In this article I’ll present a very low risk value investment opportunity in a crypto-asset called Rialto (XRL) which I’ll argue is currently trading at a ~40% discount to intrinsic value (as well as a 30% discount to net assets) and which I believe is highly likely to go up 30% in the next month as the company implements measures that allow token-holders to redeem tokens for underlying assets. I’ll start by briefly describing the philosophy of value investment for those who don’t know what it is before digging into the details of this opportunity.

Disclaimer: I am an investor in Rialto (obviously) but I have no other connection to the project or the team nor have I been paid anything to write this article.

What is value investment?

Value investment, the investment philosophy originally put forth by Benjamin Graham and successfully followed by greats such as Warren Buffett, Seth Klarman and David Einhorn, involves assessing an investment’s “intrinsic value” — what it’s really worth based on an analysis of its net assets and discounted future cashflows — and then buying it only when its market price is at a significant discount (generally at least 25%) to this intrinsic value and holding it until more of its value is realised. This difference between the investment’s price and intrinsic value affords us the all-important “margin of safety” to protect us from the possibility of human error and misjudgment in determining intrinsic value. Value investment is therefore fundamentally risk averse, looking to “buy a dollar for fifty cents”.

Graphical representation of the “Margin of Safety”

Value investing is one of the only schools of investment that has been repeatedly proven, both empirically and academically, to generate returns in excess of the market over long periods of time. Indeed, in addition to the notable success of its advocates such as Warren Buffett, there are also a multitude of studies which show that value strategies vastly outperform the market over extended time periods and under many different conditions.

Despite its undeniable success and apparent simplicity, value investment requires the patience and discipline to wait for the right opportunities at the right price. As a result, there are very few value investors and even less of them in the crypto space, where investors instead rely on technical analysis to predict short-term price movements by drawing Fibonacci triangles on market price data and trying to spot “Elliot waves”.

Value investing opportunities are extremely rare in the crypto space as it’s extremely difficult to assess the intrinsic value of most Blockchain companies because most of them don’t have cashflows and don’t publish their financials. Also, most blockchain based companies are significantly overpriced using any standard value investing metrics such as price to book value or discounted future cash-flows. One exception to this is Rialto which we’ll now look at in more detail.

What is Rialto?

Rialto is a platform using automated algorithms to exploit arbitrage opportunities in the cryptocurrencies markets. It was founded by a team of computer scientists, data scientists and economists with the aim of profiting from the massive differences in prices between different cryptocurrencies on different exchanges around the world.

In order to understand what Rialto does it’s important to understand what arbitrage is. Arbitrage is the simultaneous purchase and sale of a certain cryptocurrency on two or more different exchanges in order to profit from a difference in the price between the different exchanges. The transaction must occur either simultaneously or in the shortest possible timeframe to avoid exposure to market risk, or the risk that prices may change on one market before both transactions are complete. Arbitrage opportunities exist whenever there is a difference in price between an asset on two different markets that is greater than the costs of exploiting that difference (in our case, fees).

To make this crystal clear, let’s look at an example. This is the current price of Bitcoin on the top 10 exchanges by volume:

I could take advantage of these price differences by buying 1 Bitcoin on Bitfinex for $9701.6 and simultaneously selling 1 Bitcoin on Bithumb for $10,068.5, thus pocketing $366.9 (minus any fees). This is an example of an arbitrage trade.

Ice cream arbitrage

This is exactly what Rialto does, except instead of a human trader manually inputting orders they have advanced proprietary algorithms that automatically execute trades as soon as sufficiently large price discrepancies present themselves. Also, instead of just using Bitcoin they trade in 23 different currency pairings, further multiplying the array of opportunities available to them.

Background on Rialto

Rialto ICO’d in July 2017 where they raised $10,000,000. The total token supply is 100,000,000XRL and the team own 15% of those (15,000,000XRL) vested over 2 years. Tokens represent ownership of the Rialto algorithms, assets and profits and all profits are paid in a bi-annual dividend to token-holders. The $10,000,000 raised was used in its entirety to fund the asset-pool for the trading algorithms since the Rialto team do not take salaries and are instead paid alongside the token-holders through the dividend. This is a very elegant model which ensures our incentives as investors are fully aligned with those of the Rialto team.

