The cryptocurrency universe has exploded over the last few years. While the mania isn’t as pervasive as it was in 2017 when bitcoin reached an all-time high of $20,000, it still has enthusiasts and critics alike arguing over whether cryptos have a future as a form of payment, a store of value, and a viable alternative investment. For simplicity, we’ll just consider bitcoin in this article.
Warren Buffett has said about bitcoin: “It has no unique value at all.”, and “It doesn’t produce anything. You stare at it all day and the little bitcoins come out or something like that. It is a delusion, basically.”
He also said that “if you had bought gold at the time of Christ and you figure the compound rate on it, it’s a couple tenths of a percent.” Buffett was relating that to bitcoin in that you can buy it, but it will never produce anything of value. He called bitcoin a “mirage” in 2014 when the price was $600. With the current price at $5,500 it has vastly outperformed the broader market, even Buffett’s own Berkshire Hathaway.
Buffett himself said he sticks to investments in his circle of competency. He’s even expressed regret missing out on the big rally in technology stocks like Amazon and Apple. Is the greatest value investor of all time wrong on the future of cryptocurrency and its investment potential? Maybe he just doesn’t understand it?
So the question arises, can an informed investor consider cryptocurrency as a good investment? Should we add it to our portfolios?
It depends what we define as an investment. If we consider an investment as something that produces cash flow, then cryptocurrency doesn’t fit the bill. Some stocks produce cash flow in the form of dividends. For those stocks that don’t, investors expect to profit from the price appreciation of the stock as a result of cash flow from the business. Bitcoin produces zero cash flow. Yet it’s price can still appreciate due to demand, scarcity, and if it becomes widely accepted as payment and a store of value, similar to gold.
Perhaps bitcoin could even be used an as inflation hedge against central bank malfeasance. In this way, it could protect against currency devaluation as a result of excessive money printing by a government.
Let’s look at the case for and against cryptocurrencies as an investment.
The Case for Cryptocurrency as an Investment
Cryptocurrencies have made many investors and speculators rich over the last few years. We’ve all heard the stories, testimonials, and seen TV appearances of crypto millionaires. But should a cryptocurrency such as bitcoin be considered as a good long-term investment and addition to a portfolio?
To really understand why cryptocurrencies are revolutionary, we have to consider the blockchain. For simplicity, we’ll just consider bitcoin as a potential investment.
Most of the top cryptocurrencies rely on the blockchain as the underlying technology. A blockchain is a shared digital ledger where the verification process for transactions is decentralized. Members of the network verify and record the transactions after which the ledger can’t be fraudulently altered.
In this way blockchain technology can be extended to record transactions in things such as financial market securities, physical assets such as real estate, company inventory, and more. It has the potential to replace or seriously disrupt centralized intermediaries such as banks or stock exchanges, which are the “middle-men” dependant on transactions going through them. It’s no wonder they see blockchain and cryptocurrencies as a threat.
It’s this potential mass disruption to centralized networks where owning cryptocurrency can potentially be a good investment. But which of the 1500 cryptocurrencies in existence to choose from? That’s a good question. But bitcoin and ethereum, being the earliest, could be a good bet.
Another reason for investing in a cryptocurrency such as bitcoin is the same reason one would invest in gold: As a potential inflation hedge against currency devaluation. There is no limit to how much currency a central bank can create. If a central bank prints too much money, it lowers the value of that currency and the amount of goods one can buy with it.
Bitcoin’s algorithm only allows 21 million bitcoins to be created. This creates scarcity and could cause a cryptocurrency such as bitcoin to rise in value over time. For example, many savvy Venezuelans were able to convert whatever paper currency they held to bitcoin while the country went through hyperinflation and revolution, thereby preserving some of the wealth they had. If they were able to escape the country, they could always access their bitcoins and potentially convert them to a stable currency.
If investors start to see bitcoin as a stable store of value that’s easily portable across borders, readily convertible into other currencies and secure from theft, then bitcoin can steadily gain value over time.
A cryptocurrency could also be a good investment as more vendors start to accept it as a form of payment. Currently, Expedia, Overstock, Microsoft, and Virgin Galactic are a few firms that accept bitcoin as payment. If Bitcoin’s value stabilizes and its volatility decreases, more companies may accept it as payment, and bitcoin can potentially appreciate in value over time.
