Pantera Capital's investment approach: How to assess the cryptocurrency market through fundamental analysis and macro environment?
Original authors: Cosmo Jiang, Erik Lowe
Original translation: Deep Tide TechFlow
In the past few months, there have been some positive developments in the regulatory environment for cryptocurrencies in the United States. We all know about the ruling by the Southern District of New York court on the three-year lawsuit between the Securities and Exchange Commission (SEC) and Ripple Labs, which determined that XRP is not a security. We call it the "positive" black swan event that few expected.
Cryptocurrencies have recently achieved unexpected victories. On August 29th, the U.S. Appeals Court ruled in favor of Grayscale in its lawsuit against the SEC, which was over the rejection of its spot Bitcoin ETF application last year. We believe this greatly increases the chances of spot Bitcoin ETF applications filed by companies like BlackRock, Fidelity, and others being approved.
While the United States may seem to lag behind many regions in accepting digital assets, many countries have taken measures similar to or even stricter than those regarding cryptocurrencies. However, the redeeming factor for the United States is its court system devoted to due process, ensuring there is a corrective path when crossing boundaries.
"The rejection of the Grayscale proposal was arbitrary and capricious because the Commission failed to explain its differing treatment of similar products. Therefore, we support Grayscale's petition and vacate the order."
- Court opinion submitted by Judge RAO
We have always emphasized the need for trustless systems. In our industry, this means users can rely on blockchain-based architectures to execute designs fairly. We are able to do the same thing with the U.S. court system, which helps shape a promising regulatory environment for the future of cryptocurrencies and promotes further innovation onshore.
We have long discussed the potential of spot Bitcoin ETFs, and now we see a glimmer of hope.
Maturity of the Cryptocurrency Industry Similar to Stocks
The maturity of the digital asset space may be similar to a turning point in the development of the stock market.
Tokens are a new form of capital that could replace equity stakes in entire generations of companies. This means many companies may never go public on the New York Stock Exchange but only possess tokens. This aligns the interests of the company with its management team, employees, token holders, and other unique stakeholders of digital assets such as customers.
Currently, there are around 300 liquid tokens traded publicly with a market value exceeding USD 100 million. As the industry expands, this investable range is expected to continuously grow. More protocols have product use cases, revenue models, and strong fundamentals. Applications like Lido or GMX didn't exist two or three years ago. In our view, selecting ideas from this vast range could be an important source of generating excess returns, as not all tokens are equal, just as not all stocks are equal in the stock market.
Pantera focuses on finding agreements with product market adaptability, strong management teams, and attractive and defensible unit economics paths, which we believe is a strategy that is widely overlooked. We believe we are at an inflection point in this asset class where traditional and more fundamental frameworks will be applied to digital asset investments.
In many ways, digital asset investing is similar to the significant inflection points that have evolved in the stock market over time. For example, value investing today is taken for granted, but it didn't become popular until the 1960s when Warren Buffett introduced his first hedge fund. He was an early adopter of applying the teachings of Benjamin Graham into practice, which propelled the development of the long-short equity hedge fund industry that we know today.
Cryptocurrency investing also resembles emerging market investing in the 2000s. It faces criticisms similar to the ones faced by the Chinese stock market back then, where many companies were small companies in an irrational stock market driven by retail investors. You don't know if management teams are misleading investors or misappropriating funds. While there is some truth to these concerns, there are also many high-quality companies with strong long-term growth prospects that present good investment opportunities. If you are an insightful, fundamentals-focused investor willing to take risks and put in the effort to find these good ideas, you can find incredible investment success.
Our main view is that the price of digital assets will increasingly be traded based on fundamentals. We believe that the rules applicable in traditional finance will also apply here. There are now many agreements with real revenue and product market adaptability that have attracted loyal customers. More and more investors now use a fundamental perspective and apply traditional valuation frameworks to price these assets.
Even data service providers are starting to resemble the traditional finance field. But they are not Bloomberg and M-Science, they are Etherscan, Dune, Token Terminal, and Artemis. Their purpose is essentially the same: to track key performance metrics, income statements, management team actions and changes, and more.
In our view, as the industry matures, the next trillion-dollar influx into this field will come from institutional asset allocators who embrace these fundamental valuation techniques. By investing using these frameworks today, we believe we are at the forefront of this long-term trend.
Fundamental Investing Process
The fundamental investment process for digital assets is similar to that of traditional equity assets. This may come as a pleasant surprise and also a critical misconception for traditional asset class investors.
