Volume 92 No. 3 - March 2021
Bitcoin is a currency, just like the dollar or euro. People use bitcoins to buy and sell goods and services. It’s considered an alternative to traditional currencies because it doesn’t exist in paper bills and metal coins. Another big difference is that Bitcoin is not regulated by a government or exchanged through financial institutions. Like cash, Bitcoin transactions cannot be traced and are not subject to much oversight. Because of this, Bitcoin is often used for illegal transactions or other transactions that the parties may want to keep private. However, unlike cash, Bitcoin is transacted electronically and avoids the need for the physical transfer of cash or gold, offering the privacy of cash and the ease of wire transfers.
… Then Why All the Hype?
Recently, demand has surged for the world’s limited supply of bitcoins. As more people seek bitcoins as an investment vehicle, their price has risen exponentially—along with the volatility of their value relative to traditional currencies. Some of this demand is due to a need to transfer value in the purchase or sale of goods or services. Another source of demand is that Bitcoin is viewed by some as an investment alternative to, and an inflation hedge for, the massive amount of money printed by the world’s central banks as they have responded to COVID-19 needs. However, the greater influence on Bitcoin’s rise in price from $5,000 per coin to today’s $50,000 price-level, is speculation. Since 2015, Bitcoin has had several parabolic rises only to crash back down. Its current rise may have further to go, but history has told us that its value will more likely fall than continue to rise for an extended time.
Bitcoins are created by “miners” who are rewarded with a new bitcoin when they compete and prevail over other miners by using specialized hardware to process transactions and secure the network. Due to the extreme amount of communication and computer processing necessary for the world to agree on the validity of any “coin,” it is estimated that the cost to mine each coin exceeds $8,000. To imagine the complexity of this system, in 2018, it was estimated that the network to secure Bitcoin used over 1% of the world’s total energy consumption.
If a bitcoin can be mined for $8,000 per coin, why would anyone pay $50,000?
If Not $50,000, What Is a Bitcoin Worth?
Today’s price of one bitcoin has surged to nearly $50,000, from as low as ~$5,000 as recently as last March.
We view Bitcoin (and other crypto coins) as an alternative currency, sometimes called a cryptocurrency. While Bitcoin is the largest cryptocurrency or crypto coin on the market today, there are many other smaller, less popular types of cryptocurrencies. Distrust in traditional currencies due to rapid debt acceleration and money supply growth is causing some to look for other assets that have a limited or finite supply. Gold has fit this description for more than a thousand years—a store of value across various cultures and societies going back to the eighth century—as governments have come and gone.
Determining whether crypto coins will be able to eat into gold’s “market share” and have staying power as a store of value requires understanding the challenges of Bitcoin and other cryptocurrencies, including:
· Trust: gold has a long track record, crypto coins do not
· Volatility: crypto-coin prices have had a very erratic and volatile price history
· Regulatory: it remains unclear if central banks will allow competition against their currencies
· Security: ability to protect cryptocurrencies vs. gold (for example)
· Pricing: lack of underlying cash flow supporting valuation
· Environmental considerations: Bitcoin’s functioning requires massive electricity consumption
Valuing crypto coins – in this case, Bitcoin – is challenging. Bitcoin does not produce profits or pay an interest rate so it cannot be valued like other securities such as stocks and bonds. This creates some doubt as to whether bitcoins really have any intrinsic value. As mentioned above, the appeal to many is Bitcoin’s potential as an alternative currency, and one that promises to not be diluted by overproduction. If you want a sense of what the stock of crypto coins could theoretically grow to be valued at over time, we can analyze its ability to replace gold.
Currently, some $5 trillion worth of gold is held for investment (excluding jewelry) and crypto coins could replace some, all, or none of that. If Bitcoin comes to be viewed as a perfect substitute for gold, the entirety of the crypto-coin world could be worth $2.5 trillion. If Bitcoin is the only successful crypto coin, one coin could reach $120,000. Of course, its value could also go to $0 if any of our earlier concerns become significant problems.
Bitcoin’s Short and Troubled Life
In its short history, bitcoin has had three sell-offs at the 80% level, testing the conviction of the holders at the time. A key question for all investors to ponder is: Does Bitcoin retain its first-mover advantage, or will several new cryptos emerge and dilute the scarcity value concept? Crypto coins must be viewed as a speculative investment. We are currently not recommending crypto coins as a component of a well-reasoned, buy-and-hold investment portfolio.
Crypto coins are very volatile, and difficult to value. The only purpose we believe they serve is for speculation for long-term capital appreciation. Once the price volatility falls to a more tenable level, investors could start viewing Bitcoin in the same way they view gold. Like gold, the price appreciation would likely be episodic. Also, putting a price forecast on crypto coins is problematic with nothing concrete to base their valuation on. Without a return forecast, we cannot include them in a conservative portfolio.
Keeping all of this in perspective: Bitcoin shows a 386% one-year gain, and that’s bound to capture investor attention. But, 91 stocks over that same time period gained as much or more. There will always be investments with substantial gains. As always, investors should base investment decisions on estimated future potential—not past performance.
We do not recommend a holding in this fledgling asset class, as its history is too short and there are no traditional fundamentals to determine its value. We view Bitcoin as a speculative, high-risk investment and not suitable for our portfolios.
Investment Counsel Inc. is a registered investment adviser. Information presented is for educational purposes only. It should not be considered specific investment advice, does not take into consideration your specific situation, and does not intend to make an offer or solicitation for the sale or purchase of any securities or investment strategies. Investments involve risk and are not guaranteed. Be sure to consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein.