner Steve Bregman, it is to be expected that Horizon Kinetics will expand its offering of mining-related investment products, most likely through a closed-end investment fund. 

The Profitability of Mining

The Economics of Mining has characteristics that make it feasible as an asset class, in our opinion. It should come as no surprise that profit margins in mining can fluctuate quite wildly. Why is that? The biggest factor is the fluctuation in the price of the cryptocurrency that is being mined. 

However, there are other factors that affect profitability:

  • The cost of miners (also known as workers) can fluctuate
  • The electricity prices can vary 
  • Machines can perform or underperform 
  • The Difficulty Rate and number of miners and nodes 

Nonetheless, as is the case with Bitcoin, the whole system is designed for mining to be profitable over the long term. As Murray Stahl explained in a Consensus Money Podcast: 

So, there were times when cryptocurrency mining went to break even. It happens. But it’s not going to stay there very long because cryptocurrency mining is designed to equilibrate. So let’s just say that it was unprofitable for a number of weeks. Well, most of these companies were very poorly capitalized. 

So they can’t operate without profitability. They didn’t have huge cash reserves to operate unprofitably. What they would do to save cash is that they would turn off their machines. Which you can do in 30 seconds. If they turn off their machines, what happens is that the difficulty rating? Which you will recall, is the probability of solving this equation. If they turn up their machines, the difficulty rating goes down because there are fewer machines trying to solve the problem. 

So when difficulty rating goes down and you leave your machine on, your machine necessarily becomes more productive. The probability of earning a coin goes up. So ultimately the whole thing is designed to equilibrate. 

So, I’ve never really seen it being, maybe I’ve seen it for a day or two, get modestly unprofitable. Of course, it really isn’t moderatly unprofiitable, even so. Because when people calculate the cost of mining a coin, remember they are adding in the hosting fee plus the depreciation. The depreciation is not a cash expense. So on a GAAP basis, you might not be profitable but on a cash basis, you’re very profitable.

As Cryptocurrencies gain acceptance and their user base grows, many of them will be designed to have miners facilitating the system and the transactions flowing through that system. As acceptance and usage grow, mining will become a part of the conventional capital markets and become an asset class. 

Investing in Mining as a Service Contract

What sets investing in mining apart from investing directly in the cryptocurrencies is that, with mining, you are not speculating on the price of the cryptocurrency. The mining operations are productive assets as they produce yields. 

Think of it this way: You could mine cryptocurrency but every time you get your mining reward, you exchange it for your local fiat currency. Once you have paid for your operating costs, you will have something left over. Your operations will yield a return irrespective of the price fluctuations of the cryptocurrency itself. 

There also exists such a thing as Mining-as-a-Service. There are a number of mining companies, that sell mining agreements to customers. These contracts can have durations, ranging from 3 months up to 2 years and are sold on a per hertz per-second basis. 

At How to Value Stuff, we have not been doing any mining ourselves. We are, however, active buyers of mining contracts. In our experience, although this differs widely between providers, mining contracts carry extremely high investment yields at the moment. We will publish more about our experience with mining contracts in future posts. 

More Thoughts on Crypto

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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. 

How do Banks Make Money?

You might think that the role of commercial banks is to accept deposits from the public and channel them into projects, where the bank can lend the money out at higher rates of return. You would be wrong.

When you hear the world deposit, you might think that the bank is storing the money for you, therefore acting as a custodian. It isn’t. When you deposit your money in the bank, in a legal sense, you are lending your money to the bank.

Money Creation

Banks, currently, are the effective creators of the money supply. They produce money. They do this by selling promissory notes, such as mortgages, car loans or business loans. Deposits are more like a by-product of the money creation process.

This is brilliantly explained by Professor Richard Werner (who happens to also be the guy who came up with the terms Quantitative Easing), in the following video:

Richard Werner: Essentially, if we want to produce something we need funding. So there is a role for banking in almost everything that happening in the economy. But what exactly is that role? Banks are being thought of as intermediaries. This is not really what is happening. They are creators of the money supply. 

Interviewer: So, you are firmly of the view that banks create money out of thin air?

Richard Werner: I produced the first empirical study to prove that, in the 5,000-year history of banking. Banks are thought of as deposit-taking institutions that lend money. The legal reality is that banks don’t take deposits and banks do not lend money. So, what is a deposit? A deposit is not actually a deposit. It’s not a bailment. It’s not held in custody. 

At law, the word deposit is meaningless. The law courts in various judgements have made it very clear. If you give your money to the bank, even if it is called a deposit, this money is simply a loan to the bank. So, there is no such thing as a deposit. 

Banks borrow from the public. That much we have established. What about lending? Are they lending money? No, they don’t. Banks don’t lend money. At law, it’s very clear. They are in the business of purchasing securities. That’s it. 

So you say: “Ok. don’t confuse me with all that legalese. I want a loan.” Fine, here is the loan contract. Here is the offer letter. And you sign. At law, it’s very clear. You have issued a security, namely a promissory note. And the bank is going to purchase that. That is what is happening. 

Interviewer: Put it in laymen terms.   

Richard Werner: It means that what the bank is doing is very different from what it presents to the public that it is doing. How does this fit together? You say “fine, the bank purchases my promissory note. But how do I get my money?” 

The bank will say, “you will find it in your account with us.” That will be technically correct. If they say, “we will transfer it to your account,” that’s wrong. Because no money is transferred at all. From anywhere inside the bank or outside of it. Why? Because what we call a deposit is simply the bank’s record of its debt to the public. Now, it also owes you money and its record of the money it owes you is what you think you are getting as money. And that is all it is. 

And that is how the banks create the money supply. The money supply consists of 97% of bank deposits. And these are created out of nothing by banks when they lend. Because they invent fictitious customer deposits. Why? They simply restate, slightly incorrectly in accounting terms, what is an account payable liability arising from the loan contract, having purchased your promissory note, as a customer deposit. 

