Making decisions in the financial sector when markets are falling: Crypto vs. companies
In this article Kokkie Kooyman explains why, with rising interest rates and the recent crypto market price falls as context, ‘sane’ investors in the financial sector are currently spoilt for choice.
Warren Buffett has been warning investors for some time that rising interest rates are akin to markets like the force of gravity is to matter – they pull them down. Sure enough, after a long period of low and negative interest rates, the hiking of interest rates by the US Fed and other central banks is having that effect on equity, bond and crypto markets.
The first quarter of 2022 was one of the worst quarters on record for equity and bond markets (measured on a combined basis), whilst in May we saw the collapse of the Terra Luna stablecoin. This combination of events led to severe price falls in the whole crypto market.
Luna fell within days from $85 to $0.0002c (having peaked at $117) whilst the price of bitcoin is down from a high of $67,583 in November last year to $30,321 (as at 30 May 2022). These massive price falls have led investors to question, ‘Is now the time to invest again?’ Rather than investing in crypto, at the lower prices, Buffett bought a 2% stake in Citigroup. Why? Because ‘a bird in the hand is worth two in the bush’.
A bird in the hand means you know exactly what you have – a high probability of a certain return. For Buffett, Citi was that (high degree of certainty) bird. When markets are falling the best opportunities are those that give a high degree of certainty and low risk, compared to those with the uncertainty of a potentially higher return.
Investing in crypto comes with uncertainty.
The development of blockchain (and bitcoin), and smart contracts using the blockchain technology (Ethereum), created a faster and potentially cheaper way of storing and transmitting money and currencies across boundaries. (Read Beyond Bitcoin: Decentralised Finance and the End of Banks by Steven Sidley and Simon Dingle). This and the creation of cryptocoins, decentralized autonomous organizations (DAOs) and non-fungible tokens (NFTs) on a decentralized finance (DeFi) system attacked the weaknesses of traditional finance (Tradfi) and fiat currencies. For more on this, listen to our February podcast with Steven Sidley on DeFi and how it will affect banks and investors.
The attractiveness of DeFi has been the anti-government and anti-control dream: It’s ‘trustless’ and ‘permissionless’.
1. A trustless system is one where investors don’t have to trust (or pay) intermediaries such as banks (part of the Tradfi or traditional finance system).
Instead, trust is placed on smart contracts on blockchain and the view that bitcoin and other cryptocoins would be a store of value and used as a currency to make payments. But the volatility of their prices led to the demand for a more stable type of cryptocurrency: stablecoins.
We’ve seen the growth of three kinds of stablecoins.
- Stablecoins linked to fiat currencies or assets (like the US dollar or Japanese yen)
- Algorithmic stablecoins, where their values are derived through algorithms
- Stablecoins linked to the values of other cryptocoins – which is a great concept when the price of bitcoin and other cryptocoins go up, but not so great when they collapse).
Algorithmic coins, Terra and Luna, caused a 15% fall in the crypto markets, which accelerated the decline that started when the Fed started hiking interest rates. Terra and Luna’s link was broken due to a few large investors unexpectedly selling off Terra coins. The link, and its promised 20% yield, proved to be a mirage.
2. Permissionless refers to the lack of regulation.
While it’s the investor’s dream to not have to deal with regulatory interference, the lack of regulation also means no consumer protection. On a positive note, with no regulation or ‘big brother’ to stymie innovation, the crypto industry developed and grew quickly. The nirvana of permissionless innovation – good for advancing and testing; not good for widows and orphans to invest in.
New technologies create immense value over time, but the gold rush of ‘develop now and test later’ brings significant risks.
Investors ignored the shortcomings and structural weaknesses of the new industry. A combination of FOMO (the fear of missing out) and good marketing drove the market cap of crypto currencies to $1.8 trillion in February 2022 and bitcoin to $67,583 in November 2021.
To a certain extent, all bull markets are driven by Ponzi-like behavior – paying existing investors with money from new investors. Deutsche Bank wrote an article on this recently, in relation to crypto markets, referring to the ‘Tinkerbell Effect’. Prices go up as long as demand exceeds supply due to imagined or real value of assets. The problem is that crowd behavior often pushes valuations of mirages too far. (I recommend John Kenneth Galbraith’s book, A Short History Financial Euphoria.)
Over the past 10 years, negative interest rates gradually led to the rise of ‘silly’ investing. When interest rates are low or negative, it seems almost rational to invest in (future) growth. Valuation doesn’t seem to matter when money is free. In other words, buying bitcoin at a higher price but receiving no intrinsic value seemed rational. The higher price was driven by the difference between its limited supply and strong demand when the price was going up. The new environment of higher interest rates is bringing that illusion to an end.
To do well in investing you don’t need to be smart, just sane.
Buffett re-iterated this at the Berkshire Hathaway annual shareholders’ meeting in April. Sane for him meant investing in Citi. Citi trades at a P/NAV of 0.56x and is generating a return on equity of 10%-12%. This means Berkshire Hathaway’s investment in Citi could generate a return on investment of around 20% per annum – even if it doesn’t re-rate.
The certainty associated with this potential return is fairly high. Citi is far advanced in the process of disposing seven non-core business units across the world (from their previous global growth focused era). It could take up to 12 months to get regulatory approval for each sale, but as they get approval their cash balance will grow and can be used to buy back shares or pay dividends. Their core business is doing well. Higher interest rates mean higher returns on their portfolio of assets (both loans and other investments). There is a risk of higher bad debts in a recession, but our opinion is that the tight labour market and strong consumer and corporate balance sheets means the risk of bad debts is adequately reserved for and low. Low enough to make Buffett buy a 2% stake.
The Denker Global Financial Fund also owns Citi, it is in fact one of our top five holdings.
The changing environment of higher interest rates is presenting many opportunities in the global financial sector.
But this calls for being sane, not greedy. Sanity tells you that when you invest in well-run companies with good track records and you invest in them when they’re trading below intrinsic value (and even better, below historically average valuations), then you do well over time. And, there are many such companies out there.
We’re very excited about the prospects for investors in financials.
We do believe blockchain technology is here to stay and will increase efficiencies for the financial and other sectors. For that reason, for example, we’re using the opportunity to add to our Signature Bank holdings – one of the leading crypto-based deposits and lending banks, which was sold down along with the crypto market to a P/NAV of 1.4x from its peak to 2.8x.
At the same time, there many other financial sector shares that will benefit from higher interest rates which have recently been pushed down on the fears of a recession. At the moment, we are spoilt for choice.
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