The SportsFolio Journal - March 19, 2021

Digital Collectibles & Non-fungible Tokens: New Business or New Bubble?

The Museum of Mahomes is open. 

News circulated last week that Patrick Mahomes is jumping on the non-fungible token (NFT) train, and what a fast-moving train it is. Let’s review some highlights:

  • Mark Cuban sold this tweet for $952.

  • NBA, in partnership with Dapper Labs, created Top Shot, a marketplace for licensed digital collectibles, called “Moments.” Following a meteoric rise earlier this year, it is still going strong: according to the website, $400 million worth of collectibles changed hands as of today.

  • The NFT of a 10-second video titled CROSSROADS by Beeple (real name: Mike Winkelmann), sold for $6.6 million. If you don’t have $6.6 million, don’t worry, you can watch it here:

All of this happened literally in the last couple of weeks. 

What is going on here? Is this the next business frontier? Or is it the latest bubble that will come down faster than it went up?

Why Do People Collect?

Who knows? Everybody has a different reason, but originally, collecting something was likely an emotional endeavor. It appealed to three fundamental instincts/desires we have:

1) Hoarding Instincts. As a general matter, this may be an overreaction to our inability to hoard much when we lived in the cave. There are also some evolutionary biology-type explanations - some animals hoard because they are advertising to a potential mate

2) Longing for Nostalgia. The past was great. It probably wasn’t that great actually, but because the brain tends to remember the good stuff and suppress the bad, it always feels better than it actually was. 

3) The Need to Feel Exclusive. Let’s admit it, it feels good. Why would we otherwise have VIPs, first class, etc.? Wanting something that others don’t have is, for better or for worse, a fundamental trait of humans.

We haven’t yet gone into the full history of this yet, but it is probably not reasonable to assume that collectibles, at least initially, were likely utility generators with large emotional appeal. Like every assumption, this one must be tested, but for the sake of the argument, let’s go with it. 

Anything can be a collectible of course: stamps, cars, wine, art, etc. That said, sports is somewhat unique because it is an intergenerational connector that binds families. Other collectibles are certainly capable of triggering similar emotions, but perhaps not as much as sports.

The result: physical sports trading cards. Things you could buy at your local store for just a few cents. A source of pride, probably not many of these initial collectors thought too much about what these cards would end becoming worth. 

The Bridge from Utility to Pseudo-Assets

Can money buy happiness? Whether it can or can’t is beside the point. As long as it is presumed to buy happiness, there will always be people who use their wealth to create the emotions they want. Furthermore, as long as there is a buyer who is willing to pay a higher price, you can sell anything. 

To be clear … if somebody is willing to pay $5.2 million dollars for a 1952 Mickey Mantle baseball card, or $1.3 million for a Wayne Gretzky rookie card, or $4.6 million for a Luka Doncic rookie card, or … you get the idea. Here is the complete list. If somebody is willing to pay these sums, more power to them. 

Where we take issue with all of this is not that people are paying exorbitant sums of money for a piece of paper with some pictures on it, but rather, that a piece of paper is now considered an asset that you can invest in it. That is a myth that does not seem to be fully comprehended. These cards do not generate any cash flows. You can price them, but not value them. You can speculate on the price and hope that somebody else is willing to pay more, but you must also understand, and be aware, that a buyer may never come along and pay the price you are looking to obtain. That last point could very well leave unsuspecting speculators holding significant losses for items they were sure would return a handsome profit.

Alas, speculation is also a natural itch that needs to be scratched. Once enough potential buyers emerged to buy stuff from you, the initial purchase of a sports card did not need to be a utility generator, anymore. It could also be a speculative trade where one is buying not because they care about having a Jordan picture on a piece of paper, but rather they think what they are buying is underpriced. A brief history of sports cards is here

Perhaps nothing exemplifies the speculative focus better than fractional collectibles sites. Rally is an example. Rally is a site where you can buy a piece of a sports card, car, etc. Essentially, collectibles are split into smaller pieces and sold to the collectors through a process that very much resembles an IPO. There is also secondary trading, but it only happens during limited windows. Technically, if you buy a piece of a collectible, you are buying shares in a sub-company that owns the collectible. Rally is regulated by the SEC.

Rally came to our attention back in 2018. It was receiving decent press. TechCrunch and Bloomberg covered it. It raised money on a valuation of $25 million. To be sure, there was skepticism, this Hagerty article (Hagerty is a driving-focused publication) asked the question bluntly by using the following headline: Investing in shares of collector cars: Stupid or savvy? 

The drawback was obvious. Fractional ownership is not a great way to show off. 

“Hey, do you want to see my Ferrari, babe?” 

“Sure. Let’s go. Where do you keep it?”

“Uh … on my phone.”

