The bear market has come again. Can value investing be replicated in cryptocurrency?

Source: Fu Zhuorui

Do you remember the days when the bull market started in 2021? The names mentioned the most, besides Cathie Wood, were Warren Buffett. Of course, Buffett was more often criticized in the cryptocurrency industry due to his negative remarks. During the craziest times, people regarded ARK's Cathie Wood as a god and looked down on Buffett, believing he was out of touch with the times and couldn't understand new things. Back then, even a random child could mutter to themselves that Buffett was nothing special when they saw the returns from Tesla in the U.S. stock market, not to mention the exaggerated volatility of altcoins.

How exaggerated was the market sentiment at that time? A homemade "resignation letter from Buffett" by an internet celebrity was actually published directly by major mainstream tech media without verification. People were too willing to believe that the stock god was old and that the new world had its own logic.

But when the bubble burst and liquidity tightened, we saw that Cathie Wood's returns had already retraced over 60%, while Grandpa Buffett remained astonishingly stable. In the secondary market, drawdowns are the least desired occurrence for players. What thoughts can we glean from the stability of the stock god?

The Emergence of Value Investing

If Benjamin Graham from the 1930s were to put on the latest trendy Apple Watch at the end of 2022 and open a CeFi or DeFi platform for cryptocurrency trading, he might smile and say, "Don't panic, I can handle this."

In the 1920s America, the stock market was far less mature than the bond market, being a nascent niche market. There were few investors in this market, mostly traders. Among the traders were professionals and ordinary people, with "economists" thriving and "retail investors" chasing after the words of star fund managers. At that time, there was no concept of value investing; trading methods were primarily "technical," focusing on trends and chasing momentum. Graham, who had entered the financial market early, thrived in this environment by analyzing company financial reports and quickly became a big name and star manager, with his fund once achieving over 100% profit and a sixfold increase in market value over three years.

In this roaring 1920s, Gatsby was infatuated with Daisy, while many ordinary people relied on the myth of the stock market's blessings, hoping to turn their fortunes overnight.

Graham

By 1929, Graham was already a millionaire (equivalent to a billionaire today) and was ready to make a big score, especially since the most famous economist at the time, Irving Fisher (a monetary theorist), confidently stated in October of that year, just before the stock market bubble burst, that stock values had not yet aligned.

Starting on October 24, 1929, the U.S. stock market began to plummet, leading to the infamous Great Depression, and both big names and retail investors were not spared. Irving Fisher and Graham saw their fortunes drastically shrink; although Graham's fund only lost 70% while the market lost 74%, this could not save the wealth he lost in just a few days. Graham dismissed the servants in his New York mansion, went through a divorce, remarried, and then divorced again, experiencing a chaotic period. Later, Graham, reflecting on his experiences, organized his value investing philosophy while teaching at Columbia University and published "Security Analysis," officially starting the era of value investing.

For the next half-century, Graham's students, including Buffett, applied the theories of value investing, creating a generation of investment masters.

The stock market at that time was somewhat similar to today's cryptocurrency market; could the value investing principles used for stock analysis also be applied to cryptocurrencies?

Value investing is very simple; it's just that the world is too complex.

Graham's value investing was straightforward, and Buffett also adhered to the simplicity of the theory, often performing calculations on the back of a napkin (napkin valuation). Buffett himself has never engaged in extensive modeling or various sensitivity analyses for investments; his approach to asset pricing and stock valuation has always been remarkably simple.

The value investing calculation given in "Security Analysis" is: V = EPS * [8.5 + (2*g)].

At that time, Graham's PE of 8.5 was applicable to companies without growth rates, and it later evolved to generally apply to company valuations. For emerging companies with few reference indicators, NYU professor Aswath Damodaran has a list that outlines approximate PEs for emerging industries. This value investing calculation has also undergone some changes.

PE reference provided by Damodaran, source NYU

Today, value investing has evolved slightly, but its essence remains the same: it still insists on searching for undervalued securities in the stock market. Commonly used indicators in modeling/calculating include PE, PB, EPS, etc. Most importantly, it is essential to leave a margin of safety, meaning the company's price should be greater than its intrinsic value, with Buffett suggesting at least 25%.

