On The Brink with Castle Island - Mark Coe (Intrinsic Edge) on Blockchain Public Equity Investing (EP.249)

Episode Date: October 11, 2021

Mark Coe, the founder and CIO of Intrinsic Edge Capital Management joins the show. In this episode we discuss: Mark's professional career and path to founding Intrinsic How he came to see blockchain/crypto as an investable category His personal journey on understanding the various blockchain thesis areas How he thinks about the taxonomy of publicly traded companies in the blockchain space How Intrinsic thinks about their research and investment process for long/short equity investing The comparisons of blockchain technology to the early days of the internet Sponsor notes  This episode is brought to you by Withum, a top 25 accounting firm with a cutting-edge Digital Currency and Blockchain Technology practice. To learn more, visit  withum.com/crypto.

Today on the podcast, we sat down with Mark Co. Mark is someone that have come to know and respect in the asset management space, and he has a different perch for many of the other fund managers that we've had on this show. He's the founder and chief investment officer of Intrinsic Edge Capital Management. Intrinsic is a fundamental catalyst-driven investment firm that primarily focuses on small and mid-cap U.S. securities. I wanted to have Mark on because we spend a lot of time on the show talking about early-stage startups, but there's a whole world around the public. traded companies in the blockchain space. And Mark is the most knowledgeable person that I know in that domain. I think you'll enjoy this show. So without further ado, here's my conversation with Mark Co. Matt Walsh and Nick Carter are partners at Castle Island Ventures. All of these expressed by them or the guests on this podcast are solely their opinions and do not reflect the opinions of Castle Island Ventures. You should not treat any opinion expressed by anyone on this podcast as a specific inducement to make a particular investment or follow a particular strategy, but only is an expression of their personal opinion. This podcast is for informational purposes only.

Brought down by bad mortgage investments, Lehman, which has 25,000 employees, will be liquidated. The federal government loans American International Group, AIG, $85 billion. This is a different kind of market, and the Fed is asleep. The federal government is stepping it to stabilize Fannie Mae and Freddie Mac, the two mortgage giants that have been threatened by the housing crisis. The Bank of England has pumped 75 billion pounds more into Britain's ailing economy with a new round of Concentive Easing. You print a couple trillion dollars, and all of a sudden people start to worry. So out of this worry, we have something called the Bitcoin. Bitcoin.

Mark, I'm really excited to have you on the podcast. We've had countless chats about crypto over the past year. And I guess I'll disclose that we are each investors in each other's funds for full disclosure here. But I'm excited to finally record one with you. So thanks for joining the podcast. Oh, Matt. Great being here. And thanks for the opportunity.

Well, like we usually do, it would be great to just start with your personal background and just how you got to be doing what you're doing right now on the public equity side. Sure, Matt. I grew up in Chicago. I went to college and business school here in the Illinois area. I took a job initially out of school as an accountant in my early 20s. And I think back distinctly about taking the train to and from Chicago and reading the Wall Street Journal and learning about companies and their strategies and really learning about investments. And I thought wouldn't it be great to find a career where I could actually invest in these companies rather than audit them. So the rest is history. I've been passionate about investing ever since. It's not only my profession, but it's my hobby, but my career is really targeted on public equities. And what was the story of how intrinsic edge came to be? Well, it was just really an outgrowth of my personal passion for investing in performance orientation. We founded the strategies back in the 1990s, and it's been an evolution ever since with some measured growth. Today, our main office is downtown Chicago for about $1.1 billion of assets. I've got 12 on my

research team that span analysts, portfolio managers, and traders, and high net worth and institutional investors. But as I mentioned, our focus is equities. We go both long and short. Our sweet spot is small and mid-capitalized companies. Our focus is really on the income statement and drivers around them. We focus on key variables and how they may be tracking. A big differentiator of our approach is our breadth of calls. I did a check recently and we've had almost 4,000 one-on-one calls and meetings with public company management teams just this year, in addition to a lot of trade checks and so forth. So I'm proud of what we've done. and our commitment and our history.

That's fascinating. So I guess a lot of people in the crypto field will be less familiar with just the craft of long, short, domestic equities. So how do you think about just building a team and maybe talk a little bit about just what that research through investing process looks like in your world? Well, I've hired these great analysts out of college and train them on the way we think and approach. And I think just like crypto, there's just so many different ways to invest.

