Hello readers,
Last week we shared a data-driven market update. The TL: DR is that we think crypto will continue to be adopted in cycles. We aren’t in some secular decline or experiencing a permanent loss of interest in public blockchains. SBF didn’t break crypto. Bitcoin, Ethereum, and the ecosystem at large are still working just fine. Meanwhile, things can certainly change, but the data is pointing to valuations currently bottoming out for this cycle.
As such, now is the time to be putting in some serious work to identify crypto assets that could be severely undervalued, yet have staying power. We are currently in the first crypto bear market where we have real use cases. Projects with real daily active users. Cash flows. Product/market fit. You know, things that point to real value creation.
On the flip side, it’s also true that many projects are still grossly overvalued. But thanks to emerging data providers such as Token Terminal, we now have some tools to separate the wheat from the chaff. Some projects could rise by orders of magnitude when liquidity returns to these markets. People’s lives will be changed. As Warren Buffet likes to say: “I like to buy great assets at great prices, and hold them for a long time.” This week’s report is a guide to an approach we’re working on to identify, screen, and assess distressed crypto assets.
Disclaimer: Views expressed are the personal views of the author and should not be taken as investment advice. The author is not an investment advisor.
The DeFi Report is an exploration of the web3 tech stack and an ongoing analysis of where the most value could accrue. We provide easy-to-follow mental models, frameworks, and data-driven analysis for DeFi and web3 business models.
Let’s go.
As mentioned, if you haven’t done so, we recommend checking out the data from last week to get a sense of why we think valuations are currently finding a trough in this cycle. To follow on, I want to add a few quick notes:
Trading volume has dried up considerably — down about 33% year over year for BTC and 52% for ETH depending on the day. This will likely lead to some chop moving forward. The big spike we see below is correlated to the FTX crisis.
For the year, BTC is averaging $31b of volume per day. This is down from $46b/day last year, yet still orders of magnitude higher (10x) than the last bear market in 2018. If you’re curious, the compound annual growth rate of volume traded per day since 2013 is 99.8%. And despite the roller coaster volatility, the CAGR for Bitcoin’s price over the same time period is 65%.
We’d like to know who is selling crypto right now. Anyone who wanted to sell over the last few months likely already has done so. If you are holding crypto, and you didn’t sell, what would make you sell now? Probably price going up - which is the opposite of what most people foresee. A lot of folks are calling for BTC to drop to $14k or $10k. But what’s the trigger for more selling? We don’t see it in the market right now. Of course, this could change overnight, but it would likely take another black swan such as Binance or Tether going down. Meanwhile, the bankruptcy proceedings for the fallen giants are unlikely to cause any forced selling in the near term — we can look to Mt. Gox in 2014 as a guide. As such, we think the only sellers in the market right now are miners (who have to sell to cover opex cost) and investors looking to trim holdings for tax harvesting.
Who’s buying? Given that we are starting to exhaust the number of sellers out there, it’s possible we are nearing the point where there are more buyers than sellers in the market. Who are these folks? Smart investors look for opportunities in crisis. Considering the turmoil over the last 12 months, $17k BTC and $1.2k ETH could be viewed as signs of strength and an opportunity to enter the market. These are the macro hedge funds, family offices/other HNWI, and convicted long-term retail investors. Larger institutional asset managers are unlikely to be buyers just yet due to career risk. As such, they are more likely to sit on the sidelines until the market starts to move — FOMO’ing in later along with their peers as the game theory and career risk flip to the other side.
Now is the time to roll up our sleeves. To find the signal in a sea of noise. If the crypto markets were efficient, there wouldn’t be any opportunities out there. It’s time to find them.
Our focus is on projects that have cash flows. We don’t care about cool ideas or some new project that tweaks an existing idea with new features. We just want to see users and cash flows. Especially in the bear market. This is signal. Features and flashy ideas are mostly noise in this space.
Next, we want to look at the current market values. We could start by identifying projects with 365-day cash flows exceeding their current market values. We then bucket these projects as the initial screening process. Here is a quick example of a few that would pass stage 1:
*Please do not take the above data as investment advice.* This is simply the first step in the analysis — and the multiples are just to get a sense of where things could go. With that said, there are many crypto assets in the public markets that have users + cash flows and are trading at lower valuations than projects raising capital in private rounds, prior to launching a product. We think this could be a rare opportunity.
We are focusing on *total* revenues for these projects (as opposed to protocol revenue). Each one has a different business model, but we need to level set here with the idea that crypto networks and protocols function quite differently from traditional companies. For example, these projects don’t have ongoing “revenue costs.” There are basically no operating costs or variable costs per unit of revenue directly related to the network or protocol. Why? Because the thing that generates the revenue is simply open-source computer code. Once the smart contracts are coded, audited, and deployed, they run autonomously 24/7 365. This brings in market participants who leverage these smart contracts while supplying and consuming services. The supply side folks take on the incremental “operating or variable costs.” For example, Maple Finance earns revenue as a DeFi lending platform for institutions. But they don’t execute the underwriting or provide the loans. A distributed set of service providers handles this. The protocol takes .66% of loan originations. The loan originators (again, they don’t work directly for Maple) also earn a small fee. Interest is paid by borrowers to a distributed set of lenders — who rely on the loan originators to underwrite the borrowers. Each loan is a separate pool of borrowers and lenders.
So, the devs for Maple Finance created a platform that aggregates loans on behalf of large borrowers and has the potential to scale without the platform hiring lenders, underwriters, etc. Under this model, one could imagine a high-performing underwriter or risk assessor at a company such as JP Morgan or Goldman Sachs leveraging their expertise and relationships to run a lending pool on the Maple platform. This is just one example of the new business models we see in DeFi. A central theme we’ve observed is that they offer scaling potential with significantly less friction and overhead. Maple’s only expense is the core team. VCs cover this in the early years. Meanwhile, the revenues for DeFi projects are often split between the protocol (managed by the DAO) and the distributed set of service providers. We are focusing on *total* revenue because we want to assess total value creation at this stage of the game. A project (via DAO voting) can always vote to route a % of the revenues back to the protocol treasury or to token holders as dividend payments later — when the timing is appropriate.
When we project what a token price could look like at future revenue multiples, we are using the fully diluted token supply. Many projects are early stage and have less than 50% of their tokens issued into the market. Therefore, to compare projects on a relative basis, we need to look at the fully diluted token value at the projected revenue multiples.
Once we’ve identified projects that have cash flows exceeding their market value, we move into the second phase of our analysis. This is where we lift up the hood and do the real dirty work. We’ve identified a number of data points that are often more qualitative in nature. We assess each data point on a scale of 1 (high risk) to 5 (less risk). In no particular order of importance:
The Core Team: The first rule is the core team cannot be anonymous. We want to see people that own their work and are accountable for it. We also want to see some sort of track record — whether in web2 or web3. If the founders are young, we will want to see them in interviews. We want to read their writing. We want to understand their thesis. Basically, we are looking for quality people that are playing long-term games.
The Backers: Who seeded the project? What is their reputation? Are they playing long-term games? What % of the tokens did they get? What are their lock-up periods? Do they have other investments in the space? Are they working alongside the core team, providing resources and helping as needed? Again, we are looking for quality people playing long-term games. Messari is a good source for the VCs backing web3 projects. You can also check a project’s governance docs.
Product/Market Fit & Business Model: What is the business model and why is it better? What is the product? What blockchains is it deployed on? Who is using it and why? Are there other services integrated with it that complement the project? Are the economic incentives of the supply side of the market sound? For example, Bitcoin miners need to be incentivized to secure the network in the long run. Liquidity providers on Uniswap or any DEX need to be incentivized to use that protocol and continue providing services. Loan underwriters on Maple Finance need to be compensated and incentivized to continue underwriting loans, which means there needs to be demand for loans.
Competition: Has the project been forked/copied? This is usually a positive sign of value, however the original needs to be able to maintain a network effect. For example, Uniswap has been forked over and over and over, yet it continues to maintain a 70% market share of the trading volume on decentralized exchanges.