The philosophy and practice of value investing have traversed time through generations of value investing masters, becoming a steadfast principle over decades. However, before the U.S. stock market crashed in 2020, value investors were often overshadowed by funds that favored investing in emerging tech companies, with returns significantly lower than growth funds. One of the most notable funds at that time was Cathie Wood's ARK, which, along with the rise of Tesla—one of the highest-returning stocks—utilized a logic that was fundamentally different from value investing. Many tech stocks in our era were not profitable before or after their IPOs, with PEs in the tens or even hundreds, but this did not hinder these companies and stocks from experiencing explosive growth. The core logic of ARK was to heavily invest in tech stocks with explosive growth potential. In an era of technological explosion, such funds indeed achieved extraordinary results in the short term. Companies with exponential growth were not within the margin of safety for value funds, so value investors might not even consider such companies.

Even in China, Zhang Lei of Hillhouse Capital, who advocates for value investing and studied under David Swensen at Yale, has not fully adhered to classic value investing practices. Instead, he has redefined "value," believing that as long as something is "worth it," it can be bought regardless of price, which is why Hillhouse has previously invested heavily in high-growth stocks like Bilibili and Pinduoduo, which were not within the margin of safety and reported negative profits year after year. At the same time, Zhang Lei emphasizes the importance of thorough preliminary research, which is somewhat similar to the thoughts of Li Lu, who insists on venture capital across the strait.

This feeling is reminiscent of the logic of investing in Amazon twenty years ago. Amazon's stock rose year after year before the dot-com crash, so it was not a bad investment, even though it only turned a profit for the first time seven years after its founding, and the profit was very slim.

In contrast, Buffett's portfolio has remained consistent for decades. The few stocks that have outperformed the market for Buffett include Coca-Cola in the 1980s, Apple in 2016, and TSMC in 2022, all of which share the following characteristics: relatively low PE compared to peers, industry leadership, substantial profits, a margin of safety, and good dividends.

For the stock god, buying and selling stocks is not remarkable; the most important thing is to own quality businesses that can generate long-term profits. The stock god generally holds cash, adhering to the principle that crises present opportunities. If there is no cash to purchase quality assets at the right time, it is tantamount to investment failure.

Buffett does not reject technology; he simply assesses whether technology aligns with his criteria. The Apple company he invested in is a classic example. In 2021, Berkshire Hathaway invested in Brazil's FinTech disruptor, Nu Bank, which plans to launch its own cryptocurrency in 2023.

Buffett and his partner Munger have publicly scoffed at cryptocurrencies, believing that there is no intrinsic value behind this asset, although the stock god does not reject the technology and logic of blockchain.

Since the top practitioners of value investing in our era do not recognize the cryptocurrency market, can the principles and practices of value investing still be applied to the analysis of cryptocurrency projects?

Defining Cryptocurrency is Difficult, and Value Investing is Difficult

First, the definition of the investment object before investing may be quite important, as only then can one understand the nature and rules of the investment object.

Which asset class cryptocurrency should belong to is still unclear to regulators, investors, and users, or perhaps it should have its own asset class. In the eyes of regulators led by the Bank for International Settlements and major central banks, cryptocurrency is referred to as "crypto assets," so central banks do not recognize cryptocurrencies as a form of circulating currency. The risks associated with cryptocurrency transactions indeed prevent it from meeting some of the most basic requirements of currency. This is reflected not only in the documents issued by central banks but also in government definitions of cryptocurrencies. For example, in the documents where the U.S. SEC sued FTX, the SEC argued that FTT, through earlier buy and burn activities, should actually be classified as a security. If FTT is defined as a security, then BNB may also have similar attributes. Securities are regulated by the SEC, while commodity contracts are not. Currently, the U.S. defines virtual currencies like Bitcoin and Ethereum as commodities through the Commodity Exchange Act.

