Pt. 2 — Steps to Fundamental DEGEN

We dive deeper to the tactical level, examining the roadmap to analyzing fundamental drivers of cryptoasset projects.

When conducting fundamental analysis, we always want to consider the core framework of:1) qualitative analysis, 2) management team, 3) risks and 4) valuation.

Much of this section is adapted using Cryptoassets: The Innovative Investor’s Guide to Bitcoin and Beyond with a focus on Chapters 8, 12 and 13.

Building on the fundamental analysis framework, we want to explore these sections for cryptoassets:

  • Decentralization-ness
  • Supply and Issuance Model
  • Governance
  • Community
  • Adoption
  • Valuation

Decentralization-ness

The first question any investor should ask is “Why does this project exist?, What is the value proposition that makes it suitable to use blockchain / decentralization technology?”

For smart contracts, we want to identify whether it is an ERC 20, 721 or 1155 token.

ERC 20 are fungible tokens. They are indistinguishable and each token has the same value. This is most commonly known as “altcoins” pre DeFi summer. Common cryptoassets here would include ETH/DOT/ADA etc.

ERC 721 are non fungible tokens. Each token is distinguishable with different properties. NFTs are categorized here.

ERC 1155 supports both fungible and non fungible tokens. A good example is in video games in which there are fungibles assets such as in-game currency and non-fungible assets such as special equipment.

Often times investors look at cryptoassets and refer to them as “the Crypto version of [X]”. While making these comparisons are useful to understanding the protocol, the key question should be “When will this project reach mass adoption?”.

Mature businesses that fail to improve its growth model are most susceptible to disruption. A company (and the industry) would not be able to sustain its competitive advantage over time if its return on investment is lower than its cost of capital. Cost of capital affects the Company’s “supply of resources”. And when management teams make poor use of this resource, it generates lower returns on investment, making it less competitive in the market place.

Businesses that could survive despite providing lower value over time typically have monopoly/oligopoly rights reinforced by regulation and high invested cost of capital. Mature businesses with rigid structures struggle to adapt as the industry evolves. This “disruption zone” is where the best opportunities are available to address failures in the market.

On the other hand, for cryptoassets where a valid solution in the market already, and is highlighted by a loyal, sticky userbase and relatively underpenetrated addressable market, the investment opportunities aren’t as compelling because the threat of new entrants (and competition) in the industry is low.

This is the Airbnb, “but crypto” debate that investors fall in love with. Sure, cryptoassets could disintermediate a platform business such as Airbnb by shifting the underlying economics back to leasees and lessors, but because this solution exists in the market with scale, it would be extremely difficult to supplant it, until it reaches the disruption zone.

Supply and Issuance Model

In equities, the supply of shares can be categorized as authorized shares, issued shares and outstanding shares.

  • Authorized shares are the total number of shares that can be sold to the public.
  • Issued shares are those issued to the shareholders.
  • Outstanding shares are issued shares subtracted by “treasury stock” or share buybacks.

Some cryptoassets such as Bitcoin follow the principal of scarcity similar to gold or precious metals. There is only 21M units of BTC minted by 2140 and the inflation schedule to get there is reduced by half every 4 years. Many crypto projects follow a similar mathematical supply schedule that combines both inflation and burn mechanisms.

Often the concept of market capitalization is blurred between Circulating Supply and Total Supply. On Coinmarketcap or Coingecko, the market capitalization presented uses the Circulating Supply. This is analagous to the “outstanding shares” in equity markets, specifically free float or public float.

When analyzing price action for cryptoassets, it is very important to take a step back and analyze the market capitalization of the project. One must ask themselves whether the price action would also justify the market capitalization of the project.

On the issuance model, investors must examine: 1) issuance rate and 2) fairness of distribution.

If the issuance rate is too high, the utility of the project will not grow in line with the total supply, which then creates downward pressure on the value of the project.

The distribution of the tokens must also be equitable. Management, developers, investors, and community members might receive some supply at the launch of the token. But when there are instances of premine or instamine, these are warning signs as value would then aggregate to key constituents, questioning the fairness of the distribution.