But nobody has deposited any money.

 

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.

Clearing & Settlement | Blockchain Use Case

When you start to take a deep look at how the capital markets system actually works, you quickly come to realize that the system the capital markets operate on, is an archaic legacy system.

The Settlement System

Think for example, about how we settle securities transactions. If you buy a publicly-traded stock through a broker, how does the ownership of the stock transfer over to you? The settlement of that stock actually takes some days. This is why when companies are issuing dividends, they have a record date and execution date.

Cede & Company

But that’s just half of it. If you buy a stock, say one which is listed on the NYSE, you don’t actually own it. I first heard of this from Patrick Byrne, Overstock.com’s quirky founder. When I heard it, I thought he was exaggerating or just misunderstanding something.

But if you look it up, you’ll find that Cede technically owns substantially all of the publicly issued stock in the United States. Investors do not hold direct property rights in the securities they hold, but rather have contractual rights that are part of a chain of contractual rights involving Cede. If you still don’t believe this, there are actually plenty of legal cases where this system has caused major conflicts and confusion.

A Feature, Not a Bug

It is important to understand that this is not some sort of a conspiracy theory about men in dark rooms trying to use their power to advantage themselves. The current clearing and settlement system is built to suit the needs of a paper-based reality. Derek Edward Schloss explains this pretty well in an article called Security Tokens and The Digital Wrapper:

DTC’s system of share ownership was likely born of good intentions, although today it just looks like an expensive and inefficient upgrade of a slow, centralized, paper-based framework. As a result, our present-day public markets run on a system where we don’t actually own anything, controlled by multiple rent-seeking intermediaries at each stage, with sometimes wildly inaccurate share management and relatively slow settlement times across the board.

When the Transaction is the Settlement

If securities, such as stocks, are tokenized on a blockchain system, in theory, the transaction is the settlement. There are other advantages as well. Today it is hard for the issuer of a security to communicate directly with the shareholders. Voting, as described in the Bloomberg article that I link to above, can be quite tricky.

There are many exciting projects out there, that aim to improve those processes and would allow the issuers of securities to interact and share information with the owners of those securities. Ravencoin would be one of them.

Adoption of Security Tokens

So far, there the disruption of the current clearing and settlement system doesn’t seem to be there yet. Which is very understandable. The capital markets are huge and the barriers to entry are enormous. Not only is the regulatory scrutiny as high as it gets, but any incumbent system will also have huge network effects.

In his book, The Hard Thing About Hard Things, Ben Horowitz describes the internet landscape facing Netscape, before it came out with the first web browser:

At the time most people believed only scientists and researchers would use the Internet. The Internet was thought to be too arcane, insecure, and slow to meet real business needs. Even after the introduction of Mosaic, the world’s first browser, almost nobody thought the Internet would be significant beyond the scientific community – least of all the most important technology industry leaders, who were busy building proprietary alternatives. 

In the case of Security Tokens, at least the industry leaders seem to be very aware and already participating in clearing and settlement 2.0.

More Thoughts on Crypto

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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.

In Defence of Inflation | Bitcoin

It is not uncommon to hear proponents of cryptocurrencies in general, and Bitcoin in particular, make a libertarian case for the future adoption of the cryptocurrency. The libertarian case would be something in the vein of governments using fiat currencies as a means to illegally tax their citizens by means of money printing. For each dollar that the Federal Reserve prints and brings into circulation, the denominator increases while the total wealth of the economy stays the same.

 There are two arguments to be made against the libertarian case:

  • Inflation is a feature, not a bug: Before fiat currency, most national currencies were pegged with gold or silver. You could basically exchange your Dollars for a fixed amount of gold or silver. The gold anchor caused supply constraints when people were fearful. The currency became harder to come by when people were pessimistic which in turn amplified the deflationary pressures. 
  • Most of the time, you are not long the dollar. When you get your salary transferred into your account at the beginning of the month you consume some of it and you save some of it (hopefully). If you buy a property, you no longer are holding the dollars. The property is only denominated in dollars. If more dollars come into circulation, the property will have the same value but will be worth more dollars. 

What would happen if you knew that the dollars you got paid out at the beginning of the month would deflate by 20% by the end of the month? If you are a reasonable person, you would try to delay any use of your dollars until the end of the month. You would hold back on spending because your purchasing power would increase. Again, the inflation rate of the modern currency is a feature, not a bug, as it stimulates economic activity. 

The deflationary structure of Bitcoin might make it a good store of value, but less so a medium of exchange. 

More Thoughts on Crypto

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The Value of Mezzanine Debt for Growth Companies

For a high growth company, selling equity can be very expensive. Why?

If a company is growing its profits by 100% annually, it will have grown its profit by a multiple of x32 by the end of year 5 (a 3,200% increase).

Accordingly, if the management of that company decided to raise equity at the beginning of year 1, they would need to sell at an earnings multiple of 320x the current year’s profit to sell at a 10x multiple of profits in year 5.

Not many venture companies manage to do that and are forced to raise capital at lower multiples. If their growth projections then become reality, the equity raise will turn out to have been very expensive for the sellers.

Enter Mezzanine Financing

Mezzanine capital is hybrid financing that consists of both debt and equity exposure, which gives the lender the right to convert to an equity interest in the company at a predetermined exchange rate. Because the investor is entering with debt, his downside is better protected. As such, the investor is also willing to sacrifice his exposure to the upside. 

Mezzanine financing can be a useful tool for many high growth companies in order to fuel growth at a relatively low cost of capital. Mezzanine finance specialists work with owners to design custom funding packages that aim to lower the cost of capital and mitigate excessive dilution for founders.