Total asset pool is never increased by Rialto as every 6 months they sell any profits or excess assets all the way back to the initial balances. Thus the value of the asset pool only changes based on the appreciation or depreciation of the assets that comprise it. Due to the growth of the crypto market over the last year, the asset pool has increased ~2.5x since the ICO. The algorithms’ performance and profits are updated on a monthly basis through an online dashboard.

However, the XRL token’s market price has largely underperformed and is currently priced at $0.18, giving the project a corresponding market capitalisation of $18,000,000.

Graph of Rialto market capitalisation

The value opportunity

At this price Rialto is an extremely attractive buy as its valued at ~70% of its net assets which are currently $25,660,416.91. This works out as net assets of $0.26 per token versus current token price of $0.18. This means that if the company were to go bankrupt and liquidate all its assets immediately, shareholders would see an immediate profit of ~30% or $0.08 per token.

Rialto’s current assets

Crucially, this price also values Rialto’s arbitrage algorithms at 0. These are algorithms which since launching 5 months ago in October have generated a net profit of $418,302. Extrapolated out, these are yearly earnings of $1,003,924.8. Bear in mind, the algorithms are still in test phase and are only using 0–25% of the total asset fund and have 50% uptime to avoid any costly mistakes.

Rialto net profit since October 1st

Even if the algorithms stayed in test phase, this still equates to yearly earnings of $1,003,924.8. If we assume a Price to Earnings (P/E) ratio of 5 (which would be one of the lowest P/Es in the S&P 500 and certainly the lowest amongst tech companies) this would still value the algorithm at $5,019,624, putting the total company value at $30,680,040.91, almost double the company’s current market value.

Even if, for the sake of argument, we assume the algorithm is never going to get any better, if they scale it to use 100% of the fund with 100% uptime (which has always been the stated end-goal), that would produce yearly profits of $8,031,398.4. Taking the same P/E ratio of 5, that values the algorithm at $40,156,992. Accounting for its assets, that’s a total valuation for Rialto of $65,817,408.9 — nearly 4 times its current valuation. If we assume any rate of improvement for the algorithm at all which is reasonable since it’s only been live for 5 months, then Rialto is actually worth even more than this.

Whichever way you slice it, it’s clear Rialto is undervalued to the extent it provides a significant margin of safety for investors.

Why is it so mispriced?

For value investors, it’s always important to try and discern the reasons why an asset is undervalued and ensure none of them relate to some fundamental aspect of the business that we missed. To quote Seth Klarman:

“If in 1990 you were looking for an ordinary, four-bedroom colonial home on a quarter acre in the Boston suburbs, you should have been prepared to pay at least $300,000. If you learned of one available for $150,000, your first reaction would not have been, “What a great bargain!” but, “What’s wrong with it?”

The same healthy skepticism applies to the stock market. A bargain should be inspected and reinspected for possible flaws. Irrational or indifferent selling alone may have made it cheap, but there may be more fundamental reasons for the depressed price…When the reason for the undervaluation can be clearly identified, it becomes an even better investment because the outcome is more predictable…Such reasons give investors some comfort that the price is not depressed for an undisclosed fundamental business reason.”

Sometimes bargains exist for a reason

There are a few different reasons for Rialto’s undervaluation, none of which relate to its fundamentals as a business:

1.Incentives: Firstly, the Rialto team only gets paid in dividends, just like shareholders and their 25,000,000XRL tokens vest over two years. As such, they currently have virtually zero incentive to care about the price of the token or take any measures to increase it. Instead, their only incentive is to care about the performance of the algorithm to ensure the dividend payment is as large as possible which will then presumably also increase the token price. Indeed, the Rialto team has been extremely uncommunicative to token-holders and allowed a lot of fear, uncertainty and doubt to build up on their social media channels, causing many to sell.

