Should You Buy Bitcoin or Deep Value?

If you're looking for a once in a lifetime investment opportunity, should you buy Bitcoin?

It's hard to ignore the meteoric rise of the cryptocurrency since it's launch less than 10 years ago. Five days after launch, the Bitcoin rocketed up from $0.008 to $0.08 - a 1000% return! - and reached a peak of $19,783.06 in December of 2017. That 2,472,882.5% increase in price would have turned a $1,000 investment into $2.47 billion (with a 'B') dollars - enough to buy pretty much anything you would ever want.

In fact, Bitcoin's enormous 1390% 2017 return has caught the attention of a lot of folks who have never really seriously thought about picking their own investments. So, should you buy Bitcoin now?

As it turns out there is indeed a once-in-a-lifetime investment opportunity being offered up - but probably not the one that you think. To explain just how exceptional the opportunity is, we're going to have to unpack the Bitcoin investment thesis to figure out how credible it really is.

Should You Buy Bitcoin? Here's the Promise

Bitcoin rests upon an exceptional and novel piece of technology known as blockchain. Blockchain is essentially an online ledger system that records transactions between individuals and is - as the experts say - practically untamperable.

It's hard to see how blockchain won't become a valuable part of how we transact in the future. Peer to peer transactions can take place very quickly, irrespective of distance or borders, and unique applications of the technology offer a way to get around traditional brokers, financial institutions, or middle men, never mind corrupt governments.

Speaking of Bitcoin specifically, there's also anti-inflationary safeguards built into the technology. Restricted by the underlying code, only 21 million coins can ever be produced, making them extremely scarce, so extremely valuable if they become widely adopted.

This technology, advocates argue, will usher in a new era of economic and political freedom.

Sounds good - sign me up.

How Will You Do If You Buy Bitcoin as an Investment?

But, while this utopian future certainly sounds like a destination worth exploring, if you buy Bitcoin, the investment merits are very questionable.

New technologies often produce strong adherents who predict wonderful new futures, and great wealth for those who get in early enough. Early adopters can see large gains, causing secondary adopters to rush in, pushing up the price. Rising prices build confidence in the investment thesis which then spreads among average investors, causing more to sweep in.

This is where delusion and skewed thinking - two hallmarks of a financial bubble - set in. Take tech stocks in the late 1990s, for example. During the Dotcom Bubble, the only thing that mattered to a lot of investors was claiming acreage. The idea was that a company had enormous value if it was able to pick up valuable URLs and achieve significant market share. Business models and profitability were largely irrelevant because, investors thought, a business could figure out how to earn profit later.This goofy argument led to investors funding all sorts of crazy businesses, sending stock prices rocketing up 100s of percent, and many instant millionaires.

Bubbles are psychological events akin to a feeding frenzy in the world of finance. While it all starts with a promising opportunity to wolf down a mouthful of flesh, opportunity is soon exhausted and tails get bit. Soon the only thing left is blood in the water.

The bubble cycle... from early adopters to illicit activity, and the inevitable crash.

The bubble cycle... from early adopters to illicit activity, and the inevitable crash. As people buy Bitcoin, the cryptocurrency seems to be skipping down a similar path. (Source: Hofstra University)

In fact, investment bubbles may be the perfect psychological storm in finance. Our early adopters and secondary adopters above come out with nice winnings, and these winnings spark interest, and envy. Others want to get in on the action and the success of early investors provides evidence - or social proof - that the investment is worthwhile. Increased buying pushes prices up, providing even stronger social proof for the investment thesis, as an imbalance of demand over supply has to occur for prices to rise. All of these buyers can't be wrong, can they?

Rising prices spark two other ingrained characteristics of human psychology: the tendency to like things that make us feel good and the tendency to evaluate things positively when we feel good about them. It's human nature to feel good about investments that rise in value. Investors often evaluate these investments with much more optimism than is warranted, crafting additional reasons to justify yet higher prices. Ironically, the smarter a buyer is the more likely he may be to get sucked into a bubble since he's less likely to listen to the wisdom of others, more likely to believe his own reasoning, and less likely to remain humble. The result is more buying, higher prices, more liking, more reasons to buy, and more buying.

As an investment community forms around an asset class, group psychology starts to come into play. Since investors are largely subscribing to the same investment theses, battles for status erupt in the form of group polarization. Highly cohesive groups tend to lean towards one belief system and exaggerate those beliefs as a play for status within the community. The "I liked it before it was cool" or "nobody loves ___ more than me" members craft even more extreme investment theses which others eagerly lap up.