Governance

Burniske highlights three layers of governance for all assets: 1) procurers of the assets, 2) holders of the assets and 3) regulatory bodies overseeing the assets.

In equities, shares represents ownership in the Company, while the management team oversees the day-to-day operations. The Board of Directors have fiduciary duty to shareholders (the BoD often owns a sizable chunk of the shares so they have skin in the game too). There has been a lot of discussion of what it means to owe fiduciary duty to shareholders. On one hand, it is an excuse for aggressive investors to pursue transactions and investments that cross a legal gray area. Investment managers would often cite “fiduciary duty” as the motivation behind their aggressive pursuits. On the other, fiduciary duty has no contractual obligation, and is examined on a case-by-case basis with minimal blackletter and legislate law. Finally, the SEC is the primarily regulatory body for equities.

In credit, there is no such thing as fiduciary duty as debt instruments don’t represent ownership in the Company. While management team and BoD both play an important role in the Company’s operations and strategy, their utmost duty is still to shareholders. The SEC also plays an important role overseeing credit issuances in the capital markets, approving each debt issuance. Taking a step back, creditors are protected by legal language and contractual agreements. Therefore, the governing body behind credit is contract law. When the Company enters bankruptcy, the BoD’s priorities shift to include creditors in the discussion of fiduciary duty, because at that point, the Company has the obligation to do its best to recover value to credit holders. Often times, when Companies emerge from bankruptcy, these credit holders become new shareholders of the reorganized entity.

An important wrinkle to the governance of traditional asset classes is the emergence of Rule 144A which was introduced by the SEC in 2012:

Rule 144A modifies the Securities and Exchange Commission (SEC) restrictions on trades of privately placed securities so that these investments can be traded among qualified institutional buyers, and with shorter holding periods — six months or a year, rather than the customary two-year period.

This was game changing for credit markets especially in private lending and high yield. Before, smaller companies couldn’t access public credit markets because of issues such as disclosure requirements or immature business models. However, this is only a small % of 144A issuances. In fact, many of the most mature businesses utilize 144A:

Companies issue 144As to decrease origination fees, documentation, and time to market relative to SEC-registered bonds. Of the top-ten issuers in the Barclays high-yield index, there are only two with no 144As in their capital structures, whereas more than half of the top ten have minimal registered debt outstanding.

Greyscale GBTC also utilized 144A to enable accredited investors access to their closed-end trust. Essentially, Greyscale has an authorized participant — Genesis — which operates under the DCG umbrella, that helps it create and redeem shares of GBTC so that the market value of GBTC can be as close as possible to the underlying NAV of BTC. Shares are created if prices trade above NAV (this creates more supply… which puts downward pressure on price), and vice versa. This is true if GBTC was an ETF, but GBTC is a closed-end trust. The main wrinkle is the lock up period in which accredited investors need to hold GBTC for 6 months before they can sell it via OTC markets. There are a host of reasons why the premium to NAV has fallen over recent months, but the short answer is competition as cryptoassets investment through these investment vehicles become more available to all investors.

For cryptoassets, procurers are the developers who created the code behind the project and miners who are in charge of maintaining the project through incentives. The holders of the assets could be the procurers, but also extend to investors and end users who use the tokens underlying the project. Finally, with regulation, we expect this emerging landscape to evolve as crypto enters mainstream. But for now, we could expect both the SEC and the CFTC to play an important role in overseeing the entire industry.

Community

For traditional investors, community is the most underrated (often looked down on) driver of value in investing. When looking at BTC, traditional investors often cite TSLA as an example in which the valuation reflects the “belief” or “hype” of the project. Whether hype drives valuation is a separate discussion, but much of this momentum is driven by the community building and marketing efforts from the project’s team.

While investors have an outweighed focus on management team’s background and competency, it is the motivation and devotion in the project that truly distinguishes great from good. In other words, if Black Thursday occurs again… would they be around?

