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Value Investing

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Estimated reading time: 4 min

Overview

When assets that trade at a discount to their intrinsic value are selected as an investment, it is considered to be “value investing” and an accurate guess is made by analyzing a company’s financial reports. However, bitcoin doesn’t have balance sheets or income statements, so it cannot be evaluated in the same manner as shares of stock. That said, some of the core principles can be applied to bitcoin.

Fundamental Analysis

Typically, value investors read financial reports and research the market to predict future success. Since no balance sheets exist to analyze bitcoin or altcoins, the value is determined by its level of adoption, network effects, and speculation as to future applications. These factors that affect value cannot be predicted with accuracy but can render a rough estimation as to the direction the asset is moving. Investors review the crypto assets white paper, community, current achievements, and its roadmap.

Most investors consider Warren Buffet to be the most famous “value investor” of modern times, as he has consistently outperformed the market for over 50 years. He uses an approach that pre-filters the pool of assets to narrow the field. While the mechanics of a cryptocurrency are completely different from those of a traditional business, we will try to apply Buffet’s pre-filters in this exercise.

Filter #1: Circle of Competence
The investor asks himself if he can understand the company – cryptocurrency, in this case.

Filter #2: Moat
Buffet’s metaphor for “lasting competitive advantage” required to protect a business and the broader, the better.

Filter #3: Management Evaluation
The investor determines if the managers act in the best interest of the owners.

After these filters are applied to narrow the field, cash flow is estimated to value each candidate company. Cash and real estate value, potential earnings power, and previous growth are measured. Now to apply the same formula to crypto assets.

Filter #1: Circle of Competence
Does the investor understand the cryptocurrency? The very first step is to research the particular crypto coin, create a wallet, buy a small amount and make transactions, study the developers, join the community forums, and ask questions.

Filter #2: The Moat
This is not as easy and requires some deeper diving to determine what might give a particular crypto asset lasting competitive advantage. The obvious elements would be to have a credible developer community, engaged user base, decentralized consensus algorithm, high-level name recognition, and strong network effects.

The network effect is a phenomenon whereby the asset gains additional value as more people use it. Each new user brings value to the asset. The easiest example to illustrate network effect is the telephone system — the value of having a phone increased when everyone else had a phone.

Metcalfe’s Law indicates the value of a telecommunications network is proportional to the square of the number of system users. Network effects create a winner-take-all dynamic (think Facebook, Uber, Airbnb), which creates that protective moat. As the network grows, this competitive advantage further locks-in users and it becomes hard for users to leave because they’ve invested in it. A good example is the Internet, which initially had few users and little value to anyone but the military and a few scientists. A “data network effect” is applied to an asset that has no actual commerce involved.

“Data network effects occur when your product, generally powered by machine learning, becomes smarter as it gets more data from your users.”
Matt Turck

To further complicate matters, there is a network effect referred to as the “Nakamoto network effect” summed up nicely in this quote…

“It might make sense just to get some Bitcoin in case it catches on. If enough people think the same way, that becomes a self fulfilling prophecy.” — Satoshi Nakamoto in 2009

In the 1990s developers were building infrastructure across computing power, storage, and data. Cryptocurrency developers today are building a similar infrastructure, only it is decentralized, private, more secure, and designed to give control back to individuals. There are also “token network effects” – which occur when the growth of the network aligns with the appreciation of the token. As the network grows, the token adds value to the platform and accelerates network effects.

Filter #3: Management Evaluation
Cryptocurrencies that are decentralized network protocols, like Bitcoin, have no traditional management team. The Bitcoin Network has four stakeholder groups: CoreDev, Miner, User, and Service Providers. These groups of participants are crucial and should qualify as “management” that certainly needs to be evaluated. There are websites that grant access to developer activity for most crypto assets. Users have a say in the governance of a project, and the decision-making process will make it more viable as it promotes behaviors that benefit all participants in the ecosystem. Users are then incentivized to hold onto their asset, which in turn drives up the price and makes it more attractive to investors.

When estimating the value of the crypto asset, each has different properties. Bitcoin is a Store of Value, Steem is a social network, and Ethereum is a crowdfunding platform, for example. So the metrics and tactics to evaluate vary with each asset. Dash is a good example. In the early days, there were no mobile wallets, exchange listings, and so on needed to spur adoption. So, a portion of the mining rewards was redirected to a fund. Users proposed projects to fund, and coin holders in the masternode network voted on them. Dash created a VC fund out of thin air in record time, and the idea is now being adopted by other projects and protocols. Today, Dash’s fund is over $750K per month and is being used to build out the Dash ecosystem.

“We have a whole new asset class ahead of us and with it the opportunity to explore the theoretical foundations that people will use to value these over the next few decades. That’s the stuff to win a Nobel Prize.” –– Chris Burniske

Understanding the network effects unique to cryptocurrencies that drive value will be crucial for the evaluation of projects. Those that leverage the power of decentralization may be well worth the investment, or participation.

Disclaimer: The knowledge base does not give investment advice. The information provided is for research purposes only and should never be taken as investment advice or direction. Do your own research, ask questions, read a lot, beware of who is writing what you read, and don’t invest more than you can afford to lose. All the disclaimers applicable to any investment.

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