By: Daniyal Inamullah, CFA
Without the advantage of being part of a reputable VC or Angel group, or actively working on early-stage company investments, public market information offers retail investors with the best knowledge to invest in micro and small cap companies. Due to the asymmetric information and profit potential associated with any new industry, there will always be winners, losers, and fraud. Penny stock trading hacks show that this fraud can be depicted in the form of newsletters, sexy new ‘ICO deals’, fake advisors, and fake thought leaders.
In order to understand this risk, investors typically analyze the trading history of publicly traded stocks and form ratios (e.g., beta, volatility, etc.) to compare. Analysts can then split risk into various categories based on size, geography, industry, and so forth. These ratios are often compared against benchmarks such as the S&P 500 and the Russell 2000 to gauge the relative risk of each position. Also, in theory, high risk of a particular stock can be ‘diversified’ through the addition of uncorrelated stocks in the context of a portfolio.
Unfortunately, investors in cryptocurrency assets and companies lack a strong public market to assess these industry and operating risk factors; traditionally embedded in the trading prices of public stocks. Since the volatile end of 2017 to the beginning of 2018, investors have rushed into this asset class to share in the promises of finding the Treasure of Lima. Comments like “Ethereum and Bitcoin seem to be safe given the attraction of institutional money” or “I’m going to take a shotgun approach and see what sticks” create the guise of stable and rapid growth, both of which have not played out over the last year.
Rather than focus on the drivers of the market, the intent of this post is to analyze publicly traded companies to better understand risk. We analyzed 29 publicly traded blockchain-focused, early-stage companies (Exhibit A) that were primarily pre-revenue in the blockchain industry. The companies trade across various international exchanges, such as the TSXV, Nasdaq, and CNSX and on the pink sheets. We then calculated a market capitalization weighted index and observed the Crypto Currencies Index to compare traditional ratios against these two benchmarks.
It’s important to remember that these two indices represent different estimates of performance. The average market cap method measures the performance of the 29 selected companies. The CCI 30 index represents performance of cryptocurrency assets. While we would assume the indices to be highly correlated during sharp up and down movements, one area of focus was to see whether there was a decoupling effect between the two asset classes (like the relationship between gold and gold-mining companies) in performance after the recent drawdown of cryptocurrency asset values.
The first chart shows the risk-to-reward ratios (based on calculated weekly performance and volatility since the beginning of 2014) of the 29 companies and the indices. The indices also show greater risk-to-reward ratios, indicating potential benefits of diversification. A majority of the positions illustrate a weekly volatility range of 10 to 30 percent. This implies annual industry volatility of approximately 70% to 200%.
Chart 1 – Plot of Publicly Traded Companies
The second chart illustrates the growth of the market cap weighted index and CCI 30 index compared to the total IPO values (calculated as the market cap on the first trading week) over time. The area chart represents the gross invested capital of each position but ignores any fluctuations in the underlying stock. The indices (represented by the line charts) demonstrate the strong performance of cryptocurrency assets through the beginning of 2018, followed by a sharp fall.
The analysis reveals a few items. First, the trend of asset inflation likely contributed to almost $800 million of new IPO money flowing after the new year. Second, after calculating volatility ratios since the beginning of 2014 (or, since inception of other companies), the implied volatility figures were significantly greater than those calculated for general market indices such as the S&P 500 (Exhibit B, at the time of this post the VIX index was trading around 19).
In addition, we observed differences in risk associated with business strategy. For example, Hut 8 Mining Corp. represents a relatively recurring revenue-type business model. On the other hand, Blockchain Technologies, Inc. is an early stage R&D company focused on applications to IoT. As the industry matures, we expect additional differences and sub-industries to emerge. However, for the most part, it seemed that the two asset classes were fairly correlated over the last 1-2 years.
Chart 2 – New Blockchain Companies
Finally, we note the obvious shortcomings with the analysis, which include (i) the short trading histories, (ii) we ignore invested capital from large strategic companies such as IBM or Oracle, (iii) the private capital markets are substantially larger, and (iv) the initial focus for retail investors has been the currency rather than the underlying equity. Over time, we expect new innovations and industry maturity to allow valuation professionals and investors to increase reliance on traditional valuation tools.
Exhibit A – List of Companies
Data Accessed October 12, 2018
Exhibit B – Volatility
Data Accessed October 12, 2018
 CCI30, Source: https://cci30.com, Represents a barometer of cryptocurrency asset performance by analyzing the top 30 market cap cryptocurrency assets (index methodology is located on their website).
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