• Tarpon US Equities

Convexity, part two

In the world of blockchains and cryptocurrencies (yes, we have been studying it, how couldn’t we?), there is a stark division between Bitcoin and Ethereum. Bitcoin is the extreme in terms of decentralization, rigidity, and “faithful” followers. This is both good and bad. Good because if any crypto asset has a shot at getting humans to shift the “mass madness” of putting money into gold to doing the same with a digital asset, Bitcoin is the one, because it has a strictly limited supply, has had a huge upstart in terms of believers, and is extremely safe from cybercrime, not to mention having a mysterious, unknown creator. Gold is impossible to mess with, just as its digital equivalent may need to be. Bad because each transaction on its blockchain requires a lot of computing power, energy, and time, ultimately rendering it less prone to be the new computing platform that could catalyze a Web 3.0 that many herald (though some question it, saying a lot can be done besides the core chain, coming to it sporadically, but effectively – but that would require users trust developers or companies working on and maintaining these side pieces of code).

Quick note before we proceed: for investors like Zeca and me, who focus on productive assets, such as farms, factories, and companies, it is almost impossible to wrap our minds around an asset, be it gold or cryptocurrencies, whose value lies on the collective belief that it is worth something; this is what I referred to as “mass madness” above. Nonetheless, after a certain tipping point in terms of scale, which Bitcoin may be reaching (we are not the ones to say), many people may no longer consider it a complete madness, just another social/cultural reality.

The Ethereum network and its currency, Ether, were created by a young genius, Vitalik Buterin, in many aspects to address the less desirable features of Bitcoin. Here we see a first big difference, if not an owner, Ethereum has a clear and outspoken leader who has already led the blockchain and its community through some pivotal choices, one of which the recent change of method to establish new transactions on the chain, from proof of work, which is Bitcoin’s method (computers fighting each other off to break an algorithm and get a crypto reward to put together that last block), to proof of stake (in which Ether owners deposit their coins in a pool, so that they are allocated the rights to complete blocks, in exchange for coins, effectively making some interest on their money). One can quickly see the benefits and drawbacks of proof of stake: on the good side transactions will be quicker and cheaper, not to mention more eco-friendly due to lower energy consumption, on the other hand it leads not only to a likely larger supply of coins, which Vitalik argues should fall between 0.5% and 2% of the current stock annually and be governed by a demand-supply system for interest rates on Ether, but also to some technical risks on security and the possibility of power concentration (though on Bitcoin the mining game also leads to concentration as highly capitalized companies are created to develop and deploy hardware specialized in that code-breaking computing exercise).

It is worth noting that most new applications on Web 3.0 are being developed on Ethereum today, though they are all quite new and far from getting mainstream usage (NFTs have got a good level of attention recently), meaning this new world can, and likely will, still change quite a bit.

Interestingly, when reading about all of this, I came across an outstanding blog post from Vitalik, entitled “Convex and Concave Dispositions”. If you read our last annual letter, you will remember our main theme was convexity. But whereas I wrote about positive-convex outcomes (or, better, good odds of which) as something desirable in investments, Vitalik used the terms concave and convex for a totally different analogy, focusing on the process rather than on the outcome, which made me come back and complement my thoughts.

It is not necessary to understand the rest of this article, but I highly recommend you read Vitalik’s post (https://vitalik.ca/general/2020/11/08/concave.html) as well as our letter (https://www.tarponusequities.com/post/tarpon-us-equities-2020-annual-letter).

Vitalik writes about people’s predisposition to be either extremists, which he parallels to a convex curve, or conciliatory, akin to a concave one, saying he leans conciliatory because this mindset leads to better outcomes in most aspects of economic and social life, or at least to better probability-weighted outcomes. He also ponders that a concave approach is not always the best, for example, in terms of managing Covid-19 with a lockdown, it seems society is better off with a complete one than a halfhearted measure. Our ethical beliefs and personal values are another example where convexity better fits – we cannot compromise for a little corruption.

He uses the analogy to picture the mindset difference between Bitcoin followers (convex) and Ethereum supporters (concave). Nevertheless, interestingly, and he did not come to it, by building the bases for a new computing paradigm in a more conciliatory manner, he and the Ethereum community may land on a rather convex outcome, with their blockchain supporting a whole new breed of software applications – in fact, they are aiming for this, being pragmatic and conciliatory when needed. They may also land on a convex outcome on the other end of the curve, with Ethereum getting discredited for some reason, such as a serious attack or lost credibility - it will all depend on how good their decisions will be and how well they will execute, which is not unlike our situation as active investors.

Coming back to our letter, what I argue in there is that in investing we, at our fund, with our tools and abilities, should aim for convex outcomes, which does not mean we should be convex/extremists on how we do so, to the opposite. History has proven that blind beliefs in investing lead to disaster, just look at the late 90’s tech bubble or the mania with financial stocks and instruments in 2005-07. In other words, in our investment process, we aim for convex companies, but we go after them with thoughtfulness and balance, often being pragmatic and concave, but not necessarily always or for everything – focus, which is essential in many aspects of our job, such as how to allocate studying time, is intrinsically correlated to a convex approach.

Note: our portfolio today is made mostly of companies with concave outcomes, some even boring. Why? Because we are pragmatic instead of hard-nosed in the way we approach risk.

To close, Apple wouldn't be anything close to the powerhouse it is today hadn’t Steve Jobs adopted a concave, conciliatory approach (yes, even him!) enabling outside developers to create apps for the iPhone, breaking up with his long-held dogma that Apple should fully control its products (an approach that had served him fine until that point). Vitalik closes his post with the most brilliant point: for most positions in life we have the option of looking at it and choosing our next steps either through extremist or balanced lens. It is incumbent upon us to choose each time, wisely if possible.

Guilherme Partel

Tarpon U.S. Equities

With contributions from Victor Stabile, co-founder at Liber Capital, a friend who really understands about crypto.

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