Community teams are essential to the growth and sustainability of a project. Most teams have the essentials including: community leaders, website/marketing, telegram groups, reddit groups and discord channels. Each are important to monitor because the sustainability of the project will be judged by the activity in all these mediums.

A great example in recent months is Polkadot’s rise in Asia. Gavin Wood and his team has spent months marketing their project to developers, hosting community events to retail investors, and leading education seminars. Wood himself lives in Shanghai and has a Chinese name “Lin Jiawen”. The Polkadot team invested a substantial amount of energy in Asia:

In Asia alone, we’ve had over 70 online and offline events and presentations, together with community and local partners. During 2020, we’ve published over 1,000 Polkadot/Kusama/Substrate-related articles, news, videos, gaining well over 1 million total readings between hundreds of thousands of readers. The three-city Polkadot China tour alone attracted 700 meatspace attendees to talk about all things parachains. The three-city Polkadot China tour alone attracted 700 meatspace attendees to talk about all things parachains.

Adoption

The beauty of cryptoassets is that all on-chain transactions are transparent in real-time. This is unlike traditional finance in which Companies report on a quarterly/annual basis through SEC filings.

To examine the health of a cryptoasset project, we want to understand certain adoption metrics. Burniske highlights a few including:

  • # of daily active addresses
  • # of transactions on the network
  • Network value (market capitalization) / $ transaction

In this segment, we will look at some basic metrics for ETH.

Daily Active Addresses

“The more users, the more usage, the more acceptance”. While this is a useful metric that quantifies network usage, it does have some drawbacks. Each user can have multiple unique addresses which creates a double counting problem. As wallets become easier to use and access, expect this metric to overestimate the actual health of the network.

Transactions on the Network

Very similar concept to active addresses. Higher the transactions shows better health of the network. The key is to see sustained growth over a defined period. While large transaction spikes are episodic, showing a sincere initial interest in the project, it is the sustained momentum that matters most.

Note: The USD value of the sum of native units transferred that day removing noise and certain artifacts.

Network Value Transactions

NVT is similar to an Enterprise Value over Sales/EBITDA metric or Price / Earnings ratio commonly examined in Traditional Finance. This metric is particularly useful to see whether the value of a project is overvalued / undervalued relative to its historical performance. It is also useful when comparing across asset classes to see which projects could be trading richly.

Below is a the NVT of ETH. What is particularly interesting is that overtime, the valuation has settled compared to its historical trading profile. The average NVT of ETH since Jan 2017 is ~40x, but moving in a downward trend since Jan 2020.

This same metric can be used to compare against BTC. Notice that BTC (in red) has been trading at a premium over time relative to ETH. There are many conjectures as to why this is happening, but chief amongst them all is perhaps traditional institutions prioritizing BTC over ETH.

Valuation

For most traditional asset classes, a NPV serves as the basis of fundamental valuation, whether that is determining a base/upside case or a margin of safety. Traditional valuation metrics are less applicable to cryptoassets because many aren’t capital assets, which has value accrue to the token via some form of cashflow metric.

In cryptoassets, Burniske splits valuation into utility value and speculative value.

Utility value refers to the use case of the cryptoasset. The actual fundamental driver behind the token’s valuation such as transfer of payment or store of value. On the other hand, speculative value is the sauce that causes extreme optimism in bull markets or the kryptonite that causes extreme pessimism in bear markets. In time, the hope is that the utility value and speculative value converge. This occurs as asset classes become mature over time.

Speculative values adapts to maturity cycles. Source: Ark Invest.

In crypto, this speculative sauce mostly originates from developers, but is greatly extended through community building. Community building could enhance the narrative of the project, which then boosts demand of the token.

Closing Thoughts

Investing in cryptoassets at this stage in its lifecycle requires a lot more creativity than investing in traditional asset classes. Many of the same principles can be used especially qualitative analysis. However, some aspects, especially drivers of speculative value, should be prioritized in the due diligence process before underwriting an investment. Many analysts are often married to their thesis and seek information that results in confirmation bias. This is more apparent in cryptoassets, which are highly susceptible to narratives and headline risk. Investors are encouraged to have an evolving framework in this industry.

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