I kind of touched on it, but in public equities, there's a report card for companies every quarter. And we spend a lot of time doing research and doing trade checks to try to handicap how things are tracking, particularly against consensus or outside expectations. And I look forward to spending more time on this call kind of dovetailing both crypto and equities, but I think it's a very different market. Do you remember what it was that actually got you interested in blockchain and cryptocurrencies? I mean, for so long, I just repressed it very much like other very early stage, huge technological innovations. But it was just over a year ago, believe it or not, that I do a lot of private

investing and co-investing and friends that I have a lot of regard for. And some of these smart friends had been making some investments and they brought it to my attention. And one of my buddy sent me a book that I have here on my desk called The Truth Machine. I became a big believer in a relatively short period of time and strongly enthusiastic that this has got the potential to be a trillion dollar or more industry just like not unlike mainframes of the 70s or PCs in the 1980s or what I invested through with the internet in the 1990s. So going back to last year, I made a handful of both liquid and venture capital related investments, including, as you mentioned, with you Matt at Castle Island. And that dovetailed with my interest in equities. And we started to get

to know the public equities late last year and making investments for the firm. I love that story. I mean, I remember when I was first getting into cryptocurrency and blockchain, I was pretty taken aback by just how many people in traditional financial services were sort of opposed to this idea and sort of had these really strong, strong views that this either wouldn't work or it was a scam. You brought up mainframes and PCs and the internet. And I remember going through this process of saying, I didn't feel to me like those were as controversial. But then I go back and I read it. And those actually were as well. So you had Ken Olson at DEC talking about personal computers saying no one would ever want one of these things.

You had Paul Krugman in the early days of the internet saying the internet would be no more disruptive than the fax machine. Do you remember that? It feels like we're playing the same card with a different technology? I remember it so well, particularly in the late 90s, with the internet. And I'd be talking to public companies. And today, crypto has their own jargon. But we were talking about clicks and eyeballs for years. I just repressed any interest. And all my clients were tripling their money and saying, what do we need you for at the time? So this is deja vu. And I'm trying to learn from it. And we're really. in the early innings here.

Yeah, I definitely think we're in the early innings. And you're obviously in the really early endings of investors that are looking at this from a public equity perspective in the blockchain world. So what is it that you like about this space? Obviously, you're a public equities guy, but what got you into the public equity side of crypto and blockchain? It was making these calls at the beginning of this year. And we've had hundreds of calls with these companies since then.

And as I mentioned, I've dated myself, I've been doing this a long time. But candidly, it's one of the most exciting things I've ever seen in the public markets. You could think about the Internet, and I think this is similar. There's explosive growth and stocks are widely mispriced, in my opinion. And different than the Internet, though, a lot of these companies already have meaningful profitability. So I've come across, you know, I'm relatively new, as I mentioned, to the space, but I come across a lot of investors that want to invest in crypto, they're on the sidelines due to the trading complexities and how to open an account and the

cryptic strategies involved, the inherent volatility of the space and the currencies. But with stocks, what's attractive to me is I could make a big investment. You could apply traditional investing approach as these companies have real revenues and growth and profitability and earnings multiples. I don't know if you saw it, but our friends over at BitWise, they had a podcast recently on the merit of equities and crypto equities. And they highlighted BitWise crypto infrastructure innovator index. And what they pointed out was the stocks on average in that index are growing over 300% this year. If these stocks were in the S&P 500, there would be nine of

the top 10 fastest growing names in the S&P 500. Yet the stocks in this index are trading in less than market multiples. I just see it as a remarkable investment opportunity. That's fascinating. So obviously that would be a wild mispricing, as you suggest. Why is that? Is there just a lack of interest in cryptos or maybe a perception that there's only one or two public names? People just know Coinbase, don't know the others. Why do you think that is? As I touched on, I just think there's tremendous inefficiencies. And when I think about it, we look for certain things and we do it across all sectors and why this appeals especially to us is because, you know, a few reasons. And a lot of it has to do with seasoning and institutional seasoning. The first is there's a real dearth of sell-side

sponsorship and coverage. And for those of you that don't know equities, you know, the big brokerage firms, they all support stocks and equity research by putting out their views and building earnings models. Within crypto earlier this year, and blockchain, there was no cell-side coverage, which created more dispersion and expectations. And since that time, a few analysts have popped up on some of the names, but the models are dated and they're fraught with wrong assumptions, which give us a bar to arbitrage against because doing our own work and as much work as we've done, we're able to have positions that are strongly differentiated versus consensus thinking. And that helps both on the long and the short side.