The article noted this tension by quoting Hagerty’s vice president of valuation services.

So what do people think about the concept of fractional classic car ownership? “When you look at Rally Rd. strictly in investment terms, there are probably better ways to make money,” Brian Rabold, Hagerty’s vice president of valuation services, says. “But it really democratizes the opportunity to invest in cars. You don’t need to be able to pay $60,000 to buy a car; you can get in for $60.”

One obvious drawback, he says, is the lack of physical ownership—a sentiment echoed by many in the enthusiast community.

“The coolest thing about these cars as investments is that you have a tangible thing you can take out and show and enjoy and meet people with,” he says. “The downside of this fractional ownership model is that you miss out on the best parts of the ownership aspect.”

That was the bridge right there. Once you took away utility, what was practically left was speculation on the price action. 

Slicing and dicing a collectible into smaller pieces perhaps gave the speculator an easier access point just like Robinhood gave traders an easier access point by offering trading in fractional shares. Even the pitch is the same; Robinhood says:

Our mission is to democratize finance for all, and our Fractional Shares feature provides unique investing opportunities to people who might not otherwise be able to participate in the stock market.

Rally says:

We set out to leverage our experience as a tech entrepreneur, product designer and investment banker to democratize alternative asset investing, and ensure that it keeps up with the times and continues to engage future generations.

Democratization of finance. Democratization of investing. Our antennas go up whenever the democratization of anything is part of the pitch. Not all such pitches are made by bad actors, of course, but it certainly is a sign that more due diligence is needed. 

What exactly is wrong with these seemingly noble goals? Robinhood’s problems are obvious and we covered them extensively in previous issues, for example, see our November issue or February 4, 2021 issue. You can invest through Robinhood, but they gamify it to dangerous levels. Investing is serious business, it is not a game.  

Rally is different. There is no gamification we can see, and if we are purely grading intentions, we’d score Rally higher than Robinhood based on what we see in the public domain. The problem is, whether they realize or not, what Rally is selling is not a way to invest, but a way to speculate. 

The difference is not just semantics. Understanding this subtlety may be the difference between owning a beach house when you retire, or becoming a beach bum. As Ben Graham aptly observed in his seminal book The Intelligent Investor: The Definitive Book on Value Investing:

There are many ways in which speculation may be unintelligent. Of these the foremost are: (1) speculating when you think you are investing; (2) speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; and (3) risking more money in speculation than you can afford to lose.

Again, to be very clear ... the problem is not NFTs per se, the problem is that making people believe that they are investing when they are actually speculating. This doesn’t seem to bother many people. Rally, for its part, is doing just fine; it closed a $17 million round last summer. The valuation was not disclosed, but we know it was $25 millionish when it was reported they had 50,000 users; now they have 200,000. Even if we extrapolate linearly, that would give Rally a nine-figure valuation. Not bad for an app that sells you a piece of a car that you can’t put in your garage. 

The Bridge From Physical to Digital

That something becomes digital does not change the fundamental truths about assets and investing. It does mean, however, that a new set of collectibles that were previously not possible can now be created. It also means that because one player can have many “moments,” one person can post many tweets and one artist can paint many pictures, the universe has not more than doubled. With digital, the universe of collectibles has expanded exponentially. 

That does come at a cost, obviously. It means that the supply is increasing exponentially and the short-term incentives of issuing more of these NFTs may contribute to its eventual demise. How many Stephen Curry layups or Zion Williamson dunks can people collect? 

Top Shot is doing great, but if you bought anything in the Marketplace in the last couple of weeks, there is a good chance you are underwater. If you have been diligently hunting the packs, you may be able to turn small profits, like maybe $10-15 on the common cards. Another Ben Graham observation from The Intelligent Investor: The Definitive Book on Value Investing is in order: “there is intelligent speculation as there is intelligent investing.” If you must speculate, packs are probably the way to go. 

Beyond that, the large majority of these moments will never reach the $1 million mark. Only 16 physical sports cards have ever done that. Given the supply is much higher with NFTs, it really doesn’t seem possible that digital alone changes the pricing for the better.  If anything, it makes it worse. The success of sports physical cards can be replicated in the digital world only if demand grows even faster than supply. True - with the digital tendencies of this generation, that is a possibility but is it probable?

What could be more interesting is if these moments became building blocks of something else. Maybe a digital trivia game? A virtual slam-dunk competition? A highlight reel on Youtube that would bring ad dollars, assuming moment owners are allowed to do that? Integrating them into shows, movies, etc., again, assuming moment owners have the legal rights to “rent” these moments? 

What digital really does, beyond expanding the collectibles universe, is to open up integration possibilities like these. What rights one has when one owns the NFT, but not the source content that led to the creation of NFT in the first place, will certainly become an issue that will be debated for years to come.