Cryptocurrencies do possess commodity attributes and also have characteristics of the foreign exchange market. The trading prices of commodities and foreign exchange markets are determined by supply and demand for the assets. Similar to commodities, the price of a commodity reflects the unit value of a raw material (gold, oil, etc.), having a one-to-one relationship; each cryptocurrency token also represents a unique value. Both commodities and tokens require paired trading, and there are currently cyclical patterns. Moreover, in times of high inflation, both commodities and cryptocurrencies are perceived by investors as a hedge against inflation. Currently, cryptocurrencies existing as commodities are also relatively loosely regulated. If cryptocurrencies are defined as securities, they would need to provide more transparent financial reports, so that their price fluctuations would truly reflect the value expected by investors.

Even so, cryptocurrencies cannot be strictly called "digital gold," although the price movements of cryptocurrencies and commodities occasionally resemble each other, they do not completely align. Some scholars (Lawuobahsumo et al., 2022) suggest that this correlation is likely an overflow effect of other market environmental factors.

So, as a currency, can "cryptocurrency" use FOREX logic?

After all, the core logic of cryptocurrencies from the beginning was theoretically to solve the lag of centralized currencies, making transactions faster, more convenient, and inflation-resistant. Later, various derivative "currencies" emerged, many of which do not possess the attributes of circulating currencies, resembling more of a "stock" of a company or project, similar to how fiat currency itself can be seen as a reflection of national sovereign value, although government bonds would be a better analogy.

However, some scholars (Liang et al., 2019) have found that the current cryptocurrency market is more similar to the stock market than to the FOREX market, aside from both being traded 24 hours a day. This is understandable, as the trading objects in FOREX are all national fiat currencies and derivatives thereof, and each fiat currency essentially serves as a liquid tool for trade in a specific country or region. In contrast, each cryptocurrency has different practical uses behind it.

Based on this, can we say that cryptocurrencies are more suitable for analysis using the logic of securities analysis, because we can visually observe the high correlation between cryptocurrencies and U.S. stocks? However, Isah and Raheem (2019) point out that the underlying logic of this correlation is the quantitative easing (QE) by the U.S. central bank, so the rise and fall of both the stock market and the cryptocurrency market stem from the tightening or loosening of the dollar.

Correlation between Bitcoin and U.S. stocks, source Seeking Alpha

At this point, I believe that while cryptocurrencies have some characteristics of commodities, foreign exchange, and U.S. stocks (note that it is U.S. stocks, not other stocks), they cannot be simply categorized into one group. If they must be classified, they have the highest correlation with the U.S. stock market and are deeply influenced by macro policies. When it is impossible to quantify the financial reports of cryptocurrency projects, they may not necessarily be analyzed using micro value investing, but rather more suitable for following macro operations. Therefore, value investing may not be effectively applied to the cryptocurrency market.

Asset Pricing in Crypto: If Not Value Investing, Then What?

Conducting value investing research in cryptocurrencies is very challenging. First, there is no mature quantitative system; currently, no expert has provided a calculative tool that can model it. Second, the data on cryptocurrencies is also concerning; unlike the financial reports in U.S. stocks, which generally cannot be falsified, people can trust the financial data provided by companies, and the rest of the non-reportable information can be traced. However, in cryptocurrencies, 6 million users may just be boasting, and the actual ARPU per user is known only to the company itself.

If there is no reliable hard data to measure the project, how can calculations and value investing be conducted?

Currently, some scholars have provided some hard indicators for asset pricing modeling for reference.

Hubrich (2017) applied the French-Fama model to cryptocurrencies, using only three factors. The scholar used market capitalization, trading volume, and market cap/trading volume as indicators to measure the overall market, and used the inflation "spillover" effect of each coin to measure the relationship between the factors (i.e., the conversion rate of each coin being mined, carry), etc. The final conclusion is that the performance of the project is primarily driven by the overall market, with some relationship (carry) from previous coins, while alpha is very small.

EY has also released reports indicating that models like CAPM can be used to estimate cryptocurrency portfolios, but they did not provide detailed guidance on how to do so.

I am very interested in this topic and welcome readers who enjoy modeling or are working on related topics to contact me. If we can develop some asset pricing systems for cryptocurrencies, whether in the style of value investing or French-Fama, it would be a great contribution.

Why should we adhere to value investing in cryptocurrencies?