The other aspect is we don't have a lot of competition. As institutional investors, we look at the 13Fs where institutions report their holdings, and many of these names have very little to know institutional coverage. I could hypothesize also, it's just, again, I mentioned that season. A lot of the stocks were following are still listed on various exchanges in Canada and Europe, and they're not even traded on U.S. exchanges. And I think as all this unfolds, we would expect institutions to get more comfortable and that valuations will become more in line with what we think where they should be trading.

Yeah, it's fascinating about the sell side research. There's very little activity, as you point out there. And maybe that's driven by the fact that there's very little trading activity happening at the banks. And so maybe there will be sort of a virtuous cycle here as more banks and broker dealers get into the spot market. or the futures market, that will spur more sell-side coverage and it will be some positive feedback loops. Because I guess in your world of traditional equities, it's a full-service operation, and you just don't have that yet in the crypto world. Yeah, it's also the way I think about it's a bridge from your world to my world. And as these later stage VC companies go public, they're going to need

banking. So these same institutions that are going to bring these companies public will then have a implicit responsibility to cover them on the research side. So I think it's just a matter of time. Yeah, that makes a lot of sense. So how do you think about your investable universe here when it comes to public companies that have this type of exposure to blockchain? Yeah, it's interesting, man. I mean, clearly the universe is defined by the 40 or so names that are directly tied to blockchain and crypto infrastructure. These companies, most of their business, comes from those markets. We've parsed, let me just touch on the key verticals because it really isn't built out yet. There's just key kind of silos. And the first and perhaps the biggest vertical is the crypto miners

and related equipment companies. The miners this year should do well over a billion dollars of consolidated revenue on the public side. These miners, as you know, they invest in equipment and electricity. And then they get paid Bitcoin and Ethereum. in some cases for their problem solving. Part of this ecosystem is also the data centers and the hardware providers, and those are also fast growing in markets. Another sector within the group is the exchanges and the custodians.

We know some big players there, and there'll be more and more public companies there as they uplift in the U.S., and several of them, for those that you are familiar, will be coming despaq through mergers and become public companies in the coming months. Another sub-segment is trading and investment management. This includes prop trading and service providers to both institutional retail investors. And finally, I wanted to just touch on banks because a few of them have been forward and thoughtful

enough to have adopted to providing services to the crypto markets. So we're pretty dialed in on each of these particular sectors. I would again point you to the Bitwise Equity podcast as they provided a detail on the names within each of the subsectors. That's fascinating. One of the things that comes to mind as you're describing these categories is that you obviously have to have a really thorough understanding not only of the companies and the cash flows and the balance sheets of the businesses,

but you also have to have a point of view just on the protocols that they're building. on. And so you need to know, is a Bitcoin miner more viable than some sort of a minor that's mining a longer tail coin? That's just a made up example. So how do you think about that? I mean, are you using the management teams to really educate your view on the protocols they're building on? And how do you think about just the commodities here that underlie the companies, if that makes sense? It makes a lot of sense, Matt. But again, I harken it back to thinking about the revenue and earnings models and what may drive that. And I'm not going to do a deep dive into those protocols. As a, for instance, we spoke to a miner yesterday that's both mining Bitcoin and Ethereum.

And as we know, Ethereum is going to be set for dislocation in the next couple of years. And why would a miner be making that kind of investment when the miners may be obsolete in a relatively short period of time. I would just ask the question like that, but the company then gave a very clear answer in that gross profit margins are actually higher on the Ethereum miners today, and they're easily repurposed without a lot of cost,

and therefore their expected return on investment is higher than actually the Bitcoin miners. So I'm much more focused on it from a pragmatic profitable approach as opposed to thinking about the protocols and platforms. This episode is brought to you by Witham. Witham is a top 25 accounting firm. They have a cutting edge digital currency and blockchain technology practice.

