South Sea Bubble & Initial Coin Offerings Similarities

The craze surrounding cryptocurrency craze and initial coin offerings is an echoe of the South Sea Bubble that hit England in the early 1700s.

South Sea Bubble

The South Sea Bubble wasn’t just a bubble related to trade involving the South Seas, the waters off South America. It was also a joint stock bubble

The South Sea Company was a joint stock offering to fix the finances of England. Ultimately, it was a scheme. No trade would reasonably take place but the company’s stock kept rising on promotion and the hope of investors.

The joint stock of the South Sea Company rose so much and captivated the attention of so many, that “enterprising” individuals looked to raise money by launching their own stock offerings.

It was an unregulated market and all manner of initial stock offerings were being floated.

  • For the improvement of London and Westminster.
  • For settling the island of Blanco and Sal Tartagus.
  • For the importation of Flanders Lace.
  • For purchasing land to build on.
  • For trading in hair.
  • For breeding horses.
  • For a perpetual motion machine.

And much more. Some plausible and others absurd.

But no person was more “enterprising” in their stock offering than the following man. From Charles McKay’s classic Extraordinary Popular Delusions and the Madness of Crowds

But the most absurd and preposterous of all, and which showed, more completely than any other, the utter madness of the people, was one, started by an unknown adventurer, entitled “company for carrying on an undertaking of great advantage, but nobody to know what it is.”

Next morning, at nine o’clock, this great man opened an office in Cornhill. Crowds of people beset his door, and when he shut up at three o’clock, he found that no less than one thousand shares had been subscribed for, and the deposits paid. He was thus, in five hours, the winner of 2,000 pounds. He was philosopher enough to be contented with his venture, and set off the same evening for the Continent. He was never heard of again.

The demand or joint stock offerings grew so large that people threw caution to the side. They did not want to miss out on the next big winning joint stock offering and they would pay almost any price.

Cryptocurrencies & ICOs

Fast forward to today and the buzz around Cryptocurrencies.

The two leading names are Bitcoin and Ethereum. Both cryptocurrencies have seen their trading values skyrocket within the past year. And the rise has attracted a lot of individuals looking to invest in the next great thing.

It has also attracted “enterprising” people looking to raise capital through an initial coin offering (ICO).

An ICO typically involves selling a new digital currency at a discount — or a “token” — as part of a way for a company to raise money. If that cryptocurrency succeeds and appreciates in value — often based on speculation, just as stocks do in the public market — the investor has made a profit.

Unlike in the stock market, though, the token does “not confer any ownership rights in the tech company, or entitle the owner to any sort of cash flows like dividends,” explained Arthur Hayes of BitMEX, one bitcoin exchange.

An initial coin offering is unregulated means to bypass the traditional way of raising capital for a new venture.

Afraid of missing out on the next big thing, people are willing to hand their money over no matter how thin the premise.

DentaCoin

Dentacoin is the first Blockchain concept designed for the Global Dental Industry. The Dentacoin ERC20 token is configured to be used globally by all individuals.

Dentacoin aims at improving dental care worldwide and making it affordable through utilizing the Blockchain advantages. We believe that empowering patients to become an active part in the industry development process is the key to shaping the future of dental care.

LydianCoin

The coin issuer is asking for $100 million to make coupons for marketing services with its parent company, Gravity4.

Stox Tokens

Stox.com needs $30 million for what are essentially casino chips to use in a prediction market

Hubiits

Hubii seeks $50 million so writers, musicians, and filmmakers can cut out Netflix, Spotify, and YouTube and somehow still get paid.

Paragon Coin

Paragon requires $100 million for a farm-to-pipe cannabis supply-chain tracking and payments system.

And many others. Some more absurd than others.

How Does It End

The South Sea Bubble ended when the English government enacted laws to stop the excessive offerings.

The unregulated markets became regulated.

Most likely the same thing will happen to cryptocurrencies and ICOs.

When the cryptocurrency markets and the “me too” initial coin offerings become too big to ignore, governments will look to regulate them.

China already banned cryptocurrency exchanges.

ICOs are essentially unlicensed security offerings. The SEC and U.S. regulators don’t like that.

When the bubble bursts I don’t think the fist movers and the established players like Bitcoin and Ethereum will go away. Blockchain technology should find its way into everyday life.

Will all these “me too” offerings continue to exist after the bubble bursts?

No.

Avoid the FOMO

Bitcoin
Instagram Ad to day trade bitcoin.

If the fear of missing out on the cryptocurrency craze strikes you and you’re bombarded with all sorts of “get rich quick” cryptocurrency schemes remember this.

If you think you want to invest in an ICO remember you’re giving your money to a stranger on the internet who might be using a fake name, who probably isn’t building what they say they will, whom you can’t sue for fraud and is probably stealing your money to buy a Porsche.

What I Wish I Wrote ~ September 1, 2017

A collection of mostly finance related links that I wish I had the talent to create.

