In various Chinese cryptocurrency investment chat rooms, “value investing” is often a joke-like presence. People often use it to make self-deprecating remarks. When an investor is trapped, he/she may say, “Now I can only resort to value investing.” Then, onlookers either express sympathy or make a few jokes, and the group is instantly filled with a joyful atmosphere.

Alternatively, value investing is like an elusive fashion trend, sometimes praised by everyone, sometimes considered “worthless,” suddenly declared “dead,” but soon after, it resurrects again.。

Search for “value investing”, you can find many similar messages.

We also occasionally encounter fellow group members who identify themselves as “value investors.” When asked what value investing is, they often mention key words such as “long-term holding” and “patience,” among others. In our opinion, this is not the original intention of value investing.

What is value investing?

The definition of value investing is not complicated, but it is not as simple as most people think.

Its concept may have originated from the American investment master Benjamin Graham and his groundbreaking work “Security Analysis”, emphasizing the analysis of investment value based on the intrinsic value of stocks.

Subsequently, a group of masters such as Philip Fisher, Charlie Munger, Seth Klarman, and Howard Marks have continuously contributed to the concept of value investing, making its ideological system flourish. However, it was Warren Buffett, who has had more than 50 years of brilliant investment performance, that truly popularized the value investing system and made it a household term.

So, what is value investing? Some say that the essence of value investing is: buying assets at a price lower than their intrinsic value, like buying something worth $1 for only $0.40.

This statement is not wrong, but it is the result or goal of value investing. What we are most concerned about is how to achieve “buying assets at a price lower than their intrinsic value.”

Sec 1. The Four Pillars of Value Investing

In our view, value investing can be summarized by four key concepts, which we can call the “Four Pillars of Value Investing”. They are:

1. Buying stocks means buying companies.
2. Circle of Competence.
3. Margin of Safety.
4. Mr. Market.

These four key concepts form the foundation of the value investing theory. When we understand, acknowledge, and start practicing these four key concepts, we embark on the path of value investing.

What do these four concepts mean specifically? Let’s discuss them in detail.

1.Buying Stocks Means Buying Companies

The value of stocks comes from the ownership of the represented company, and the company has value because it can generate profits and cash flow. So, when we buy stocks, we are essentially buying and holding the ownership of the company behind the stocks. The value of this ownership is determined by the total future cash flows that the company can create. Buying stocks is the process of assessing the future cash flow value of a company.

Here, the concept of “intrinsic value” emerges. The intrinsic value of a company refers to the sum of the discounted* cash flows that the company can generate from the present until its demise.

*Discounting refers to the process of converting future asset prices into present prices. For example, if you will receive $10 in income after 10 years, which is equivalent to $5 in present value, then $5 is the present value or discounted value of that $10.

2.Circle of Competence

The Circle of Competence refers to an investor’s range of abilities. When we truly understand an asset and possess knowledge that surpasses the majority of the market participants, that asset falls within our circle of competence. The concept of the Circle of Competence is not difficult to understand. The real challenge lies in people’s tendency to overestimate the radius of their own circle of competence.

3.Margin of Safety

The Margin of Safety is a principle widely practiced in daily life. For example, if we build a stone bridge with a maximum load capacity of 20 tons, we will only allow cars with a total load of 15 tons to pass through it. The extra 5 tons is the “margin of safety” we leave for the bridge.

In investing, the Margin of Safety means buying a company’s stock at a price lower than its intrinsic value (or the intrinsic value of any other asset). It is what Warren Buffett refers to as “buying something worth a dollar for 40 cents.”

The Margin of Safety acknowledges that we are prone to making mistakes and that the market is unpredictable. It serves as a buffer zone between our hard-earned money, our miscalculations, misfortunes, and the volatility of the economy and the market. The more Margin of Safety we have, the more room we have for our mistakes, and the lower the likelihood of eventual losses.