Wherever your company is from a stage perspective, from pre-C to IPO, they have tailored solutions just for you. They have helped some of the largest companies in the crypto industry with audit, tax, and advisory needs. And they've also helped a number of our portfolio companies. To learn more about advisory, audit, and tax services, head over to on the brink. link slash with them. That's on the brink.com. with them. You mentioned SPAC mergers. Is there a difference in terms of just the education

on the street around a company if that company goes public via a SPAC merger versus a traditional IPO process? And how does that work in the traditional market? It's really quite tricky. And there's a handful of companies that are in the process of spec mergers currently. It's not until the spec merger is completed that you can really evaluate the company on its merit and looking at it as a public company under traditional metrics. So we're having a hard time with the companies that are pre-spec because we've found them to be less available, less forward-looking as far as their views on their near-term performance. and we've had a hard time kind of building their models and valuation. So we're deliberately taking more of a waitancy approach on these SPACs until such time they become despaq.

And it's just an aside, but these companies are trading much more about the votes and the number of shares that actually get exchanged into the companies and noise around those lockups than they are about the fundamentals. And that's not really our game. Really interesting. I know part of your strategy is around. Shorting. So we'd love to just hear how you think about the art of shorting and maybe just talk me through what that world looks like. Sure, there's a lot of variables or considerations relating

to the short side of a book or an industry. You know, the big picture of two ways to think about are structural shorts where their business model hasn't adopted or will be disrupted. And then there are companies where they may be good, better, and different, but I mentioned sell-side expectations. If there's a material miss versus expectations that's not anticipated, that could lead to a great opportunity as well. And it's not any different for blockchain infrastructure-related names. One example, like even if there is huge growth in an industry like this, you need a sustainable model. And we talked earlier about the internet, but I think about AOL that didn't adopt and they got disrupted. And they're no longer part of the internet infrastructure

today. When I think about short-term variables, the key for us is just continual interaction with management teams and doing trade checks to try to find inflection points. And each subsector in every industry has their own key drivers. One example may be like brokers and exchanges that I touched on before, a key metric for these kind of companies is obviously trading volume. trading volume really exploded in Q2 and the stocks performed extraordinarily well. And then after hitting peaks in May, trading volume really fell off a cliff in June, July, and August. And if as an analyst were able to handicap these trends, you could use this information to trade into long and short ideas, oftentimes in the same stocks. Probably trading some of these stocks makes you appreciate the crypto industry that's open 24-7, 365.

That's a completely different animal to be shorting something like that. I guess you're lucky you don't have to deal with that. Oh, please. Yeah, I'm looking forward to tomorrow I could get some work done because the market will be closed. Yeah, these guys who are doing it on the liquid books, I don't know how they sleep. You do bring up a really interesting point just around the companies that will be disrupted and referenced AOL. I look around the landscape and just having spoken to a lot of traditional financial services firms, I'd love to be intellectually short those management teams, actually, because they don't

see this coming. And so how do you think about just thematically some of these types of companies that will be at risk here when it comes to blockchain technology companies getting into the fold? That's a great question that we give a lot of thought too. And we're making a lot of calls to financial intermediaries that aren't historically in the blockchain technologies space to see what they're thinking about. But the way I think about it is all these intermediaries are the ones that are going to be at risk. Finance is definitely going to move from the old guard of centralized finance to decentralized infrastructure. And the ones that are clearly at risk are just traditional banking and payments. When I think about, and, you know, still early, but where I

see the middleman dislodged would be financial transactions, such as money transfer, stock settlement, real estate transactions, and payments. Blockchain is clearly going to be faster, easier, and cheaper. So we're going to find a lot of short opportunities for those companies that aren't going to adopt. Yeah. I think we'll see that across a range of industries. I mean, you see decentralized internet architecture. Just look at the total addressable market for some of these companies that really are nothing but data monopoly structures. And so my guess is that we'll start to see it in financial services first, but this will pervade really anything where there's an intermediary. Anyone who's bought a house will see that there's a lot of fat in that transaction as well.

That's for sure. So one of the things you must think about all the time is if you're running a long short book here, how do you think about managing risk? So what does that look like in the context of the crypto market? So the beauty of a long, short strategy is that you can strive for like great returns, but without the volatility of Bitcoin or the overall stock market, as we all know, Bitcoin has been a great asset class and is up a lot again this year. But we all remember just a few months ago when we had a 50% drawdown in a short period of time. Personally, that makes me uncomfortable and not the way.

I think about investing, and I don't want to have that directional bet. So when I think about investing in all cases, risk management is front of mind. The nature of being long and short naturally hedges one group of securities versus another and causes a natural hedge. But particularly when I think about this digital infrastructure landscape, the conscientious of my exposure to the underlying cryptocurrencies and correlations and have used hedges like GBTC to manage that risk. And for crypto equity risk factors, we've used some crypto ETFs to hedge that out.