Why Everyone Should Write. Putting yourself out there increases optionality. (Collaborative Fund)

Shorting Uber (Jeff Matthews Is Not Making This Up)

McDonald’s (MCD) used to make the best fast food french fries in the world — until they changed their recipe in 1990. (Revisionist History)

5 Tips to Avoid Dividend Cuts (ValueWalk)

Big name consumer brands earn outsized economic returns in part because they lowered the consumer’s search costs. The internet is changing all this. (Intrinsic Investing)

Flywheel Effect: Why Positive Feedback Loops are a Meta-Competitive Advantage (Evergreen)

Tencent’s wide moat and it pays a dividend albeit a very small one. (Saber Capital Management)

Why The Auto Parts Retailers Will Slowly Go Extinct (The Drive)

Three Financial Red Flags to Avoid When Investing For Dividend Growth (Sure Dividend)

Importance of ROIC: “Reinvestment” vs “Legacy” Moats (Base Hit Investing)

Howard Marks’ Checklist

One of our core tenets at American Money Management is we can’t predict the future. We don’t know what the equity markets will do this year, next year, or the year after that.

No one can.

Capital markets are dynamic systems. There are too many participants involved and too many variables interacting and influencing each other to make accurate predictions about the future.

What we can do is take the temperature of the capital markets. To see where we stand along the risk spectrum. Are capital markets pro-risk, anti-risk, or somewhere in between?

This is the position of Howard Marks, Chairman of Oaktree Capital. I can’t remember in which one of his memos he put this in but Howard Marks created a checklist for gauging the capital markets’ appetite for risk. I recreated Howard Marks’ checklist below.

Market Risk Checklist

Download Howard Marks’ Checklist

I recently went through the checklist and I found myself checking all the boxes on the left side.

I view the market as being very pro-risk.

I tried to be objective as possible when filling out the checklist but I can’t escape my biases. I could have easily over estimated how much risk the market is taking. If you work with a team or a couple other people, I would recommend each person complete the checklist on their own and then compare each other’s answers.

Third Point Invests in BlackRock (BLK)

In their Q2 2017 letter, Third Point outlines their reasons for investing in BlackRock (BLK). BlackRock is a long time holding in our dividend growth portfolio.

BlackRock is the world’s largest asset manager, with $5.7 trillion in AUM. In a classic scale industry, BlackRock is an asset-gathering machine, with organic net inflows of over 7% annualized2. Coupled with a tailwind from rising markets, AUM grew 17% year-over-year in the second quarter, which remains a key input for earnings power. Yet we see BlackRock as far more than an asset manager dependent on market movements. It is increasingly becoming a network or index-like business, with earnings power driven by ETFs (via iShares) and data & analytic services (via Aladdin). These are oligopoly businesses with faster growth and much higher incremental margins than traditional asset management – and thus deserve much higher P/E multiples over time. With shares at less than 15x our 2019 EPS forecast, and an outlook for consistent mid-teens EPS growth, we think BlackRock is a misunderstood franchise that is just beginning to inflect.

BlackRock’s iShares business has over 38% global market share in ETFs, and rising. It took in a record $74 billion of net flows in 2Q – a 21% organic growth rate – and had nearly as many inflows in the first half of 2017 ($138 billion) as all of last year. In the US, iShares had more inflows in 1H17 than the next 10 competitors combined. We think this acceleration in ETFs is just getting started, as regulatory change globally pushes lower-cost, transparent investment products, and institutional investors use ETFs as investment solutions, particularly in fixed income – an area where BlackRock has an even higher global market share for ETF products (~50%). We see iShares delivering mid-teens topline growth over the next 3 years and producing over half of BlackRock’s earnings by 2019. More importantly, this is a business with significant operating leverage as it scales, with far less variable costs from compensation and benefits, which limit the margins of traditional asset managers.

BlackRock’s Aladdin business is a data, analytics, and risk management platform originally built for internal use that now services over 25,000 external users. Historically, Aladdin was focused on institutional investors and corporates but we see a huge opportunity to bring it directly to retail financial advisor networks. This new product, called Aladdin Risk for Wealth Management, will link the world’s biggest asset manager and ETF provider directly to the desktops of thousands of financial advisors and their customers. As with other data and analytics providers in which we have made investments, these services become sticky, must-have products for users, with upside from ancillary fees. We see Technology and Risk Management revenue, which became a new line-item on BlackRock’s P&L in 1Q17, continuing to grow at 12-15%, and delivering 20% of incremental operating income growth in 2019.

BlackRock is valued like a traditional asset manager but it has much greater potential for structural revenue growth and operating margin expansion. Previous headwinds like USD strength have now become tailwinds, helping recent performance, but we are much more excited that higher-margin, higher-multiple businesses like iShares and Aladdin will become almost 2/3 of BlackRock’s earnings power within 3 years. This evolution in business mix should deliver 20x+ forward P/E multiples for the stock as well as faster, more consistent mid-teens EPS growth – a combination which drives ~40% total return potential for shares over the next 2 years.