4.Mr. Market

The concept of “Mr. Market” comes from a fable in “Security Analysis”, as follows:

Imagine that you are engaged in stock trading with a person named Mr. Market. Every day, Mr. Market will propose a price at which he is willing to buy your stocks or sell his stocks to you. Mr. Market’s emotions are highly volatile. So, on some days when Mr. Market is in a good mood, only seeing the bright side of things, he will quote a high price. On other days, when Mr. Market is feeling down and only sees difficulties, he will quote a low price. Additionally, Mr. Market has a charming characteristic: he doesn’t mind being ignored. If people ignore what Mr. Market says, he will come back tomorrow with a new quote. What is useful about Mr. Market is the prices he carries in his pocket, not his wisdom. If Mr. Market seems abnormal, you can ignore him or use his weakness to your advantage. However, if you let him control you completely, the consequences will be unimaginable.

Mr. Market only reports the prices of assets, not their values. Prices are what we pay, and value is what we get.

Combining these four concepts, we can define value investing as buying assets within our circle of competence, at a price lower than their intrinsic value, and with a sufficient margin of safety.

The definition is clear, but implementing it is not easy.

“Choosing within our circle of competence” means first objectively evaluating our own abilities, which is challenging because humans are naturally self-centered and tend to overestimate themselves. The circle of competence needs continuous expansion because a small circle means missing out on many investment opportunities. However, expanding the circle of competence should not be too aggressive since our time is limited, and attempting to understand a large number of sectors and projects may mean that the investor is not an expert in any of them.

“Buying at a price lower than the intrinsic value”：This means you need the ability and a yardstick to measure the true value of asset assets. More importantly, factors such as invisible competitive advantages not yet reflected in the company’s balance sheet, such as those derived from network effects, switching costs, intangible assets (brand, franchise rights), and cost advantages, need to be taken into consideration.

“Leaving a sufficient margin of safety” : The more safety margin you leave, the fewer opportunities you have to swing the bat. Being left empty-handed after making the right judgment is sometimes more painful than the losses incurred from making the wrong purchase.

During this process, Mr. Market will constantly confuse you. When asset prices are soaring, he will urge you not to sell, and when prices are plummeting, he will advise you to sell everything. Mr. Market is sometimes right and sometimes wrong, but as long as you keep an eye on him, he has the opportunity to influence you.

Each guideline requires practice, and it is easier said than done.

Sec 2. Does Value Investing Really Work in the Crypto World?

It is well known that Warren Buffett and his partner Charlie Munger have never been fond of cryptocurrencies, with Buffett even referring to Bitcoin as “rat poison.”

Nevertheless, we believe that the concept of value investing still holds true in the crypto world.

Buffett may never buy a Bitcoin in his lifetime, just as he never invests in gold because he sees gold as “just a cube with a side length of 20 meters” that doesn’t produce anything and doesn’t change over time. Since he doesn’t like gold, he naturally wouldn’t be fond of digital gold, BTC.

However, Buffett has invested in companies that produce gold, such as Barrick Gold, the world’s second-largest gold mining company, because it generates good cash flow.

I believe that if Buffett were 60 years younger and discovered projects in the crypto world that also have good cash flow and a wide margin of safety, he wouldn’t be able to resist getting involved.

The four pillars of value investing can be applied with slight modifications to crypto investments: buying tokens is equivalent to buying projects, circle of competence, margin of safety, and Mr. Market.

Let’s understand these four concepts in the crypto world through examples.

1.Buying Tokens is Equivalent to Buying Projects

The value of project tokens fundamentally comes from the value provided by the underlying projects and their ability to capture revenue. From the perspective of value investing, the crypto projects we invest in should have the following characteristics:

a. The tokens issued by the project can capture all or most of the economic value created by the project.

For example, there are some products with a large user base and high activity, but the majority of the project’s value cannot be transferred to the tokens issued by the project. Take crypto wallets as an example. The user base, transaction volume, and asset management of wallets are all significant, but the market value of wallet project tokens is relatively small. This is because the majority of the value provided by the wallet to its users cannot be captured or linked to its tokens.

b. The problem the project aims to solve has significant value, a long and wide track, and a long lifecycle.