Extremely powerful waves of social proof often emerge when reputable investors or industry leaders begin to capitulate to the bubble's psychological pull, corrupting their well-honed strategy to get behind the investment publicly themselves. Even the strong willed, the stalwarts of rational capital allocation, succumb to the psychological black hole. These revered experts provide strong psychological justification to double down.

Celebrated Physics genius Isaac Newton famously went broke during the South Seas Bubble. Would he buy Bitcoin today? (Source: Marc Faber, retrieved here.)

Individuals aren't the only ones to get corrupted. As envy turns to greed, and the bubble reaches its climax, scams become increasingly common. During the internet bubble, companies would go public for millions of dollars without ever intending to build a business and some managers simply left with the cash. Other companies just slapped the suffix ".com" behind their name to boost their market cap.

But, nothing lasts forever. Eventually some event - a particular large scam, a piece of regulation, some indisputable fact which nullifies the investment thesis - pops up and investors, almost as a single entity, shift from buying to selling, causing prices to plunge. The end result is financial and personal ruin.

Few internet companies from the late 1990s would ever turn a profit, and most went bankrupt. Even those that didn't, today's internet titans, took more than 10 years to regain their former all time stock price highs. Investors were devastated - many mortgaging their homes to buy internet stocks, only to commit suicide when their dreams evaporated.

Amazon stock shed 93% of its value during the Dotcom Crash. It took 9 years to trade back up to its former high.

Amazon stock shed 93% of its value during the Dotcom Crash. It took 9 years to trade back up to its former high. That's 9 lost years that your money is not compounding. Even if you buy Bitcoin now and the thesis works out as planned, you could still be out a lot of money for a very long time. (Source: Chart from Yahoo! Finance; Graphics made in-house by The Broken Leg)

So, how does Bitcoin stack up?

Will You Buy Bitcoin or Bitbubble?

All the tell-tail signs are there to indicate that Bitcoin, and the crypto-world in general, is in a major bubble. There's been an enormous Bitcoin price increase, early adopters have made a fortune, and people totally divorced from the investing world now talk about buying Bitcoin.

But maybe most telling are major problems with the investment thesis itself. Take scarcity*, for example. Usually, scarce sought after items are expensive because there are a lot of people vying to gain access to a limited number of assets. Bitcoin is definitely scarce, limited to just 21,000,000 coins, but nothing is stopping smart capable computer nerds (as opposed to us financial nerds) from creating high quality competing coins - and many are. So long as there are an increasing number of cryptocurrencies, there will be strong downward pressure on the price of Bitcoin. There's little reason to buy Bitcoin over another crypto currency if alternatives are easily useable. Alternatives will also become more widely available as the price of Bitcoin remains high. So, the idea that Bitcoin - or any other cryptocurrency - will reach some enormous end valuation due to scarcity is very questionable.

The argument that Bitcoin is the clear choice for commerce due to its market share just doesn't stack up, either. It is easy for competitors to take market share in a rapidly growing market. While market growth is often cited as a major positive for an investment, the opposite is actually true because it helps to quickly erode the dominant market position of the industry leader. More market opportunity means more opportunity for competitors to take an increasing percentage of the expanding market. With market fragmentation, specialized products start to become increasingly important to consumers or users. All of this calls into question the utility of Bitcoins leading market position when it comes to long term values.

Promoters say that adoption will ultimately lead to increasing demand and, when Bitcoin becomes widely adopted, its use will cause it to trade at an enormous valuation. But, again there's a contradiction here. For Bitcoin to become widely adopted, it has to start acting like a store of value and not an investment. It has to stop rapidly increasing in price. If holders believe that the price of their Bitcoins will continue to rise, they'll be very reluctant to part with their investment. But, consumers have to insist that businesses accept Bitcoin for Bitcoin to be widely adopted. It's a catch 22.

Similarly, merchants are not likely to widely accept the currency due to its extreme volatility. No business wants to accept a currency that drops -50% in a month, never mind hold the currency over dollars. Stripe, one of the largest internet payment management providers initially embraced Bitcoin, adding it to the currencies the firm accepted, only to end up dumping the online currency due to Bitcoin's extreme volatility. This is a major blow for the adoption thesis. Most businesses need a stable store of value to function. At minimum, this volatility slows adoption tremendously, but it could also put a lot of downward pressure on the price of the cryptocurrency.

