“Only when the tide goes out do you discover who's been swimming naked.” –Warren Buffett
It often takes a black-swan event to uncover which market participants were taking excessive risk with their investment dollars. The sudden unwinding of FTX, the now infamous cryptocurrency exchange, resulted in massive losses for even the most sophisticated investors. Venture capital firms, private equity groups, high-profile celebrities, and so much retail money all trusted FTX and its founder and former CEO Sam Bankman-Fried (also known as SBF).
The collapse has shades of Long-Term Capital Management (LTCM), Enron, Lehman Brothers, and Bernie Madoff all rolled into one scandal. From highly-leveraged financial market wagers to astounding hubris to non-diversified holdings to outright fraud and theft, there are lessons we all can learn from FTX’s fall from (perceived) grace.
“It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so.” –Mark Twain
Lesson 1: Check your ego at the door.
While Twain is credited with this century-old quote, it lends itself well to the events of the past year with crypto and at FTX. Back in November 2021 — when interest rates were near all-time lows and free money was there to be borrowed – the price of bitcoin soared to a peak of around $69,000. Ether was even hotter, rising from under $100 in March 2020 to almost $5,000 in Q4 last year. Speculative altcoins were day traders' best friends during bouts of Covid as folks worked from home and had plenty of stimulus cash burning holes in their electronic pockets. The total value of the digital currency landscape peaked near $3 trillion. For context, that’s about the same size as the entire S&P MidCap 400 and S&P SmallCap 600 combined today.
How could the nascent asset class be worth so much? So many value investors and long-time money managers asked this question while some all-in tech professionals and even those in Gen Z became fast millionaires. Their daring bets and the so-called ‘hold on for dear life’ (HODL) mindset worked during the meteoric rise of crypto. Confidence turned into hubris. Trades became investments. Portfolios of stocks transformed into digital wallets of cryptocurrencies.
At Dana, we are not fast-money traders. We are not crypto investors. We believe in owning companies with a track record of producing free cash flow that also have sound environmental, social, and corporate governance (ESG) policies. With governance, we value management teams that exude and demonstrate humility. We also own shares in tech companies as we believe the future is likely driven by advances in automation, processing, consumer behavior, and so much more that major tech-media-telecom firms will deliver on. Digital tokens, however, are unproven and produce zero cash flows.
Our portfolio managers did not get tempted by the crypto craze since it does not fit what we look for when selecting investments. Moreover, our team with decades of experience has seen the calamities of LTCM, Enron, WorldCom, Tyco, Adelphia, Bear Stearns, Fannie Mae, Freddie Mac, Lehman, Madoff, and so many others. Did we foresee crypto’s crash and systemic failure of supposed “exchanges” (more aptly described as reckless private dealers) in 2022? No, but we have been skeptical of the mania. Seeing Mr. Bankman-Fried donning the covers of investment magazines as the next Buffett or described on financial TV as today’s J.P. Morgan did seem like a stretch, though.
“All of humanity's problems stem from man's inability to sit quietly in a room alone.” –Blaze Pascal
Lesson 2: The fear of missing out (FOMO) effect is real.
Following crypto’s zenith in November 2021, we were all treated to celebrities one by one endorsing the promises of what bitcoin and ether could deliver. Who can forget Super Bowl LVI between the Los Angeles Rams and Cincinnati Bengals? While the Rams won by a field goal, maybe the most memorable part of the four-hour TV event was Matt Damon’s now-infamous FTX commercial. The spot featured Damon pitching crypto to billions of watchers. “Fortune favors the brave,” he said.
So, if you and I were not hodlers,i we weren’t brave enough? Were we meant to feel like fools and the out-crowd if we were not allocated to digital currency? That’s perhaps how many people sitting in their living rooms felt as the game progressed. Along with FTX, Crypto.com and eToro ran ads during the game, effectively enticing retail investors to get in on the action. Maybe it worked.
Even before the big game, more than one in three Super Bowl viewers say they were likely to invest in cryptocurrency, according to a poll conducted by Morning Consult.ii Another survey in May 2022 conducted by Ascent found that 46.5 million Americans who had never before purchased cryptocurrency said they were likely to invest in the asset class for the first time “within the next year.”iii There is a bias at play here — it's called social proof, and it describes the notion that people are more likely to participate in an activity if they see others doing it. There’s safety in numbers. We want to be part of a crowd. Being an outcast is painful. All of these inherent feelings drive the FOMO effect.
At Dana, our process is our superpower. It is by sticking with a tried, true, and tested method that we can avoid bubbles. Our superprocess consists of quantitative modeling to rank potential investments and qualitative research into business models and management, while also integrating ESG factors. We add to this a disciplined adherence to sector and industry weightings so that we are not unintentionally allowing human bias to affect your investments.
We check our egos at the door, and we slam that door shut when FOMO tries to enter.
“When you were made a leader, you weren't given a crown, you were given the responsibility to bring out the best in others.” –Jack Welch
Lesson 3: Corporate governance might no longer be the third wheel in ESG.
Bankman-Fried's arrogance and downright unlawful behavior will go down in finance lore as among the worst examples of how to run a business. There was no corporate governance. FTX did not have a board of directors. There was no Chief Financial Officer making decisions. It was primarily just Mr. Bankman-Fried running the show.
SBF also owned the trading firm Alameda Research. It turned out that the FTX founder moved customer deposits from the FTX exchange to Alameda in order to make risky bets. Some of those wagers included investing in other crypto exchanges during 2022 so that those floundering firms would not have to liquidate their crypto positions, which would have sent FTX into a tailspin. The house of cards finally fell when rival-company Binance pulled its offer to rescue FTX.
The purported market wunderkind once had a net worth of almost $30 billion back when he was dubbed as crypto’s white knight. Today, he’s seen more like a black swan, as his fortune is all gone and some speculate he will end up in prison for his financial transgressions. John Ray III, the incoming CEO of FTX tasked with cleaning up the mess left by SBF, says the situation at the bankrupt exchange is even worse than the corporate governance structure (or lack thereof) at Enron more than 20 years ago. SBF used customer funds to not only make dangerous investments but also to buy homes and luxuries for FTX employees. Mr. Bankman-Fried once said of regulators, “they only make things worse.”
How all of these red flags are just now being reported by mainstream financial media makes you scratch your head. What’s more, FTX was given a higher leadership and governance score than Exxon Mobil by Truevalue Labs.iv We expect more emphasis will be placed on the ”G” in ESG in the years ahead in the wake of the FTX blowup. Better reporting, research, and evaluation of all firms must be done so investors with a preference for strong ESG companies can have confidence in what they look to own.
Advisors now more than ever must be equipped with the tools and knowledge to navigate the growing field of ESG funds. Due diligence might replace crypto as the next hot investment fad — the difference is that researching ESG managers better will always be important.
“Fortune favors the … disciplined.” –Dana
Investors today, many of whom are new to the scene, might be afraid of what comes next in these volatile markets. Will more bodies rise to the surface following the FTX fallout? Recall that Bear Stearns was rescued for pennies on the dollar on St. Patrick’s Day 2008, but it was not until six months later when Lehman went bankrupt along with other leveraged financial firms going bust.
We do not know if other institutions will get hit hard following the FTX debacle. And we are okay with that. Dana’s team of portfolio managers has the edge of a sound process and deep experience to weather whatever comes next. Our team has diverse, specialized knowledge, and we are adept at navigating challenging market environments and developing customized solutions for our investors and clients.