For example, the mixer project Tornado Cash has a good concept and satisfies some needs (money laundering), but the scale of its demand is still relatively limited compared to other tracks (there aren’t as many users with a real need for money laundering). It has an obvious business scale ceiling. In contrast, financial services such as lending, trading, and derivatives are healthier and have longer-term tracks.

c. The project has an excellent management team.

For example, some projects started early in promising tracks but were constantly surpassed in later development due to limitations in the team’s overall strength. The earliest trading project on BSC, Burgerswap, is a typical example.

2.Circle of Competence

As Charlie Munger said, “If I know where I am going to die, I would never go there.”

Serious investment losses often occur when we invest in areas where we think we understand but actually don’t.

So how can we determine whether we understand or not? We can refer to two criteria:

1.Our understanding of a track or project should surpass at least 90% of other investors who have invested in the same project.

2.When others discuss the project, there should be very little information that you are unaware of or perspectives you haven’t considered.

3.Margin of Safety

To establish a margin of safety, we need to have an estimation of the “fair price” of the project. Based on this estimation, we can then apply a discount, which represents the margin of safety for our investment.

Currently, it is almost impossible to accurately value most crypto projects, especially public chains. Even for DeFi protocols with very transparent cash flows, it is challenging to use discounted cash flow (DCF) models for valuation due to numerous uncertain factors such as the project’s lifespan and profit growth rate. A large number of assumptions often lead to a “precise error.”

Therefore, using relative valuation may be a more practical approach. We have predominantly used this method in our previous research reports. If you’re interested, you can review our past reports.

While we may not be able to calculate the fair value of a project most of the time, we can identify “visibly undervalued” projects through relative valuation.

As Buffett said, when we see an overweight person, even if we don’t know their exact weight, we know: this person is overweight.

4.Mr. Market

Regarding this, we only need to remember on the basis of adhering to the first three principles: Mr. Market is useful to us because of the prices in his pockets, not because of his wisdom. The market reports are not about the truth of the project but rather the collective votes of everyone in the current market.

When we attempt to apply the concept of value investing to crypto investments and make buying and selling decisions, we continuously ask ourselves these four questions:

1.Is this project a good project and in a good track? (Buying tokens is equivalent to buying projects)

2.Have I reached the standard of understanding this project? (Circle of competence)

3.Have I left a margin of safety by buying at the current price? (Margin of safety)

4.Am I using the market or being used by the market? (Mr. Market)

These four questions help us assess our ignorance (questions 1 and 3) and counteract the weaknesses of human nature (questions 2 and 4).

Ignorance and human nature are the only reasons why we lose a significant amount of money in the market.

Sec 3. Finally, how should value investing view selling?

My criteria for selling are as follows:——

1. The reasons for buying the asset are no longer valid. For example: the competition in the track that was once optimistic has deteriorated rapidly, the moat (margin of safety) of the project that was believed to exist is actually only ankle-deep, and there are serious issues with the integrity and management level of the team, among others.

2. The price of the asset has risen too high, and its potential return rate is already too low compared to other assets with higher potential return rates. In this case, sell the asset and switch to a more cost-effective one. Investment is constantly about calculation, measurement, and comparison. Even holding Chinese yuan cash is a form of investment, which can be understood as a current bond with an annual interest rate of about 2% (by depositing in a money market fund).

Value investing is certainly not the only way to invest in the crypto world.

Perhaps there are really people who can consistently profit relying on technical analysis, and there are always investors with a keen sense of smell who can set sail in advance when the wind rises, catching up with the market’s narrative wave.

However, there is also fierce competition in the above areas, and the reflexivity of the market is constantly destroying the rules that have been proven true before.

More importantly, is this really within your circle of competence?

Disclaimer：

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