So we're using a lot of tools and we're striving for absolute returns from contributions, both on our longs and our shorts. I guess the tools in your toolkit will only be getting better with time here if we start to see new products approved by the SEC around ETF. and things like that. Yeah, definitely, without question. Both a number of public companies are going to grow exponentially. I mentioned the bridge with VC, but we're following a lot of late stage venture capital

companies that will be coming public. And then as these ETFs and other tools become available, there's going to be not only more investment options, but more ways to hedge it. How do you think about it in terms of just the regulatory status and the risks that are relevant to some of these companies. Do you have a sense of what that looks like and how do you think about it? Yeah, at a really high level, I think a regulatory framework will be embraced and it'll be the best thing for the industry because it's going to delineate the rules for the playing field. You know, when I speak to companies, they're leery of making certain investments because,

and they're hedging their direction because they don't have that clarity. As these rules become delineated, they'll be enhanced awareness. overall. And I think it'll ultimately lead to more institutional investment that I've touched on. And again, that in turn will lead to more stock investment and re-rating that we've touched on. And the key for this market, as much innovation as we've seen. And I was looking at some VC stats about how much that second quarter had nine times more VC dollars going into it than in the second quarter than the year prior. I think there'll be even more innovation and there'll be more public companies.

But in the near term regulatory noise really does, you've got to be considerate when you're making investments. And so when we speak to companies, we're sure they ask about their exposure to regulation. And when we look at our overall portfolio, we want to measure or hedge positions so that we can address that risk. But regulation and the way we look at things isn't only a risk. It creates short-term dislocations and opportunities as well. I mean, look at Chinese regulation and how they've

enforced their ban on minors and what that's done for the markets and the public markets. It's just so challenging and devastating for the Chinese miners who have to move their minors to other jurisdictions and find energy and do it in a short period of time. And this has created a windfall for North America miners as global hash rates have come down. And they've taken share in the near term due to less competition. So you've got to be measured and thoughtful about regulatory risk. But I'm excited about the opportunities as well. I mean, the China point is a great one.

The speed that that happened was breathtaking in terms of the shutdown, the immediate drop in hash rate. And so how are you staying up to speed on that? Is that just scouring for publicly available? data sources trying to talk to people that are running these businesses. What's that research process look like? Yeah, there's outside data that shows hash rates. There's outside consultants that we've spoken to. The south side tracks it. And we had one of the largest Bitcoin miners in our office today and has spoken to a handful this week. So something we're really in touch with. But we may know and have as much information as you can, but dealing with the Chinese and what

they're doing and how they're behaving. It's a really opaque market. So while the Chinese miners and equipment companies are being displaced, they're very tricky on the short side because it's hard to know exactly what's going on. Yeah, that makes sense. So in your day-to-day, obviously, your friends and colleagues with a lot of folks that are on the public equity side that are not involved in the blockchain universe, when do you think that this starts to become much more of a mainstream phenomenon where you will have people like you at scale deploying. You know, right now you're sort of a lone wolf is my perception in this market. I really think it's fascinating, Matt.

It's kind of evolution. I've never, I don't know, maybe there's been other scenarios like this, but I'm finding, I want to date myself, but it's my friend's grandchildren that are driving this and their parents and the older guard is just skeptical. But where there have been people of my generation, and again, I've been doing this 30 years have gotten intrigued with the space. It's really from their family. I think it's just going to be gradual adoption. And as I mentioned, I just think there'll be more public companies, more institutional investors. And, you know, I just think investors are going to gravitate

to equities because investing in cryptocurrencies and trading strategies and even VC is something that's not normal on every day for a lot of American investors. though most of them are very familiar with investing in equities. Yeah. Well, I think that makes all the sense in the world. And I certainly think that it's a big and growing market. Well, I want to thank you, Mark, for coming on the podcast. Hopefully we can make this more of a frequent thing.

And I'm sure the universe of companies that you'll be looking at will only be growing, probably at the same clip as the universe of companies that we're looking at on the venture side. So thanks for coming on the podcast. Oh, great. Thanks for having me. That's a lot of fun. Thanks for listening to another episode of On the Brink with Castle Island. To find out more about Castle Island, visit castle island.V.C.

To listen to all of our podcast episodes, please go to On the Brink-Podcast.com or just click on the tab in our website. Thanks for listening.