2. Crypto market opportunity cost: Given the team’s disregard for the token’s short-term market price, in the eyes of the average short-term minded crypto investor, every month spent holding a token like Rialto which is very unlikely to appreciate in price is a month wasted where you could’ve instead benefitted from 9000% “to the moon” gains in some random coin. Given this, many investors have chosen to sell their XRL.

“To the moon!”

3. Disappointed expectations: Many disgruntled Rialto investors points to Rialto’s projection that the algorithms would return 80–120BTC per month in profit. In today’s terms, this would be a profit of nearly $1,000,000/month. However, when the Rialto team made this projection, the price of Bitcoin was $2500, meaning they projected a profit of ~$250,000/month. While this is still significant under-performance as the algorithm has made roughly a third of that, the market has vastly overreacted to this underperformance as at its current price the market is valuing the Rialto algorithm at 0.

4. Limited liquidity: In addition to all this, Rialto also currently suffers from debilitatingly low liquidity with an average 24h volume of $4000 as it’s only traded on two small exchanges according to CoinMarketCap— making it extremely difficult to transact. This limited liquidity puts off many buyers who a) don’t hear about and/or can’t invest in the token as it’s not listed on any of the well-known exchanges and b) worry that they won’t be able to sell the token if they do buy it. However, it’s worth mentioning that most of Rialto’s volume comes from Forkdelta (an exchange not covered by CoinMarketCap) in which the 24h volume is consistently ~$15–20k which is still low, but better than 4k.

All these factors put together have created the perfect storm leading to Rialto being substantially undervalued. However, I believe this is about to change due to two fundamental events happening this month…

Catalysts

In value investment, a catalyst is an event which causes an investment’s market price to approach its intrinsic value, thus unlocking its “trapped value” and causing an undervalued company to stop being as undervalued. These can be events such as a company announcing its going into liquidation, an acquisition/hostile take-over or a share buyback programme.

In the case of Rialto, there are two main catalysts approaching which will lead to an appreciation in its price over the following month:

Firstly, Rialto is launching its platform this month which will allow XRL token holders to exchange their XRL tokens for the underlying assets. This is effectively a stock buy-back programme which virtually guarantees that Rialto will never trade at less than its net assets by creating an arbitrage opportunity for investors whenever XRL tokens trade for under the underlying assets. That means that any tokens purchased right now at $0.18 could be redeemed later this month for assets worth $0.26 per token — an instant 30% profit. Secondly, Rialto will be paying its first bi-annual dividend ever this month, which should be something in the order of $0.005/token or 3% return at current prices (6% annually). While this is definitely nothing to write home about, it’s still worth more than 0 which means Rialto should be valued at something more than its net assets of $25,660,416.91, probably somewhere around $30,000,000.

Risks

Even if the algorithm’s results were completely fabricated and there was never any arbitrage going on, Rialto would still be undervalued taking into account purely the value of its current assets. This being the case, the only risk I can see is that the whole project is an elaborate scam and Rialto intend to steal all the assets and keep them for themselves.

Given all the team members’ names are public, the fact that they are relatively well-known names in the crypto space, their backgrounds and the fact that their main cold storage addresses are publicly recognized and everyone is able to track movements and verify that assets are there, I find it exceedingly unlikely they would risk such a dangerous and public scam and I rate the chance of it being a scam at <1%.

Even if you’re particularly paranoid and believe that there’s an 100% chance the algorithm doesn’t exist and a 20% chance that they’re out to steal the fund’s assets, it’s still undervalued as 90% of the time it’s worth $25,660,416.91 and 10% of the time it’s worth 0, for an expected value of $20,528,333.5 or ~$0.21 per token. In fact, you’d have to believe there’s an 100% chance the algorithm doesn’t exist and >30% chance they’re out to steal the fund’s assets for Rialto not to be a profitable purchase.

Conclusion

To conclude, Rialto is a very solid value investment with a significant margin of safety of at least~40% in a space where value opportunities are often quite hard to come by. Let me know what you think in the comments!