The full Q2 2017 letter from Third Point

Network Effect & Switching Costs for Intuit’s QuickBooks Online

Intuit’s QuickBooks Online is its Software As A Service (SAAS) business. It is replacing Intuit’s legacy QuickBooks Desktop software. QuickBooks Online is part of Intuit’s effort to transform its revenue from highly repeatable transactional sales to highly recurring subscriptions.

QuickBooks Online is experiencing strong adoption and growth. I wouldn’t say it has built an enduring business moat yet. But I see two potential drivers for Intuit to build a moat around its QuickBooks Online business: Network Effect and Switching Costs.

Network Effect

Accountants & Small Businesses

One Intuit’s strategies for growing QuickBooks Online is to target the accountants for small businesses and the self-employed. These are the nodes from which QuickBooks Online can branch off of.

If a small business hires an outside accountant and that accountant uses QuickBooks Online then you as the small business owner would most likely use QuickBooks Online too.

The most significant one right now is really working with your accountant and we know that if an accountant switches their practice to QBO, they’ll bring their clients along with them and they’ll help the client in the transition. So that’s the big idea we’ve been working on for the last year or so, but I think it’s going to be pretty steady for a while. -Neil Williams from INTU Bank of America Global Tech Conference June 7, 2017

It also works in reverse.

The more small businesses that use QuickBooks Online the more pressure it is for accountants to use QuickBooks Online too. It can help the accountants win more business.

Two-Sided Network Effect

I see this as a Two-Sided Network Effect

Network effects can also be two-sided: increases in usage by one set of users increases the value of a complementary product to another distinct set of users, and vice versa. In many cases, one may think of indirect network effects as a one-directional version of two-sided network effects.

3rd Party Integrations

QuickBooks Online is an open platform. Other companies can build and integrate their software with it. For example, Intuit has its own Payroll and Payment Processing products but Intuit allows ADP, Paypal, Square, and others to integrate with QuickBooks Online.

The more 3rd party integrations QuickBooks online has the more valuable it is to their customers. And the more customers QuickBooks Online has the more valuable it is to 3rd parties to integrate their software with QuickBooks Online.

Indirect Network Effect

This is the Indirect Network Effect.

Network effects may also be indirect, where increased in usage of the product spawns the production of increasingly valuable complementary goods, and this results in an increase in the value of the original product. For instance, while there are some direct network effects associated with Windows, the indirect network effects that arise from the increased quality and availability of complementary applications software are probably much more important.

Switching Costs

If you’re a small business that uses QuickBooks Online, your accountant uses QuickBooks online, and all your other business software integrates with QuickBooks Online then it becomes hard to switch over to a new platform.

  • Can all your information and transaction history transfer over seamlessly?
  • How much work do you have to do the transfers?
  • How much will it cost in time and man hours?
  • How long will it take to learn the new system?
  • How many people need to be trained on the new platform?
  • Will you have to find a new outside accountant?

Unless something drastic happens with QuickBooks Online and the decision to switch becomes urgent and vital, you as the business owner are unlikely to switch.

I put QuickBooks Online’s switching costs in the following categories as laid out by Strategyzer.

Data Trap

The ‘Data trap’ consists encourages customers to create or purchase content and apps that are exclusively hosted on a platform. These platforms can be websites, software or devices. But, leaving one platform for another forces customers to let go of data or activity that can’t be migrated to another app.

For QuickBooks Online it is your data. It must be transferable. I see less of a risk of losing your data.

But I see the Data Trap as the worry that your data won’t transition smoothly between software platforms. You risk spending a lot of time trying to fix it. Or you’ll have to spend a lot of money and time working with your new software’s data transition team. Or you’ll have to do it through Excl exports increasing the time it will take and increasing the risk for entering the data wrong.

The time, money, and effort to transfer your data must be worth it.

Learning Curve Trap

Customers can be discouraged when they have to start over and learn how to use a new product. The ‘learning curve’ trap is centered around offering a great value proposition that’s only accessible to those willing to train to know how to use it. Salesforce and Adobe use the ‘learning curve trap’ to get customers hooked to their products–some users get so good at using their software that they become certified experts. They don’t feel like switching to something else unless they experience a very strong pain with their existing product.

If QuickBooks meets your needs and the user interface isn’t utter garbage then why learn a new system? A small business owner wants to focus on running and growing their business not learning new accounting software.

Plus, Intuit wants to retain its users and Intuit knows it needs to continually update and improve QuickBooks’ user interface to do so. Any current user interface issues can be resolved quickly.

Industry Standard

And then to a smaller extent the Industry Standard trap. This could be a bigger switching cost if QuickBooks Online becomes the industry standard for small business accountants. Right now QuickBooks online is the top choice, not the necessary choice.

QuickBooks Online Opportunity

Intuit has a real opportunity with QuickBooks Online to build a product with a strong network effect and high switching costs. It is why they are aggressively trying to gain more users. QuickBooks Online doesn’t have an enduring business moat yet and it’s still vulnerable to outside competition at this stage. But Intuit has a big head start with its entrenched users of its legacy QuickBooks Desktop software. Converting all of them to QuickBooks Online will make it extremely hard for competition to overtake Intuit.