FRMO Corp letter to the investors for the years of 2017.
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Dear Fellow Shareholders,
The past several years, insofar as FRMO is concerned, have been devoted to the search for alternatives to the conventional asset classes. It might be recalled that the 2016 shareholder letter concluded on this note. Actually, the 2015 shareholder letter contained similar sentiments. At the end of fiscal 2015, we had about $44 million in cash and equivalents on our balance sheet. At the end of 2017, we had over $51 million in cash and equivalents on the balance sheet.
Nevertheless, we have been increasing our exposure to two areas. These are cryptocurrency and hard assets. We believe this logically follows from our view of the traditional investment landscape. Bonds of any type clearly offer negative real rates of return after taxes. Equity valuations are high as a consequence of low interest rates. Cryptocurrency is merely a reaction to global monetary policy. If this policy does not change, in our humble opinion, one should expect to see a vast increase in investor interest in this area.
Hard assets, which refers to commodities, is the great exception among the conventional assets. Gold actually traded at $1,719 per ounce in October of 2012. It has since lost about 26% of its value. West Texas Intermediate crude oil actually traded at $110 per barrel in September 2013. It has lost 56% of its value. Even the IDEX Diamond Index has declined by about 13% since July 2014.
Since these have been our areas of focus, we shall direct proportionately more of the commentary of this shareholder letter to those subjects. We require disproportionate space, since cryptocurrency is a subject with which few people are likely to be familiar and it needs to be explained. As a consequence, this letter will necessarily take a somewhat different form than prior letters. Nevertheless, as was the case with the 2016 letter, we commence with some strategic considerations.
A. Strategic Considerations
FRMO cash and marketable securities alone total about $70 million. The various partnerships in which FRMO is invested control at least another $225 million, inclusive of the FRMO investment in the funds. FRMO alone holds nearly $25 million of that sum, as one can readily see on the balance sheet. Horizon Kinetics LLC (“Horizon”) has another $40 million in liquid assets, apart from investments in the same funds as FRMO. All of this is exclusive of any form of borrowing capacity.
We have the ability to act on a large scale if necessary; however, at least for the past several years, we have been reluctant to act. The reasons for the inaction are fairly straightforward. Fixed income assets, viewed after taxes and after any of the almost inevitable errors that we might make, clearly offers a negative real rate of return. Of course, a negative real return is true of cash as well. Nevertheless, at least the nominal value of cash is not in question.
Equities are more or less at the highest valuations in history. Ordinarily, such valuations provoke a negative reaction. In the current instance, the valuations and attendant negative real rates of return have provoked the birth of a new asset class: cryptocurrency. There is a reasonable chance of failure, as there is in any entirely new venture; nevertheless, in the past year, we have dramatically increased our exposure to this new asset class.
B. Cryptocurrency: What is it?
Cryptocurrency is a digital asset that uses cryptology to make transactions secure. It is decentralized insofar as the creation of new units of currency is fixed via an algorithm, and it is outside the control of central banks. The fact that the currency is digital is not an innovation. Most people already use digital assets. Apple Pay or Pay Pal are more sophisticated versions of digital assets. The technical innovation is that cryptocurrency uses a distributed ledger as opposed to a centralized ledger used by banks. Every node in the system of a distributed ledger has a copy of that ledger, so that corruption of the system would necessitate corruption of a vast number of ledgers simultaneously. The ledger cannot be corrupted without gaining access to encrypted private keys. Each participant or account in a distributed ledger has a different set of encrypted private keys. Of course, a private key can be stolen; however, that theft would be a localized event. Corruption of the system would require the theft of possibly millions of private keys all stored in different locations unknown to the potential thieves. Even then, the thief must act quickly and without the knowledge of the intended victim, since the victim could always transfer the digital asset to a newly created private key if actions is taken quickly. This system is entirely different from and inherently far more secure than the central databases currently used by banks.
Yet, from an investment perspective, this characteristic is not necessarily an interesting feature. All of the code is open source and imitation is invited. From an investment perspective, the innovation is that issuance, or supply, can be fixed. In the case of bitcoin, for example, there will not be more than 21 million units created, and this figure should be reached in the year 2140. As of this writing, there are in existence about 16,519,000 bitcoin.
A currency with fixed issuance cannot be debased by a central bank. The idea that private money could compete with fiat money is not new. In fact, it was proposed by Friedrich Hayek in a 1976 book entitled The Denationalization of Money. He suggested that the problem with private money as opposed to government issued fiat money is one of trust. The public must believe that the private issuers of money will not abuse the power of issuance, that there will be a fixed and verifiable sum of money and no more. Given the 1976 technology, this was not readily achievable. Given blockchain technology, it is easily achieved.
At the moment, most people do not accept the legitimacy of private non-fiat money; however, cryptocurrency was recently made legal tender in Japan. Thus, the possibility exists that a cryptocurrency like bitcoin could become a parallel currency to the fiat currency. Merely as an exercise, to understand the appreciation potential, let us assume that bitcoin becomes a parallel currency to the dollar in the U.S. The U.S. supply of money, known as M2, is currently about $13.17 trillion. The market capitalization of bitcoin is about $67.72 billion. Under the no arbitrage rule, if bitcoin were the functional equivalent of fiat money, one might be tempted to say that it should have the same value as fiat money. In this case, it implies appreciation of 194x, without any allowance for the fact that U.S. M2 is constantly increasing. Of course, bitcoin is a worldwide