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

Author: Fu Zhuorui

Source: Rhythm BlockBeats

Do you remember the days when the bull market started in 2021? The most mentioned names, besides Cathie Wood, were Warren Buffett. Of course, Buffett was more often criticized in the cryptocurrency industry due to his pessimistic remarks. During the craziest times, people regarded ARK's Cathie Wood as a deity, while dismissing Buffett, believing he was out of touch with the times and unable to understand new things. At that time, even a child could mutter to themselves that Buffett was nothing special, especially considering the exaggerated volatility of altcoins.

How exaggerated was the market sentiment back then? A self-made "resignation letter from Buffett" by an internet celebrity was published by major mainstream tech media without verification. People were too eager 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 last thing players want to experience. What reflections can we draw from the stability of the stock god?

Comparison of returns between Buffett and Cathie Wood from January 2020 to May 2022, source Twitter @CharlieBilello

The Emergence of Value Investing

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

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 both 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, navigated 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 three years.

In this roaring 20s, Gatsby was infatuated with Daisy, while many ordinary people relied on the myth of the stock market to hope for a miraculous overnight fortune.

Graham

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

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. The fortunes of Irving Fisher and Graham shrank dramatically; although Graham's fund only lost 70% compared to the market's 74% loss, 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 tumultuous period of divorce and remarriage, and then reflected deeply on his experiences. While teaching at Columbia, he organized his value investing philosophy 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.

In some ways, the stock market of that time was somewhat similar to today's cryptocurrency market. So, can the value investing principles used for stock analysis also be applied to cryptocurrencies?

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

Graham's value investing was straightforward, and Buffett also adhered to the simplicity of the theory in practice, often performing calculations on the back of napkins (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 straightforward.

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

At that time, Graham's PE ratio 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 PE ratios 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 finding undervalued securities in the stock market. Commonly used indicators in modeling/calculation 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 that spans bull and bear markets. However, before the 2020 stock market crash, value investors were somewhat suppressed by funds that favored investing in emerging tech companies, yielding returns far below growth funds. One of the most notable funds at that time, Cathie Wood's ARK, and the rise of Tesla, which had the highest returns, operated on a logic that was vastly different from value investing. Many tech stocks in our era were not profitable before and after their IPOs, with PE ratios in the tens or even hundreds, but this did not prevent these companies and stocks from experiencing explosive growth. The core logic of ARK was to heavily invest in tech stocks with explosive growth. In an era of technological explosion, such funds indeed achieved extraordinary success in the short term. Companies with exponential growth were not within the margin of safety for value investing funds, so value investors might not even consider such companies.

Even in China, Zhang Lei of Hillhouse, who advocates for value investing and studied under David Swensen at Yale, has not completely 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 previously invested heavily in high-growth stocks like Bilibili and Pinduoduo that were not within the margin of safety and had negative earnings year after year. At the same time, Zhang Lei emphasizes the importance of thorough preliminary research, which is somewhat similar to the thinking of Li Lu, who insists on venture capital on the other side of the strait.

This feeling is reminiscent of the logic of investing in Amazon two decades 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 thin.

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

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

Buffett does not reject technology; he simply evaluates whether technology can meet his criteria. The Apple company, which Buffett invested in, is one of the classic investments. In 2021, Berkshire Hathaway invested in Brazil's FinTech disruptor, Nubank, which plans to launch its own cryptocurrency in 2023.

Buffett and his partner Munger have publicly scoffed at cryptocurrencies, believing that there is no real 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 operations of value investing still be applied to the analysis of cryptocurrency projects?

Defining Cryptocurrency is Difficult, and Value Investing is Difficult

First, defining 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 cryptocurrencies belong to is still unclear to regulators, investors, and users, or perhaps they should have their own asset class. In the eyes of regulators led by the Bank for International Settlements and various central banks, cryptocurrencies are referred to as "cryptoassets," so central banks do not recognize cryptocurrencies as a form of circulating currency. The risks associated with cryptocurrency transactions also indeed prevent them from meeting some of the most basic requirements of currency. This is reflected not only in the documents released by central banks but also in government definitions of cryptocurrencies. For example, in the documents where the SEC sued FTX, the SEC stated 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, in the U.S., virtual currencies like Bitcoin and Ethereum are classified as commodities under the Commodity Exchange Act.