Add to this the erroneous idea that Bitcoin cannot be regulated by governments. While it may be impossible for governments to track whether individuals have or are using Bitcoin, the same is not true for businesses. All a government has to do to derail adoption is make it illegal for businesses to accept cryptocurrency, and enforce that law through tax audits and stiff penalties. The US government made holding gold illegal in 1934 to help gain further control over monetary policy. To think that governments wouldn't or couldn't enforce the domestic use of monetary instruments today is a little silly. This would definitely disrupt the currency's use case, creating downward pressure on the price of the currency for people who buy Bitcoin today.

That downward pressure would be okay if the currency had some sort of financial value independent of its price in the market. Promoters often argue that the technology is extremely valuable, citing numerous use cases. To Bitcoin devotees, the value is obvious, hence the price. But, there's a big difference between value in use and financial value; and, things that are very useful do not always command a high price. Your mother's hug is very valuable when it comes to emotional support, comfort, or even the development of a psychologically healthy child, but it's worth almost nothing in the market. Similarly, you could't build a house (or many other things) without a hammer, but I bet you'd never pay $20,000 for a hammer.

A solid example of financial value independent of price is when holders of American dollars could swap those dollars for physical gold before 1934, a deep value company's NCAV, or the fact that the Coca-Cola company produces a steady stream of cash for its owners. All have an underlying value independent of their price in the market.

Bitcoin is very similar to mineral wealth, though, since coins are mined using computers. An approach similar to that used to value physical metal could be the best way to arrive at some central tendency, or "fair value," for Bitcoin. In this case, fair value would amount to the cost of producing a Bitcoin. For physical metals, as the price rises above the average miner's cost of production, more producers enter the market to make a profit. As the price of the mineral falls below the average miner's cost of production, firms begin to shut down production and players leave the industry until the price rises back above the average cost of production. This creates a sort of fair value for the mineral. While not perfect, this is the most plausible hypothesis for Bitcoin's fair value, and producing a Bitcoin now costs a little over $4,361USD.

The cost of mining 1 Bitcoin in various states throughout the USA in December 2017.

The cost of mining 1 Bitcoin in various states throughout the USA in December 2017. (Source: Crescent Electric Supply Company, accessed here.)

But mining Bitcoin is not the only way for producers to get rich. Again, we come back to the thousands of smart computer scientists at work in their den or at coffee shops figuring out how to make their own cryptocurrencies. They're slowly increasing the supply of cryptocurrency generally, producing a large number of coins for investors to pick up. At the very least, this creates a lot of downward pressure on the price of digital currencies.

But, another big question is which of these horses you should bet on. Picking winners and losers in an emerging market is nearly impossible -- even the leader is not a safe bet. What happened to Microsoft post-Dotcom Bubble? Likewise, IBM had a dominant market share in home computers during the late 1990s... where are they today? How about late 1990s search engine leader Yahoo!? Air Canada was THE major carrier in Canada until its bankruptcy. Research In Motion was THE smartphone king with its Blackberry until Apple, Google, and Samsung came along. Leadership does not necessitate investment success.

Looking back over market history reveals something else, too. Certain growth for new industries and obvious emerging value for society does not mean certain wealth for investors. Think cars. There were over 1800 automobile manufacturers between 1900 and 1930 in the US but there's not nearly that number today. Some were acquired while many went bankrupt. Investors could have easily spotted the obvious fact that the automobile industry would explode in growth over the next 100 years but still end up broke. Likewise, Warren Buffett often claims that the total profit earned off of investing in the airline industry over its existence was actually a loss -- but think about how revolutionary air travel has been.

Microsoft investors were devastated after the Dotcom Bubble. It took the stock 17 years to regain its former high!

Microsoft investors were devastated after the Dotcom Bubble. It took the stock 17 years to regain its former high! Will this happen to you if you buy Bitcoin? (Source: Chart from Yahoo! Finance; graphics made in-house by The Broken Leg)

To top it off, one of the most common reasons people have to argue that Bitcoin is going to keep rising is because, well, look at how much money they've already made. 'nuff said.

Other Reasons Not to Buy Bitcoin

It's pretty clear that the investment thesis behind cryptocurrencies is full of holes, but what other signals are there that suggest it's a bubble?