The first step is conducting fundamental due diligence, answering the same questions as analyzing public stocks. Is the product market fit? What is the total addressable market (TAM)? How is the market structured? Who are the competitors, and what are their differentiations?
Next is business quality. Does this business have competitive barriers? Does it have pricing power? Who are their customers? Are they loyal, or will they leave quickly?
Unit economics and value capture are also very important. Although we are long-term investors, ultimately cash is crucial, and we want to invest in sustainable businesses that can ultimately return capital to their token holders. This requires sustainable unit economics and value capture.
The next layer of our due diligence process is researching the management team. We care about their background, track record, incentive alignment, and their strategies and product roadmap. What is their marketing plan? What strategic partnerships do they have, and what is their distribution strategy?
Compiling all this fundamental due diligence information is the first step for each investment opportunity. This will ultimately establish financial models and investment memos on our core holdings.
The second step is translating this information into asset selection and portfolio construction. For many of our holdings, we have multi-year three-statement models with capital structures and forecasts. The models we create and the memos we write are the core of our process-oriented investment framework, enabling us to have knowledge and insight to select investment opportunities and adjust position sizes based on event catalysts, risk/reward, and valuation.
After making investment decisions, the third step is ongoing monitoring of our investments. We have a systematic data collection and analysis process to track key performance indicators. For example, for the decentralized exchange Uniswap, in which we invest, we actively collect on-chain data in our data warehouse to monitor the trading volumes of Uniswap and its competitors.
In addition to monitoring these key performance indicators, we strive to have conversations with the management teams of these protocols. We believe that conducting on-site research calls with management teams, their customers, and different competitors is crucial. As a seasoned investor in this space, we also leverage Pantera's wider network and connections within the community. We see ourselves as partners and are dedicated to assisting management teams with reporting, capital allocation, or best practices in management to contribute to the growth of these protocols.
Fundamental Investment Practice: Arbitrum
One major criticism of Ethereum is that during periods of increased activity, trading on the base layer can become slow and expensive. While the roadmap for creating a scalable platform has been contentious, second-layer solutions like Arbitrum are emerging as viable alternatives.
The main value proposition of Arbitrum is straightforward: faster and cheaper transactions. It offers transaction speeds 40 times faster and costs 20 times lower compared to trading on Ethereum, while still being able to deploy the same applications and having the same level of security as trading on Ethereum. As a result, Arbitrum has found product-market fit and has shown strong growth both absolutely and relative to its peers.
For fundamental investors looking for evidence of growth driven by fundamental factors, Arbitrum ranks high on that list. It is one of the fastest-growing second-layer solutions on Ethereum and has captured significant market share in the past year.
In order to delve deeper into the last point, Arbitrum is one of the few chains that has shown an increase in trading volume during the entire bear market, while overall usage remains relatively weak. In fact, if you look at the data separately, you will find that Arbitrum has actually contributed 100% of the growth in the Ethereum ecosystem this year among Ethereum and all other Layer 2 solutions. Arbitrum holds a huge share within the Ethereum ecosystem, while Ethereum itself holds a huge share within the entire cryptocurrency space.
Arbitrum's network is in a virtuous cycle. Based on our on-the-ground research, developers are attracted to the growing usage and user base on Arbitrum. This is a positive virtuous cycle: more users mean more developers interested in creating new applications on Arbitrum, which in turn attracts more users. But as fundamental value investors, we must ask ourselves, is all of this important unless there is a way to monetize this activity?
Answering this question is why we believe this is a good fundamental investment opportunity - Arbitrum is a profitable protocol with several upcoming potential catalysts.
In this space, many ordinary investors may not be aware that there are protocols that can generate profits. Arbitrum generates revenue by charging transaction fees on its network, batching these transactions, and then paying the Ethereum base layer to publish these large-scale transactions. When a user spends 20 cents on a transaction, Arbitrum collects this fee. They then bundle these transactions into batches and publish them to the Ethereum first layer, paying a fee of about 10 cents per transaction. This simple math means that Arbitrum can make about 10 cents in gross profit per transaction.
We have found a protocol that has found product-market fit and has reasonable unit economics, which ultimately makes us believe its valuation is reliable.
Growth in Key Operational Metrics for Arbitrum
Here are some charts that illustrate some fundamentals.
Since its launch, the number of active users has been increasing continuously, with nearly 90 million transactions per quarter. Revenue in the second quarter was $23 million, with gross profit reaching nearly $5 million in the second quarter, annually amounting to $20 million. These are key performance indicators that we can track and verify on the blockchain every day to monitor whether Arbitrum aligns with our investment thesis and financial forecasts.
