A Value Investor’s Perspective on Cryptocurrency

As a stock analyst, I was unusually busy this holiday season—everyone wanted to know about the Bitcoin bubble. As a value investor, you’d think that cryptocurrencies would be one of the last asset classes I’d be likely to research, but when my 16-year-old neighbor started talking about it, I thought it was time to dig in.

The fundamental question for a value investor is how to value the cryptocurrency. Without knowing its value, you cannot determine if it’s in a bubble. Maybe cryptocurrencies are worth much more than they are trading at today, or maybe they aren’t.

In March 2014, Warren Buffett said to CNBC about Bitcoin, “Stay away from it …. It’s a mirage basically. The idea that it has some huge intrinsic value is just a joke, in my view.” Since then, Bitcoin has gained about 30 times! It would take more than 18 years to make such a return at a 20% compounded rate. How could any investor not be tempted by such a staggering return and wonder at the opportunities he’s missing?

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So how could we measure the value of a cryptocurrency?

How to Value Cryptocurrency

The fundamental challenge to valuing cryptocurrencies is the difficulty in determining their intrinsic values. When we appraise stocks, we can make reasonable assumptions on how much cash companies could generate in a given period. We could estimate intrinsic values by discounting the companies’ future cash flows. Without even looking at stock price charts, we could come up with reasonable estimates.

However, currencies by themselves have no earning potential. They are governed purely by supply and demand, which is broadly based on factors such as trust, utility and (sometimes) collateral.

As a thought experiment, imagine that you have no idea about the value of Bitcoin and you are asked to price it. What number would you come up with? A dollar or a hundred thousand dollars? Any attempt to find a reasonable approximation of the value of Bitcoin would be fruitless because it’s virtually impossible to measure its intrinsic value.

However, as much as we accept our limitations in estimating the intrinsic value of cryptocurrency, it is worth evaluating the nature of cryptocurrencies. Such analysis will help us evaluate companies that might have significant assets invested in cryptocurrencies.

To start, I see two broad uses attributed to cryptocurrencies: as mediums of exchange and commodities.

Howard Marks, the famous value investor and co-chairman of Oaktree Capital, asks in his Memo, There They Go Again… Again,  “The price of Bitcoin has more than doubled since the start of the year. Can something that does that seriously be considered a “medium of exchange” or “store of value,” rather than the subject of a speculative mania?”

A volatile entity like Bitcoin can hardly be considered a medium of exchange for most purposes. Bitcoin is purely decentralized and doesn’t have the backing of a sovereign authority, so it is subject to wild volatility. The merits of faster transactions and lower costs are easily outweighed by the volatility, so I’m highly skeptical of whether such a currency will ever have utility for regular transactions.

To inquire more about the monetary nature of cryptocurrencies, I reached out to Professor Perry Mehrling, Professor of Economics at Columbia University and an expert in monetary theory. His view on cryptocurrencies is based on the fundamental fear of credit by the crypto enthusiast. He argues that the paranoid mindset of individuals and institutions is transmuted to a new form of currency. Basically, the fear of concentrated power fueled the urge to disrupt the centralized financial system through a decentralized blockchain technology.

Prof. Mehrling points out that credit is the key to the success of the modern economic system. Credit largely works through trust of future payments through IOUs.

Credit wouldn’t work through anonymous contracts, so there doesn’t appear to be a way to expand blockchain technology for credit. A crypto-credit? How could anyone lend to another without knowing who he/she is lending to?

If cryptocurrencies cannot be used as a means of transaction, what about their value as commodities? Satoshi Nakamoto, the unknown founder of Bitcoin, wrote in the forum bitcointalk.org, “Bitcoins have no dividend or potential future dividend, therefore [they are] not like stocks. [They’re] more like a collectible or commodity.”

Satoshi compares Bitcoin to gold or silver or any other commodity. It is true; Bitcoin is a commodity stored on millions of servers with an upper cap of around 21 million coins. Just like gold, the supply of Bitcoin is limited. Humans have hoarded gold for thousands of years, with the expectation that gold could be exchanged for other goods, and that has stayed true for most of history. Will Bitcoin serve as a digital gold?

There are good reasons to believe that it’s unlikely.

Bitcoin Not a Precious Metal

First, unlike gold, which is a natural resource with no human control of its existence, Bitcoin is a set of computer codes, which is reproducible in different forms with the same set of qualities. Coinmarketcap lists more than a thousand cryptocurrencies, and a thousand more cryptocurrencies could be issued in the future. What would make one currency preferable to others? As hundreds more cryptocurrencies are created and marketed, the popularity of one will likely overtake the other and then another, causing very high volatility.

Second, any government intervention to stop cryptocurrencies would immediately devalue the whole cryptocurrency world of more than half a trillion dollars. Irregularities in price manipulations in unregulated exchanges and the use of Bitcoins for illegal transactions and tax evasions will not go unnoticed for long. Government scrutiny has already started in China, South Korea and France, and the list of countries participating in negative interventions will only get longer.

Calculating intrinsic value becomes irrelevant considering the risk associated with the very nature of cryptocurrency. Given the risk and intangibles involved, there is no way a value investor could identify even an approximate value of cryptocurrencies.

On Bloomberg Surveillance, Nobel laureate economist Robert Shiller got it right, “Professional investors work well when there is something to analyze … but there is nothing clear to analyze here, so I think they might be as much vulnerable to Bubbles as retail [investors].”

Being aware of such a vulnerability, it’s good to remember the parable noted by Seth Klarman in the classic book, Margin of Safety:

“There is the old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, ‘You don’t understand. These are not eating sardines, they are trading sardines.’

So, is Bitcoin an eating sardine or a trading sardine? I think the latter.

Timothy Lutts

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