How to evaluate the crypto market through fundamentals and macro environment?

Original author: Cosmo Jiang, Erik Lowe Original compilation: Shenchao TechFlow

Over the past few months, there have been some positive developments in the cryptocurrency regulatory environment in the United States. We are all aware of the U.S. District Court for the Southern District of New York’s decision in the three-year lawsuit between the Securities and Exchange Commission (SEC) and Ripple Labs, ruling that XRP is not a security. Let’s call it a “positive” black swan event that few expected.

Cryptocurrencies have had another unexpected win recently. On August 29, the U.S. Court of Appeals ruled in favor of Grayscale in Grayscale’s lawsuit against the SEC over its spot Bitcoin ETF application that was rejected last year. We believe this significantly increases the chances that spot Bitcoin ETF applications like those proposed by BlackRock, Fidelity and others will be approved.

While the U.S. appears to be lagging behind much of the world in accepting digital assets, many countries have adopted the same or even more stringent measures regarding cryptocurrencies. But America’s saving grace is that it has a court system committed to procedural due process, ensuring there is a path to correction when lines are crossed.

"The rejection of Grayscale's proposal was arbitrary and capricious because the Commission failed to explain its disparate treatment of similar products. Therefore, we support Grayscale's petition and rescind the order."

——Court opinion submitted by RAO circuit judge

We have always emphasized the need for trustless systems. In our industry, this means users can rely on blockchain-based architectures to execute designs impartially. Our ability to rely on the U.S. court system to do the same helps shape a promising regulatory environment for cryptocurrencies in the future, fostering more innovation onshore.

We've long discussed the potential of a spot Bitcoin ETF, and now we're seeing a glimmer of hope.

Crypto industry has similar maturity to stocks

The maturity of the digital asset space may be similar to an inflection point in the development of the stock market.

Tokens are a new form of capital, and they have the potential to replace equity in an entire generation of businesses. This means that many companies may never list on the New York Stock Exchange and will only have tokens. This is the alignment of interests between the business and its management team, employees, token holders, and potentially other stakeholders unique to digital assets, such as customers.

There are currently approximately 300 publicly traded liquid tokens with a market capitalization of over $100 million. This investable universe is expected to grow as the industry expands. An increasing number of protocols have product use cases, revenue models, and strong fundamentals. Apps like Lido or GMX didn't exist two or three years ago. In our view, sifting through ideas from this vast universe could be an important source of excess returns, because just like in the stock market, not all stocks are created equal, and the same goes for tokens.

Pantera focuses on finding protocols with product market fit, strong management teams and paths to attractive and defensible unit economics and believes this is a generally overlooked strategy. 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 major inflection points in the development of stock markets over time. For example, fundamental value investing is taken for granted today, but it didn't become popular until the 1960s, when Warren Buffett launched his first hedge fund. He was an early pioneer in applying the lessons of Benjamin Graham into practice, which fueled the development of the long-short equity hedge fund industry as we know it today.

Cryptocurrency investing is also similar to emerging market investing in the 2000s. It faced criticism similar to that of the Chinese stock market at the time, which was that many companies were small companies in an irrational stock market driven by retail investors. You don't know if the management team is misleading investors or misappropriating funds. While there is some truth to this, there are also many high-quality companies with strong long-term growth prospects that represent great investment opportunities. If you are a discerning, fundamentals-focused investor who is willing to take risks and put in the effort to find these great ideas, you can find incredible investing success.

Our main point is that digital asset prices will increasingly trade based on fundamentals. We believe the same rules that apply in traditional finance will apply here. There are now many protocols with real revenue and product market fit that attract loyal customers. An increasing number of investors are now applying traditional valuation frameworks to pricing these assets using a fundamental lens.

Even data service providers are starting to resemble the traditional financial world. But they are not Bloomberg and M-Science, but Etherscan, Dune, Token Terminal and Artemis. Their purpose is virtually the same: to track a company's key performance indicators, income statement, management team actions and changes, etc.

In our view, as the industry matures, the next trillion dollars entering this space will come from institutional asset allocators who are trained in these basic valuation techniques. By investing today using these frameworks, we believe we are at the forefront of this long-term trend.

Fundamentals-Based Investing Process

The investment process of digital assets based on fundamentals is similar to the investment process of traditional stock assets. This may be a pleasant surprise for investors in traditional asset classes, and a key misconception.