Currently, there are approximately 2.5 million monthly average users, with an average of 11 transactions per month per user, totaling approximately 350 million transactions per year. Based on this data, Arbitrum is almost a $100 million annual revenue business, generating about $50 million in standardized gross profit. Suddenly, this has become a very interesting business.
As for the catalyst and reasons for making it a timely investment, a key part of our research process is tracking the entire Ethereum technical roadmap. The next important step is an upgrade called EIP-4844, which will effectively reduce the transaction costs of roll-ups like Arbitrum. The main cost of Arbitrum, which is currently 10 cents per transaction, may be reduced by 90% to 1 cent per transaction. At that point, Arbitrum will have two options. They can pass these cost savings directly onto users, further accelerating adoption, or they can retain these cost savings as profits, or a combination of both. Either way, we anticipate this to be a significant catalyst for increasing the usage and profitability of Arbitrum.
In fundamental investing, valuation is an important part. Based on the issued shares, Arbitrum currently has a market cap of $5 billion. In our view, this is quite attractive compared to some layer-one and layer-two protocols with similar market caps but only a fraction of the usage, revenue, and profit.
To put this valuation in perspective of growth, we believe that within the next year, Arbitrum's transaction volume could grow to over 1 billion transactions annually, with a profit of 10 cents per transaction. This translates to approximately $100 million in earnings, which means a forward earnings valuation of about 50x at a $5 billion market cap. In absolute terms, this may seem expensive, but in our view, it is reasonable for an asset that is still growing at triple-digit rates. Compared to valuations of real-world companies, if you look at popular software companies like Shopify, ServiceNow, or CrowdStrike, their revenue growth rates are in the double digits and their average trading multiples are around 50x, while their growth rates are much slower than Arbitrum.
Arbitrum is a protocol with market adaptability, growing rapidly (both in absolute and relative terms to the industry), clearly profitable, and reasonably valued compared to its own growth, other assets in the cryptocurrency space, and other assets in traditional finance. We continue to closely monitor these fundamentals, hoping for validation of our arguments.
Macro Catalysts
There are several macro catalysts on the horizon that could have significant impacts on the digital asset market.
Although institutional investment interest has cooled off in the past year, we are keeping an eye on upcoming events that could generate new interest among investors. The most significant one is the potential approval of a Bitcoin ETF for spot trading. Specifically, BlackRock's application is an important event for two reasons. First, as the world's largest asset management company, BlackRock undergoes rigorous scrutiny and only makes decisions after careful consideration. Even in the regulatory haze and current market environment, BlackRock has chosen to increase its investment in the digital asset industry. We believe this sends a signal to investors that cryptocurrencies are a legitimate asset class with a lasting future. Second, we believe that ETFs will increase exposure to and demand for this asset class faster than most people anticipate. Recent news is that the U.S. appeals court supported Grayscale in its lawsuit against the SEC's rejection of its Bitcoin spot ETF application last year. We believe this significantly increases the chances of spot Bitcoin ETF applications by companies like BlackRock, Fidelity, and others being approved, possibly as early as mid-October.
While the regulatory landscape is starting to become clearer, it still remains a significant factor hindering market development, especially for longer-tail tokens. To some extent, the courts are beginning to push back against the SEC's "enforcement-centric" approach, which seems to be a counter to the SEC's actions. In addition to the news of Grayscale's Bitcoin spot ETF, the court's support of Ripple in its case against the SEC is positive for the interpretation that digital assets should not be considered securities. This is an important event as it indicates that regulatory oversight of digital assets can and should be more nuanced. Regulatory clarity is important for consumer protection and for entrepreneurs who need appropriate frameworks and guidance to have confidence in creating new applications and unleashing innovation.
Lastly, cryptocurrencies are at what we call the "dial-up to broadband" moment. We have mentioned in previous communications that cryptocurrencies are at a stage similar to the internet 20 years ago. Ethereum scaling solutions like Arbitrum or Optimism are making significant progress, and we see transaction speeds increasing, costs decreasing, and the accompanying capability enhancement. Similar to how we couldn't envision how many new internet companies would be created after the internet transitioned from dial-up to broadband speeds, we believe the same will happen with cryptocurrencies. In our view, we have yet to see the widespread application of new use cases brought about by this significant improvement in blockchain infrastructure and speed.
