Value investing has produced some of the wealthiest investors in the world, including Warren Buffett, Sir John Templeton, and many others. While these investors didn’t make money in cryptocurrencies, their teachings and thought processes apply to various assets – including crypto tokens and assets.
In this article, we’ll look at how value investing principles apply to crypto assets, how to read a whitepaper, what drives a token’s value, and why diversification is essential to maximize your risk-adjusted returns.
Value Investing Lessons
Benjamin Graham introduced the world to value investing in his seminal book, The Intelligent Investor. Rather than jumping on trends or speculating on price, value investing focuses on measuring intrinsic value, investing in undervalued opportunities, and minimizing risk.
For example, a value investor might use discounted cash flow analysis to determine the net present value of a company’s future earnings. Or they might look at a company’s book value (the value of its assets) relative to its stock price.
At the same time, value investors tend to focus more on minimizing risk than maximizing returns. As Howard Marks points out in his book, The Most Important Thing, “Too little risk can make you underperform in a bull market, but no one ever went bust from that.”
Most cryptocurrencies don’t generate cash flow, but you can apply value investing principles by researching tokens and minimizing risk. For example, a token with a clear use case and compelling economics is much safer than a meme coin with an unlimited supply.
How to Read a Whitepaper
Cryptocurrency whitepapers are essential to the due diligence process. Like a prospectus or annual report, these documents explain a project’s goals, tokenomics, products, features, and information about the team, enabling investors to make a more informed decision.
For example, the Ethereum Whitepaper explained the then-current state of cryptocurrencies and how Ethereum planned to introduce new capabilities through smart contracts. In addition to explaining ether’s tokenomics, the paper even discussed some potential concerns.
Some key elements to look for include:
- Team – Warren Buffett has long advocated investing in people rather than companies. When reading a whitepaper, consider the team’s experience in the area they’re targeting (e.g., cross-border payments or cloud storage) and their technical expertise (e.g., past projects or educational background).
- Use Cases – Value investors often seek established companies with defensible brands and pricing power. Unfortunately, most crypto projects are pre-revenue or in the startup phase. So, when reading a whitepaper, you should carefully assess the project’s use cases, existing alternatives, and whether it meets a real market need or pain point.
- Tokenomics – Traditional stocks and bonds involve ownership or interest payments, whereas crypto assets involve a broader range of investment types. For example, some tokens are a medium of exchange for their ecosystem, and others represent an interest in the revenue generated from the ecosystem.
- Roadmap – Many public companies lay out their goals for the coming quarter or year in their SEC filings. Similarly, many crypto projects outline a roadmap for the future in their whitepaper. These timelines can help inform everything from when an initial coin offering (ICO) will occur to when to expect customer adoption.
Like SEC filings, crypto whitepapers can be lengthy and technical. But, as any value investor will tell you, skimping on due diligence is a recipe for disaster. Understanding what you’re buying is essential to know if you’re getting a bargain.
What Drives a Token’s Value?
The value of a stock depends on the underlying company’s revenue, earnings, and valuation, as well as the supply and demand of its shares. Meanwhile, the value of a bond depends on interest rates and the issuer’s likeliness to make on-time payments.
Likewise, a crypto token’s value depends on its unique factors. While supply and demand influence the current price, the long-term value depends on supply economics (e.g., mining and supply limits), competition from other tokens, and the utility (or value) for users.
Some key things to look for include:
- Utility – The overall usefulness of a project primarily drives a utility token’s value to customers. If the platform remains useful, customers will purchase utility tokens to use the platform. For example, Ethereum’s usefulness leads to buying ether for transaction fees and computational services.
- Staking Yields – Staking crypto tokens enables holders to generate a yield. Different tokens offer different staking yields that change over time, depending on supply and demand. Value investors might look at these yields (and the potential income) when determining how much they’re willing to pay for a crypto token.
- Risk & Volatility – Crypto prices are notoriously volatile compared to stock or bond prices. While the potential for absolute returns may be high, the risk-adjusted return might be substantially lower when factoring in volatility. As mentioned earlier, limiting risk is one of the best ways to increase long-term performance.
- Competition – A crypto project may have a compelling use case, but if there’s a lot of competition, there may be limited upside potential. Generally, a more significant number of competitors translates to an increase in potential supply options, pushing down the price of the product or service for the final customer.
Of course, this isn’t a comprehensive list of factors influencing the value of crypto tokens. An accurate measurement depends on the characteristics of each project, the target markets, and other technical factors driving token supply and demand.
Building a Diverse Portfolio
Modern portfolio theory shows that investors can achieve the best performance by choosing an optimal mix of high- and low-risk investments based on risk tolerance. The financial community calls this diversification.
The expected return of a portfolio is equal to the weighted sum of each asset, while risk is a function of the variances of each asset and the correlations of each pair of assets. While these computations are beyond the scope of this article, the takeaway is that a portfolio of multiple crypto assets (ideally with a low correlation) produces superior risk-adjusted returns.
A popular way to diversify is by investing in multiple token types, including payment, security, utility, governance, gaming, and non-fungible tokens (NFTs). In addition, you can invest in different target markets ranging from decentralized finance (DeFi) to supply chain management to gaming assets.
And finally, you may want to consider including crypto as just one part of your overall investment portfolio. Holding stocks, bonds, real estate, and other assets can mitigate crypto-specific risk factors, such as potential regulatory actions impacting the entire industry.
The Bottom Line
Value investing may not be the first thing that comes to mind in the crypto space, but a handful of value investing principles can help long-term crypto investors. In particular, value-focused crypto investors should carefully read whitepapers and understand the factors influencing a token’s valuation while building a properly diversified portfolio.
If you invest in crypto assets, ZenLedger can help you aggregate transactions across multiple wallets and exchanges, compute your capital gain or loss, and generate the paperwork you must file each year. In addition, you can access tax-loss harvesting, portfolio management, and other tools to help you better understand your holdings and optimize your taxes.
This material has been prepared for informational purposes only and should not be interpreted as professional advice. Please seek independent legal, financial, tax, or other advice specific to your particular situation.