Cryptocurrencies indeed 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.) and has a one-to-one relationship; each cryptocurrency token also represents a unique value. Both commodities and tokens require trading to be conducted in pairs, and there are also cyclical patterns. Moreover, in times of high inflation, both commodities and cryptocurrencies are perceived by investors as a hedge against inflation. Currently, cryptocurrencies classified 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 that investors expect.

Even so, cryptocurrencies cannot be strictly referred to as "digital gold," although the price movements of cryptocurrencies and commodities occasionally show similar trends, 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, since their inception, has been to solve the lag of centralized currencies, making transactions faster, more convenient, and resistant to inflation. Later, various derivative "currencies" appeared, many of which do not possess the attributes of circulating currencies and resemble "stocks" of a company or project. Just as fiat currency itself can be seen as a reflection of national sovereign value to some extent, government bonds would be a better analogy.

However, some scholars (Liang et al., 2019) found that the current cryptocurrency market is more similar to the stock market than to the FOREX market, apart 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 within 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, because we can visually see 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 monetary 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 exhibit 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 are most closely related to 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 be more suitable for following macro operations. Therefore, value investing may not be effectively applied in the cryptocurrency market.

Asset Pricing in Crypto: What to Do if Value Investing is Not Possible?

Conducting value investing research in cryptocurrencies is very difficult. First, there is no mature quantitative system; currently, no expert has provided a tool for modeling. Second, the data on cryptocurrencies is concerning; unlike 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 unreported information can also be traced. However, in cryptocurrencies, the claim of 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 projects, 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), concluding that the performance of projects is primarily driven by the overall market, with some relationship (carry) from previous coins, while the alpha is quite small.

EY has also released reports indicating that CAPM and other models can be used to estimate cryptocurrency portfolios, but no detailed guidance on how to use them has been provided.

I am very interested in this topic and welcome readers who enjoy modeling or are working on related projects 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 was not 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 greatest 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 do not fall much. Thus, we can grasp two key 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 too expensive. In 2020, Buffett repeatedly stated that he did not intend to invest because the projects in the market were too expensive. When everyone had lost their shirts, the stock god began to buy up assets with his strong cash flow.

However, people might think this is a bug; "cheap" is a relative term. $600 is very expensive compared to $100 but relatively cheap compared to a valuation of $60,000. Value investing believes in absolute cheapness, not relative cheapness. When Buffett invested in Apple, his average cost was about $37, while today Apple's stock is already above $100.

Translating these principles to cryptocurrency "investing," I believe we can learn some lessons. That is, do not chase the market's ups and downs aimlessly. Do not chase after prices when the market is high. Diversify and buy some stocks that are already generating positive cash flow when the projects are 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; perhaps we can look at gas/ARPU + whether 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 in hand. Buy a few coins in a bear market, but also keep enough cash. Avoid meme coins. Do not short.

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

At the very least, Buffett has proven through his investment career that value investing is still a timeless tree. Although ARK achieved a 152% return in 2020, and Tesla reached a peak return of 695%. By 2022, ARK had retraced 65%. Berkshire Hathaway, on the other hand, only experienced a 19% retracement due to stock declines in 2020, and continued to thrive in the following two years. In 2020, holding about $48 billion in cash, it swept the globe for bargains, and by 2022, Berkshire Hathaway's stock price reached a new high. This was the closest operation of the stock god to us; in fact, Buffett's operations have been consistent every decade. The stock god repeatedly tells everyone to buy cheap, buy good companies, and once bought, just hold. Do not engage in chaotic operations; people simply find this method too simple, too simple to reflect the complexity of finance and understanding of the market.