The first step is to conduct fundamental due diligence, answering the same questions you would when analyzing a public stock. Is the product market fit? What is the total addressable market (TAM)? What is the market structure? Who are the competitors and what differentiates them?

Next is the quality of business. Are there any barriers to competition in this business? Does it have pricing power? Who are their customers? Are they loyal, or do they move on quickly?

Unit economics and value capture are also very important. Although we are long-term investors, ultimately cash is critical and we want to invest in sustainable businesses that can ultimately return capital to their token holders. This requires sustainable profitable unit economics and value capture.

The next level in our due diligence process is to research the management team. We care about the management team’s background, track record, incentive alignment, and their strategy and product roadmap. What is their marketing plan? What strategic partners do they have, and what is their distribution strategy?

Compiling all this fundamental due diligence information is the first step in every investable opportunity. This culminates in building financial models and investment memoranda on our core holdings.

The second step is to translate this information into asset selection and portfolio construction. For many of our positions, we have a multi-year three-table model with capital structure and forecasts. The models we create and the memos we write are at the core of our process-oriented investing framework, which gives us the knowledge and foresight to select investment opportunities and size positions based on event path catalysts, risk/return and valuation.

After making an investment decision, the third step is to continuously monitor our investments. We have a systematic data collection and analysis process for tracking key performance indicators. For example, for Uniswap, the decentralized exchange we invest in, we actively collect on-chain data in our data warehouse to monitor the trading volume of Uniswap and its competitors.

In addition to monitoring these key performance indicators, we strive to maintain a dialogue with the management teams of these agreements. We believe it is important to conduct on-the-ground research calls with management teams, their customers, and various competitors. As an established investor in this space, we are also able to leverage Pantera's broader network and connections with the community. We see ourselves as a partner and are committed to contributing to the growth of these protocols by assisting management teams with areas such as reporting, capital allocation or management best practices.

Fundamentals-Based Investment Practice: Arbitrum

A major criticism of Ethereum is that during periods of increased activity, conducting transactions on the base layer can become slow and expensive. While the roadmap for creating a scalable platform has been controversial, second-layer solutions like Arbitrum are becoming viable solutions.

Arbitrum’s main value proposition is simple: faster, cheaper transactions. It is 40 times faster and 20 times cheaper than trading on Ethereum, while being able to deploy the same applications and have the same security as trading on Ethereum. As a result, Arbitrum has found product market fit and is growing strongly on an absolute basis and relative to its peers.

For fundamental investors looking for evidence of growth with fundamental traction, Arbitrum would rank higher on this list. It is one of the fastest growing second layer solutions on Ethereum and has captured a significant share of the exchange market over the past year.

To delve deeper into the last point, Arbitrum was one of the few chains to show volume growth throughout the bear market, while overall usage was relatively weak. In fact, if you look at the data separately, you'll find that within Ethereum and all its other second-layer solutions, Arbitrum has actually contributed to 100% of the growth in the Ethereum ecosystem this year. Arbitrum has a huge presence within the Ethereum ecosystem, and Ethereum itself has a huge presence in the overall cryptocurrency space.

Arbitrum’s network is on a virtuous cycle. Based on our field research, developers are attracted to the growing usage and user base on Arbitrum. This is a positive network virtuous cycle: more users means more developers are interested in creating new applications on Arbitrum, which in turn attracts more users. But as fundamental value investors, we have to ask ourselves, does all this matter unless there is a way to monetize this activity, right?

Answering this question is why we think this is a good fundamental investment opportunity - Arbitrum is a profitable protocol with multiple upcoming potential catalysts.

In this space, many ordinary investors may not be aware that there are actually some protocols that can generate profits. Arbitrum generates revenue by charging transaction fees on its network, batching those transactions, and then paying the Ethereum base layer to issue these massive transactions. When a user spends 20 cents on a transaction, Arbitrum charges this fee. They then bundle these transactions into large batches and publish these transactions to the first layer of Ethereum, paying a fee of approximately 10 cents per transaction. This simple math means Arbitrum makes about 10 cents in gross profit per trade.

We have found a protocol that has found product market fit and has reasonable unit economics, which ultimately leads us to believe its valuation is solid.

Arbitrum’s growth in key operating metrics

Here are some charts that illustrate some fundamentals.