Interest from non-investors, for one. In the late 1920s, even shoeshine boys would know a lot about the market and which stocks were the real hot issues. Today, it seems like everybody I know wants to buy Bitcoin, largely due to its enormous rally. People are attracted by the idea of getting really rich, very quickly. When I was younger, we called these sorts of opportunities "get rich quick schemes" and people mocked them. Today, a rapidly increasing number of people want in - including people who think common stocks are what you buy in 8 packs at Walmart along with boxer briefs.

That doesn't mean that some people won't become enormously wealthy. I now know a number of new millionaires who were working dead-end jobs just a few short years ago - instant millionaires being another sure sign of an aging bubble. Whether they get to keep their newfound wealth is another question, though. It only takes a bit of reading to uncover all sorts of people who grew to live like kings before being utterly destroyed financially in The Great Depression, or more recently in the Dotcom Bubble, or Mid-2000s Housing Bubble.

Part of that destruction is due to the growing number of scams, theft, and shady dealing as bubbles age. There were all sorts of lending scams and corruption as American housing ran its course during the mid-2000s. NINJA loans, or outright fraud was commonplace.

Those who buy Bitcoin today have to contend with the growing number of scams and increasing amount of theft in the cryptocurrency space. Just as in the Dotcom Bubble, for example, firms today are slapping terms like "Blockchain" to the end of their name to try to lure ignorant investors. Long Island Ice Tea Corp is one of the latest culprits, changing their name to Long Blockchain Corp, and the Security and Exchange Commission is not happy. The securities regulator recently announced increasing scrutiny of firms changing their name in the hopes of defrauding investors and cashing in on the bubble. Just another sign that the bubble is aging.

Things are just as slimy on the other side of the Pacific. Officials in South Korea's Financial Supervisory Service (FSS), Korea's version of the SEC, were just caught insider trading ahead of a major regulatory announcement. As the bubble ages, holders can expect to see scams and other sort of illegal behaviours grow in number.

"I think there's a bit too much scam in the space, in terms of people getting in just to get rich quick.

It's quite easy for a founder to pump a coin and make it seem like it's the latest and greatest and it will cure world hunger, and the price can go up to $10 billion. And it's easy for whoever did that to cash out.

And it will leave a lot of people hanging. A lot of people can lose a lot of money because of this.

I'm sad to see this happening all over the place. There's a lot of initial coin offerings (ICOs) that have nothing but a white paper that's full of technical jargon, and they're able to raise $100's of millions of dollars; these coins will likely just go to zero."

- Litecoin founder Charlie Lee

This is not a place that I would ever want to park my money.

So Where Does This Leave Those Who Want To Buy Bitcoin?

Not anywhere good.

Will Bitcoin continue to make new highs?

It very well could. One of the quirks about investing is that good investment decisions do not correlate to good outcomes 100%, and sometimes bad decisions can make you money. If you buy Bitcoin today, it's impossible to know where the cryptocurrency will end up over the short or medium term. But, over time, the quality of your investment decisions has a major impact on your net worth.

At best, Bitcoin is a speculation. Investment legend Ben Graham, Warren Buffett's teacher, used to say that there's nothing immoral about speculating but it's also not lucrative. It's a bad way to build wealth. Rather, he favoured investing, which he defined as safety of principle plus a good chance at making a good profit. That's definitely not the case if you buy Bitcoin today.

The question you have to ask, given everything we know about Bitcoin and bubbles, is if you want to take on a thin chance of riches and high likelihood of losing money, or whether you would rather have a great chance of a great profit while protecting your downside.

I've taken on the latter. There is a real once-in-a-lifetime opportunity today that a few smart investors have adopted... and it doesn't require me to buy Bitcoin It involves buying things for a fraction of what they're worth, based on solid value - and the best part about it is that you're more and more likely to come out way ahead financially the longer you keep at it.

That opportunity is the miracle of deep value investing. The returns associated with deep value stocks, such as Ben Graham's own Simple Way strategy, are tremendous but truly a once-in-a-lifetime chance since you only have one life in which to save and invest.

My bet will always be on deep value stocks. Throwing my money behind anything else would at best lower my returns, introduce uncertainty into my long term outcome and, at worst, could totally destroy me financially.

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*Here I'm using the term scarcity differently than the actual economic definition. I'm referring to the limited supply of coins relative to the much larger number of coins demanded (or demanded in the future) by the public.