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Bitcoin, pricing dislocation and value investing

Price and value. Many investors think these two concepts are substitutable, but they refer to two different qualities. As value investors, we believe there can be large divergences between the two, which we call ‘pricing dislocations’. These pricing dislocations mean the price of something, in our case, the share price of a company, does not reflect the intrinsic value of that company. By identifying undervalued companies, investors can make superior long-term profits.

Price is what you pay and value is what you get. For example, anyone can know the price of Bitcoin, but do they know its value?

You can buy a flight ticket from Sydney to Melbourne for as low as $120 but think about the value you get from that trip. You get to transport yourself from Sydney CBD to Melbourne CBD in around two hours when by car it would take you a gruelling nine hours and the fuel costs alone would be considerably higher. I would be willing to pay a much higher price to fly instead, because reaching Melbourne in two hours versus nine hours has significant value to me.

Price versus value in the equity markets

At any time, there can be varying degrees of pricing dislocation within the stock market. We focus on buying specific companies that might have severe pricing dislocation in favour of value based on a very bankable causality: people. People are a reliable source of pricing errors. Whether they are retail or institutional investors, they make extreme errors of judgement and assess value based on a list of hard-wired factors that trigger an irrational decision framework. Factors such as greed, fear, peer group pressure, loss aversion, short-term bias and anchoring help to create erroneous decisions. Over time, the divergence between market prices and intrinsic values will converge and pricing becomes rational.

Think about the stockmarket crash in 1987 which saw prices fall on average by more than 20%. Now the intrinsic value of companies across the world could not all have fallen by 20% in the space of 24 hours. So, either there was pricing dislocation before the crash or there was pricing dislocation after the crash. Remember the dotcom boom? When the dizzying market prices of that bubble finally corrected back to intrinsic values, the NASDAQ composite index fell by 78% in the 30 months post the then all-time high. Market prices during the bubble phase clearly did not reflect intrinsic values.

Value drivers

Intrinsic value in investing is derived from cashflows. The value of the business is assessed by discounting the free cashflow the business is expected to generate in the future. Returns above a return appropriate for risk may mean that the market value of the business might be undervalued. On the other hand, investors would have avoided a lot of pain during the dotcom boom as many companies were decades away from generating profits and hardly generated any revenues. The intrinsic valuations in those cases were close to negligible.

Is Bitcoin a bubble?

Bitcoin is based on a revolutionary technology called blockchain. Blockchain is based on a decentralised ledger system which uses nodes as opposed to a traditional single-source ledger or single source of truth, to validate and hold ledger entries. It uses these nodes to evaluate and verify a proposed transaction and if the majority of nodes concur, the new entry is added across the network of nodes. This system should improve the integrity and security of data and radically improves the speed and reduces the costs of transactions. The technology will prove to be highly valuable and change the way many large data networks function. It will make a transformative contribution to society and help achieve increased productivity, reliability, and security.

So, Bitcoin is therefore valuable? Not exactly. Bitcoin purports to do two fundamentally important things.

First, it is a digital currency and any currency whether digital or otherwise must do a few things well. It must be widely-accepted as a means of exchange, preferably as legal tender. Bitcoin is not legal tender in any main jurisdiction and some countries have actually made transacting in Bitcoin illegal. You can’t go into a car dealer and buy a car in Bitcoin, you cannot settle a property purchase in Bitcoin, and if you go into Amazon or JB Hi-Fi they will not accept Bitcoin for the purchase of goods.

Furthermore, the price volatility of Bitcoin against major currencies like the US Dollar and the Euro is so wild and erratic that even if it were widely-accepted, why would merchants want to settle business accounts in something that could quite quickly swing their customers transactions from profit to loss in a matter of minutes? There are reasons why banana republic currencies are not in high demand as a medium of exchange – they are volatile currencies. As currency or pseudo currency, Bitcoin is awful.

Second, Bitcoin purports to do is be an efficient store of value like gold. It is an interesting assertion. Bitcoin’s proponents claim that unlike gold, Bitcoin has a finite predetermined supply. Many objects have a limited supply and might be very ordinary. What is the intrinsic value of a cryptocurrency? Well it is a wonderfully engineered peer to peer ledger system that is open-sourced with a technology platform that will prove invaluable to society, but its architecture can be widely-replicated, improved, or further developed and it already has been. There are already many Bitcoin-like substitutes: Litecoin, ZCash, Dash etc. The value of Bitcoin in terms of functionality can be replicated by others, and unlike the example of the value I get from flying to Melbourne versus driving to Melbourne (the substitutive alterative), it is likely the value of future iterations of cryptocurrencies will improve upon the technological architecture and security of Bitcoin. Indeed, as blockchain adoption gains increased usage, governments may launch their own cryptocurrencies and legislate them as legal tender, immediately bestowing those currencies with a competitive advantage over Bitcoin and undermining its value.

The price has risen, not the value

Bitcoin has risen in market price by 2000% over the last 12 months, not value. Market prices and value are two very different qualities, a lesson that for many cryptocurrency investors may prove an expensive one.

 

Carlos Gil is the Chief Investment Officer of Microequities Asset Management. This article does not constitute financial product advice. You should consider obtaining independent advice before making any financial decisions.

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