Three Ways Cryptocurrency Investing Is Similar to Equity Investing
Background — Crypto becoming mainstream
Total cryptocurrency market size crossed $1 trillion in Nov’21. College students are now doing Systematic Investment Plan (SIP) for crypto investment, over doing SIP in equity Mutual Funds. Cryptocurrency has been hogging the limelight on the internet. Sometimes for good reasons (making investors millionaires), or for not-so-good reasons (countries banning cryptocurrencies). No matter from what angle you look at it, cryptocurrency is an accepted form of investment. It is trusted by millions of investors around the world, and is here to stay.
Well known veteran equity investors have held different views on cryptocurrencies. On one hand Warren Buffet believes that cryptocurrency will never replace currency, and he will never invest in it (read full article here). On other hand, the likes of Ray Dalio have now started investing in relatively less volatile (large cap) crypto currencies, such as Bitcoin (read related article here).
For existing retail equity investors, investing in crypto currency might look like a huge learning curve. However, this is not entirely true. The basics of investing remain the same — to manage risk and reward. And doing your own research in order to invest in good quality, long term growth.
In this post, I lay down three similarities between cryptocurrency investing, and equity investing. There can be more similarities, however below are the main ones according to me. Post reading these similarities, I hope crypto currency investing will sound a little easier for equity investors; and existing crypto currency investors will learn something from the century long learnings of equity investing.
Similarity 1: Bull and Bear Cycles
Bull cycle is the period when prices of stocks/cryptocurrencies are rising. This rise is beyond the fair value of these investments. Bull cycles are usually caused by euphoria among the investors. This positive emotion is also called as ‘Greed’. Investors are positive about the future growth potential of the invested assets. They keep on investing more and more, even at premium valuations of the invested assets.
The opposite of the Bull cycle is the Bear cycle. In bear cycle, investors have less hope, and see zero to negative growth potential in the invested assets. Bear cycle is categorized by the emotion — Fear. Bear cycles see panic selling by investors. Prices of good quality assets fall below their fair valuations.
Bull and Bear cycles follow each other. A bull or a bear cycle typically last more than a year (1–3 years). These cycles are common among Equity investments, and Cryptocurrency investments.
Equity Bull and Bear market cycle (S&P 500 index) from investopedia.com.
Bitcoin (leading Cryptocurrency) Bull and Bear Market cycle from coindesk.com.
Tip 1: How to to use Bull and Bear cycles to your advantage
Bull Cycle: Avoid investing in overpriced investment assets. It is ok to book some profit.
Bear Cycle: Invest in good quality investment assets which are available at attractive valuations, below their fair price. Bear cycles weed out good quality assets from bad ones. Bad quality stocks fall more than the category average.
Know the reason for the fall in prices — whether it is the overall bear market which is taking the price down, or there is a fundamental change in the invested asset which is driving down the confidence of the investors in the asset. If former, invest more in good quality assets. If latter, evaluate your investment, and even exit from low quality assets.
However, one thing you should NOT do in Bear cycle — is to sell in panic with the aim of saving your capital. If you have invested in good quality assets, the price will bounce back as the next Bull cycle comes. So hold tight.
Are wondering if there is a way to find out which cycle (bull or bear) we are in? Some websites provide the emotion indicator of the investors, which acts as a good proxy of the bull/bear trend. Example: tickertape.in provides market mood index on its home page (snapshot below):
Market Mood Index (MMI) taken from tickertape.in on 4th Feb, 2022
Similarity 2: News/Media driven short term price fluctuations
Current price of an investment asset is an indication of the future value the asset will generate. Therefore, the price of a high growth asset in a sunrise industry rises faster (such as IT/eCommerce stocks) vs a sunset industry asset (oil and petroleum stocks). However, many times, the indication of future potential of an investment asset is not evident. In such cases, the market looks at indicators from influencers in the investment world — advice from fund houses, opinions of veteran investors/public figures, and news articles. These opinions and news cause a short term fluctuation in the price of both equities and cryptocurrencies, either upward or downward.
When news of leading investors investing in a stock comes around, the price of that stock goes up. Example: when news of Rakesh Jhunjhunwala (leading investor in India) investing in Canara Bank came out in 28th Aug, stock price of Canara Bank increased by 5% in one day.
Similarly, when Elon Musk announced in Feb’21 that Tesla company has bought bitcoins worth $1.5 billion, Bitcoin prices shot up by 20% in a single day (popularly now known as the ‘Musk Effect’ !).
There are many more such examples in the equity investment space, as well as cryptocurrency investment space.
When leading fund houses (Domestic Institutional Investors — DII or Foreign Institutional Investors — FII) invest in an Indian stock, the confidence of the market in the stock goes up. And the resultant price of the stock goes up. Vice versa, when DIIs or FIIs sell or reduce their holdings in a stock, market confidence in the stock goes down, dragging down the price of the stock in the short term.
Similarly when a Tier 1 or Tier 2 Venture Capital (VC) firm is backing a cryptocurrency, market confidence in the cryptocurrency goes up, resulting in sharp price increase of the cryptocurrency.
Price fluctuations may vary in the equity world and the crypto world. As the equity market is more mature and larger, price fluctuations based on news/opinions are smaller (10–15%). Whereas in the cryptocurrency world it can be large (20–40%).
There are some exceptions though. When a stock posts weak quarterly results, combined with a weaker future outlook, the price of the stock can tank upto 30% in a single day. Example: Meta (formerly known as Facebook) stock price tanked 26% in a single day after it posted a relatively weak Q3’22 results, and weaker 2022 year outlook with several headwinds impacting its future profit growth.
Bitcoin price increase impact post Elon Musk tweet (taken from https://www.blockchainresearchlab.org/)
Similarity 3: Differential Growth Multipliers for Large Caps vs Mid/Small Caps
It is common knowledge (and advice) that Large Caps are slow movers (moderate price growth), vs Small and Mid cap stocks (faster price growth). Large Caps are the blue chip companies, whose market capitalization is large. Imaging the top player in an industry segment, say Hindustan Unilever (HUL) for FMCG in India, Divis Labs for Specialty Chemicals etc. Mid Caps and Small Caps are companies with smaller market capitalization. Example: Amrutanjan in FMCG sector in India, Laurus Labs in Specialty Chemical segment etc.
If the overall industry segment is rising, the price of large caps tends to rise slower than mid-caps or small caps in the same segment. The logic is simple — large caps have less room for growth. Whereas small and mid-caps have more room for growth. Smaller companies are relatively more nimble in terms of their strategy (considering smaller company size).
Thus, investors’ confidence in growth potential of small and mid-caps of a growing industry segment leads to higher premium pricing of these stocks vs large cap stocks in the same segment.
Example: HUL share price growth in 2021 is -4.57% (negative), even with a 17.5% revenue growth in 2021. However, Amrutanjan share price growth in 2021 is 65.86%, with a revenue growth of 28% in 2021.
Same is true in Cryptocurrencies as well. Ethereum’s price (considered large cap) grew by 390% in 2021. Whereas another mid-cap in the same segment, Solana, grew by 8800% in 2021 in terms of price.
Hence, investors try to find the next multi-bagger, by researching and investing in small and midcap stocks in a sunrise industry segment.
See Price change chart for Ethereum, Solana in 2021 (taken from fool.com).
Smaller Companies do not always outpace larger companies
Small and Midcaps in the sunrise industry do not always outperform large cap stocks. This can be due to poor management in small/mid-caps. Or less bargaining power in the supply chain. Or less free cash flow to survive uncertain macroeconomic situations vs large caps. Please do your due diligence before investing in small and mid-cap stocks, and crypto currencies.
Note 1: Classification of Cryptocurrencies?
In the crypto world, there hasn’t been a standardized classification in terms of large cap stocks, mid-cap stocks etc. However, basis the market capitalization of the cryptocurrency, this classification can be inferred, and is used by crypto currency investors.
Note 2: Keep Beta of Small Caps in mind
Small and mid-cap stocks or coins, are also more volatile, and have higher Beta in stock investment terms. This means that small and mid-cap stocks’ price will rise higher than large cap stocks during bull run. And will drop further down than large cap stocks during the bear cycle. Please do your research to make the right investment at the right time to reap the most benefits.
Note 3: What about micro-caps?
I have left out micro-caps, which are very small companies with little to no historical data to help in their analysis. Micro cap stocks or coins are highly volatile
Another personal reason for me to not consider micro-caps is that I believe that a good idea or execution, which is preferred by the buying customers or the market, will at least grow to a small cap level. If not, and the micro cap has been in business for more than 3–4 years, then there is either something wrong with the business, or the product-market fit is too weak to consider investment.
Other Notable similarities between Crypto investing and Equity Investing
Listing Process
Companies list on the Stock Market Exchange via the process called Initial Public Offering (IPO).
Cryptocurrencies list on the Crypto Exchange Market via the process called ICO (Initial Coin Offering).
Demand and Supply Driven Pricing
Demand and supply drives the price of equity or cryptocurrency — up or down. Less supply, higher demand drives up prices. More supply, or stable supply, but less demand drives the price lower.
Liquidity impacts Trading
High liquidity implies more sellers and buyers, hence ease of trading. This applies to both equities and crypto currencies. In case there is less liquidity, you may not be able to buy or sell equities or cryptocurrencies immediately. If you are a seller, you will have to wait for someone to buy; and vice versa. Some cryptocurrency exchanges are more liquid (example: Coinbase, Binance), hence preferred by investors over other less liquid exchanges.
Parting Thoughts
The fundamentals of investing will remain the same. The way of application will differ for newer investment assets. Buy low, sell high, has been the merchant’s thumb rule for centuries. This rule still holds. As technology evolves, the way trusted money is exchanged also evolves. We had barter system thousands of years ago, where liters of cow milk was exchanged for bags of rice. Then the system of coins issued by kings came into picture. After that, gold took the place of money. Still, gold was heavy to carry around. This gave way to paper money.
And now, the newer generation are using blockchain technology to create cryptocurrencies. The real value of cryptocurrency is yet to unfold. This will happen once applications of crypto currency in real world becomes common place.
I believe that existing equity investors will find themselves at home investing in cryptocurrency. The resources they use to research will change. The valuation criteria might change. But the basics of making money by investing, and enjoying the joys of compounding over time will remain.
What are key similarity of dissimilarity between equity and cryptocurrency according to you?
Do share in the comments below.
Happy investing!
Disclaimer: This post is taken from my original blog here.