Graham proposed value investing, but he himself is not considered the ultimate practitioner of value investing. Although his returns were not bad, he had too many other interests and hobbies; he even participated in drafting the Bretton Woods system and considered his contributions to monetary theory as his most significant achievement. In the following decades, as the U.S. stock market gradually matured, Buffett, who had a more singular focus on investing and making money, refined this theory to perfection.

In Graham's system, the net is core; that is, worthwhile stocks must be bought cheaply and in groups. If they rise, they rise significantly; if they fall, they don't fall much. Then, we can grasp two points of value investing: margin of safety + high value at low valuation. Based on this, although there are many excellent assets, Buffett may not invest in them because they are expensive. In 2020, Buffett repeatedly stated that he did not intend to invest because the projects in the market were too expensive. When everyone else had lost their shirts, the stock god began to buy up assets with his strong cash flow.

However, some may feel this is a bug; "cheap" is a relative term. $600 may be expensive compared to $100, but it is cheap relative to a valuation increase to $60,000. Value investing believes in absolute cheapness, not relative cheapness. When Buffett invested in Apple, his average cost was about $37, while today's Apple is already over $100.

Translating these principles to cryptocurrency "investing," I believe we can learn some insights. That is, do not chase the market's ups and downs aimlessly. Do not chase after prices when the market is high. Diversify by buying some stocks that can generate positive cash flow when the project is relatively small, and do not use leverage. Technical analysis may not be effective because you are not buying based on explosive technology logic. It is essential to see if there is positive cash flow, which is the challenge; specifically, one might look at gas/ARPU + whether the users represent a profitable business. If it falls, it won't fall much. When the market rises, it will naturally lift the value of the coins you hold. Buy a few coins during a bear market, but also keep enough cash. Avoid meme coins. Do not short-sell.

We do not know whether cryptocurrencies will mature like the stock market or will cease to exist one day. The above summary only supports friends who wish to adhere to the faith of value investing in cryptocurrencies, not just verbally, but practically following the core logic of value investing.

At the very least, Buffett has proven through his investment career that value investing is still a long-lasting tree. Although ARK reached a 152% return in 2020, and Tesla peaked at a 695% return, by 2022, ARK had retraced 65%. Berkshire Hathaway, with a mere 19% retracement due to stock declines in 2020, continued to shine in the following two years, sweeping the globe with about $48 billion in cash in 2020, and by 2022, Berkshire Hathaway's stock price reached new highs. This was the closest operation of the stock god to us; in fact, Buffett's operations have been the same every decade. The stock god repeatedly tells everyone to buy cheap, buy good companies, hold them after buying, and avoid chaotic operations. However, people feel that this method is too simple, simple enough that not trading reflects the complexity of finance and understanding of the market.

Reference https://mudrex.com/blog/what-is-value-investing-in-cryptocurrency/ https://www.holcombefinancial.com/decisions/warren-buffetts-simple-investing-principles/ https://www.motilaloswal.com/blog-details/similarities-and-differences-between-crypto-and-forex-online-trading/20126 https://thevineadvisors.com/resources/cryptocurrency-a-commodity-or-a-security-and-why-that-makes-all-the-difference/ https://virtuse.medium.com/8-surprising-similarities-between-commodities-and-cryptocurrencies-ba5c4a665b17 https://doi.org/10.3390/commodities1010004 https://www.researchgate.net/publication/332786433 https://ijbmcnet.com/images/Vol1No2/1.pdf https://deliverypdf.ssrn.com/delivery.php?ID=421000089122084068066090117086110031057007068045058024089023086126082020086087017010033060122005052003049114067019005091109082112008078077085086092021105066078119034020076099121076082123117125006005092112074068094088101102022016088105123095097094116\&EXT=pdf\&INDEX=TRUE https://www.bis.org/publ/arpdf/ar2018_5_zh.pdf https://www.jinse.com/blockchain/1043077.html https://www.weiyangx.com/249739.html https://assets.ey.com/content/dam/ey-sites/ey-com/en_gl/topics/emeia-financial-services/ey-the-valuation-of-crypto-assets.pdf https://cointelegraph.com/trading-for-beginners/the-most-common-crypto-metrics-a-beginners-guide