Addressable Market: is the addressable market large enough to support significantly higher valuations? Who are the users and what is the user growth? Comparing to traditional finance counterparts as a starting point can be helpful.
Tokenomics: How many coins are in the market? What is the total supply? What is the breakdown of tokens to insiders vs the public? What are the lock-up periods for the insiders? Does the native token have utility outside of governance voting? How does value accrue back to the token — for example, does the network buy back or burn the token based on usage? Can you stake the asset to provide a service and earn a yield? Can you vote to re-direct a portion of protocol revenues back to the treasury or to token holders when the time is right?
Security Audits: Have the smart contracts been audited? By who? What type of audit was conducted? Are there unresolved issues? Do they have a white hat bounty program to incentivize outsiders to battle-test the code?
Crypto Presence: Does the project have a strong community? Are people talking about it on Twitter? Does the founder have a large Twitter following? Is there an active Discord server? What are people talking about in there? These things matter.
Governance/Community: How strong is the community? It sounds silly, but if there is a religious type of fervor, it could be a good sign. Are lots of people evangelizing and defending the network? We should also ask if the DAO making good or bad decisions. For example, a community demanding dividend payments to token holders a few years into the project would be a really bad sign. This is a sign of an immature community that is not seeing the big picture. A community deferring dividend payments and instead paying out 100% of revenues to their service providers or returning a small % back to the protocol to reinvest in growth is a good sign. We want to see communities playing long-term games.
Treasury Management: How much runway do they have? Are they going to make it through the bear market? We want to see at least a few years of runway. We also like to see some diversification — which is tricky because the community will not like to see the native token sold for another token like USDC. However, diversifying the treasury away from 100% of the native token can reduce risk and extend a project’s runway.
Narratives: Narratives just flat-out matter. Most of the conversation is happening on Twitter, Discord servers, YouTube, newsletters, etc. Reflexivity is a powerful force in crypto. We should ask ourselves if the project is aligned with emerging narratives in the market. For example, DeFi projects have a strong narrative right now as many of the “blue chips” have been repeatedly battle-tested over the last year. Meanwhile, CeFi has basically blown up — so where are crypto native market makers, traders, and borrowers going to go to access liquidity in the next cycle? This could create considerable demand for platforms such as Aave, Compound, Maker, Maple, etc. Meanwhile, DeFi valuations have been beaten down over the last year, yet many have product/market fit and cash flows. Watch for narratives like this. Gaming is another one to watch out for. This can become a self-reinforcing feedback loop once price action collides with the narrative.
Trading Volume/Liquidity: How much trading volume does the token get per day? What exchanges is it listed on? We typically weed out anything that is not listed on the majors: Coinbase, Gemini, Kraken, or Binance. Keep in mind that many of the smaller cap tokens have low trading volumes. This is ok if you are a buyer during the depth of the bear market, and a seller during the bull phase. However, if you are trying to access liquidity during a market sell-off you could get stuck holding an illiquid token. “Holding the bag” as they say. Your trading volume threshold should align with the amount of the token you hold and your risk tolerance.
You may be wondering how you can get access to all of this data. Herein lies the challenge. It’s not easy to get the data. You have to do some dirty work. Warren Buffett made a name for himself by manually sourcing and combing through mountains of data when he was getting started. There was no internet back then. No yahoo finance. No EDGAR database. This creates information asymmetry. Which creates opportunities.
The only way these markets become more efficient is with better data, professional analysis, and new valuation frameworks and standards suitable for the new business models. In the interim, the arbitrage is simply to do the work — and wait for the market to catch on later.
Thanks for reading.
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Individuals have unique circumstances, goals, and risk tolerances, so you should consult a certified investment professional and/or do your own diligence before making investment decisions. The author is not an investment professional and may hold positions in the assets covered. Certified professionals can provide individualized investment advice tailored to your unique situation. This research report is for general educational purposes only, is not individualized, and as such should not be construed as investment advice.