The Case Against Cryptocurrency as an Investment
The issues against an investment in cryptocurrency are numerous. Bitcoin’s success has invited mass competition. Subsequently, we now see over one-thousand cryptocurrencies in existence so it’s hard to predict which will come out on top. There’s also the potential for heavy-handed regulation by governments that could make life difficult for investors.
Bitcoin’s price increase has been exponential over the last 7 years or so. Although off its highs of $20,000, investors buying bitcoin at around $5,500 have to ask themselves if buying something that’s risen thousands of percent in a few years has more upside or if they’re just late to the party.
While bitcoin’s volatility may make it attractive to short-term traders, it makes it less likely for transactors to use because of the uncertainty in value. This could put a hamper on its value increasing.
Another reason against a cryptocurrency investment is that it provides zero cash flow. As value investors we expect an investment to provide some sort of return. This could be in the form of dividends, or buy-backs, or an increase in cash flow from reinvesting in the business. Since a crypto like bitcoin doesn’t provide cash flow, investors have to rely on the price increasing due to demand. It becomes a pure supply and demand game and hoping at some point down the line another buyer will emerge to buy your bitcoin for a higher price than you paid.
Although several retailers accept bitcoin as payment, in terms of processing transactions, bitcoin can process about 7 transactions per second, falling severely behind Visa’s ability to process 65,000 transactions per second.
Valuing a cryptocurrency such as bitcoin is also difficult. Normally, we as value investors want to buy investments below their intrinsic values. For that we have to value investments using a discounted cash flow model. Bitcoin provides zero cash flow, so we can’t use a DCF valuation. The only way we can value bitcoin or any other cryptocurrency is relative to another currency. This is just like all fiat currencies are valued relative to each other, like USD/EUR. The difficulty in determining a “fair” value for a cryptocurrency like bitcoin is another reason against investment.
Security is also a huge problem for cryptocurrencies. There have been several high profile thefts of bitcoin and other cryptos over the years. The most notable recent one was the 2018 hack of Japanese exchange Coincheck, which saw $530 million-worth of cryptos stolen.
Another high-profile theft was perpetuated against the bitcoin exchange Mt. Gox in 2014, where about 850,000 bitcoins valued at $450 million at the time were stolen. This is in addition to several other smaller hacks. In these hacking cases, investors have almost no recourse. They can’t go to the SEC and file a complaint, they don’t have FDIC depositor’s insurance, they can’t call police, nor can they go after and sue some anonymous hacker.
The answer to this could be to have a centralized regulated authority guarantee a coin holder’s investments. However, since cryptos are all based on the concept of decentralization and no regulation, it’s hard to imagine that happening soon. Until the crypto universe can provide better security from hackers or a way to insure a cryptocurrency holder’s assets, the prudent long-term investor is better off staying away.
The question of whether a cryptocurrency such as bitcoin is a good long-term investment really comes down to how confident an investor is that the particular crypto will be accepted as a medium of exchange, a unit of account, and a store of value.
If bitcoin becomes easier to transact in, becomes more secure, stabilizes in value and maintains buying power, then it could continue to increase in value and be a solid investment. An investor in bitcoin is similar to an investor in gold in that regard. They don’t receive cash flows but hope for prices to increase due to scarcity and demand increasing.
The younger and more technology savvy will be the biggest investors. Also, as trust in governments and central banks decrease, then we should continue to see investors gravitate toward cryptocurrencies, attempting to protect their wealth and purchasing power.
For the disciplined value investor however, there’s plenty to be concerned about, especially since we only purchase investments below their intrinsic values, and it’s difficult to determine whether a cryptocurrency is undervalued. If an investor is concerned about potential dollar depreciation, then an investment in bitcoin, in the same way as gold, may be the best thing to do. If anything, cryptocurrencies should represent a small portion of a prudent investor’s portfolio to provide diversification.
The technology underlying bitcoin, the blockchain, is where the real breakthrough and genius is. Investors should be on the lookout for companies that utilize or provide blockchain technology to streamline and make businesses more efficient. That’s where the money is likely to be made. Just as during the gold rush, the ones who really got rich were the merchants selling supplies to the gold miners.