Since its launch, the number of active users has grown continuously, with nearly 90 million transactions per quarter. Second quarter revenue was $23 million and gross profit reached nearly $5 million in the second quarter, annualized to $20 million. These are key performance indicators that we can track and verify on the blockchain on a daily basis to monitor whether Arbitrum is meeting our investment thesis and financial projections.

Currently, the average monthly users are approximately 2.5 million, each person conducts an average of 11 transactions per month, and the number of annual transactions is approximately 350 million. Based on these numbers, Arbitrum is almost a $100 million revenue business, generating normalized gross profit of about $50 million. All of a sudden, this became a very interesting business.

As for the catalysts and what makes it a timely investment, a key part of our research process is tracking the entire Ethereum technology roadmap. The next important step is an upgrade called EIP-4844, which will effectively reduce transaction costs for roll-ups like Arbitrum. Arbitrum's main cost, 10 cents per transaction, could be reduced by 90% to 1 cent per transaction. At that point, Arbitrum will have two options. They can pass these cost savings directly to users, further accelerating adoption, or they can retain these cost savings as profits, or a combination of both. Either way, we foresee this will be a significant catalyst for increased Arbitrum usage and profitability.

In basic investing, focusing on valuation is an important part. Arbitrum's current market capitalization is $5 billion, based on shares outstanding. In our view, this is quite attractive relative to a number of other layer 1 and layer 2 protocols that have similar market caps but only a fraction of the usage, revenue and profits.

To put this valuation into the context of growth, we believe that within the next year, Arbitrum's transaction volume could grow to over 1 billion transactions per year, with profits of 10 cents per transaction. This represents earnings of approximately $100 million, which implies a valuation of approximately 50x forward earnings at a market cap of $5 billion. That looks expensive in absolute terms, but in our view it's reasonable for an asset that's still growing at triple digits. Compared to real-world business valuations, if you look at popular software companies like Shopify, ServiceNow, or CrowdStrike, their revenue growth rates are in the double digits, their average trading multiples are around 50x, and they The growth rate is much slower than that of Arbitrum.

Arbitrum is a protocol with product market fit, growing very quickly (both in absolute terms and relative to the industry), clearly profitable, and relative to its own growth, other assets in cryptocurrency, and other assets in traditional finance, Its valuation is reasonable. We continue to track these fundamentals closely in the hope that our thesis will bear out.

Background Catalyst

There are several major background catalysts on the horizon that could have a significant impact on the digital asset market.

While institutional investment interest has subsided over the past year, we are keeping an eye on upcoming events that could spark renewed interest among investors. On top of that is the potential approval of a spot Bitcoin ETF. In particular, BlackRock's filing is an important event for two reasons. First, as the world's largest asset manager, BlackRock is subject to intense scrutiny and only makes decisions after careful consideration. Even amid regulatory fog and the current market environment, BlackRock has chosen to continue 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 durable future. Second, we believe ETFs will increase exposure to and demand for this asset class faster than most expect. The latest news is that the U.S. Court of Appeals sided with Grayscale in its lawsuit against the SEC for rejecting its spot Bitcoin ETF application last year. We believe this greatly increases the chances of spot Bitcoin ETF applications from companies like BlackRock, Fidelity and others being approved, possibly as early as mid-October.

Although the regulatory environment is starting to become clearer, it may still be the biggest factor holding back the market, especially for the prices of longer-tail tokens. To some extent, the courts have begun to fight against the SEC's "enforcement supervision" actions, which seems to be a fight back against the SEC. In addition to the news about the Grayscale Spot Bitcoin ETF, the court sided with Ripple in its case against the SEC, interpreting the digital asset not as a security in a positive light. This is an important event because it shows that the regulation of digital assets can and should be more nuanced. Regulatory clarity is important both for protecting consumers and for entrepreneurs who need the right framework and guidance to feel confident creating new applications and unleashing innovation.

Finally, cryptocurrencies are in what we call the “dial-up to broadband” moment. We have mentioned before in previous letters that cryptocurrencies are at a stage similar to that of the internet 20 years ago. Ethereum scaling solutions like Arbitrum or Optimism are making huge progress, and we are seeing increased transaction speeds, reduced costs, and the accompanying increased capabilities. Similar to how we couldn't imagine how many new internet businesses were created after the internet accelerated from dial-up to broadband, we think the same will happen with cryptocurrencies. In our opinion, we have yet to see widespread adoption of the new use cases enabled by this massive blockchain infrastructure and speed improvement.