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Bitcoin, pricing dislocation and value investing

  • January 2, 2018
Bitcoin

Price and value. Many investors think these two concepts are substitutable, but they are not. Each of these terms refer to two very different qualities. As value investors, Microequities believes that there can be large divergences between the two. These divergences, 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.

So, what is the difference between price and value? Put simply price is what you pay for something and value is what you get. Anyone might be able to know the price of Bitcoin, but do they actually know its value? More on that later. Have you ever flown on a domestic inter-city flight? You can buy a domestic flight ticket on Webjet 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 to Melbourne in around 2 hours when by car it would take you a gruelling 9 hours and the fuel costs would be considerably higher. I choose to travel from Sydney to Melbourne by air and I would be willing to pay a much higher price to do so if the airlines all decided to increase their fares. Why? Because getting to Melbourne in 2 hours versus 9 hours has significant value to me. So, in the case of the airline industry, many consumers obtain far more value for their travel service than they are actually paying. This is called the consumer surplus and is merely another form of “pricing dislocation” that occurs.

Of course, as professional investors we are focused on pricing dislocation in equity markets. At any time, there can be varying degrees of pricing dislocation within the stock market. But given we don’t intend on buying the whole stock market, we are happy just to focus on buying specific companies that might have severe pricing dislocation. Unlike the airline industry which creates a consumer surplus (pricing dislocation) due to the peculiarities of its market structure, we identify pricing dislocation based on a very bankable causality, people. People are a reliable source of pricing errors. Whether they are retail investors or institutional investors, time and time again they are prone to 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 in equity capital markets which help fuel pricing dislocation. Over time the divergence between market prices and intrinsic values will converge and pricing becomes rational – pricing dislocation is stabilised.

Not yet convinced? Think about the last stock market 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. What one cannot uphold is that the was pricing efficiency both before and 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. Intrinsic value in investing is derived from cashflows. We assess the value of the business by discounting the free cashflow the business is expected to generate in the future. The level of discount we apply to future free cash flows is tied to the fundamental risks associated with that business and the return on a risk free asset. For example, if we invest $1m into business XYZ, at some point in the future we expect the business to generated $1m plus a return premium to compensate us for our risk exposure. Returns above that risk exposure denote the market value of the business might be undervalued. Following this template for investing means investors would have avoided a lot of pain during the dotcom boom as many companies were decades from generating profits and hardly generated any revenues. The intrinsic valuations in those cases were close to negligible.

So that brings us to Bitcoin. Bitcoin is based on an evolutionary and quite revolutionary technology called blockchain. Simply described, blockchain is a technology 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. The system is quite revolutionary and will improve the integrity and security of data and radically improve the speed and 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 very valuable? Not exactly. Bitcoin purports to do two fundamentally important things, firstly it is a digital currency and any currency whether digital or otherwise must do a few things very well. It must be widely accepted as means of exchange, 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 Hifi they will not accept Bitcoin for the purchase of goods. So as a medium of exchange, a very much needed quality for a currency, it fails miserably. However, lets notionally accept that it is a pseudo currency, a stretch, but let us indulge in the exercise. The price volatility of Bitcoin against major currencies like the US Dollar and the Euro is so wild and erratic that even if it was 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. Sure, with the use of derivatives you can manage those risks but that is just an expensive exercise and adds to the cost of accepting a currency. There are reasons why banana republic currencies are not in high demand as a medium of exchange, they are darn volatile currencies.

As currency or pseudo currency, Bitcoin is pretty awful. But the second thing Bitcoin purports to do is be an efficient store of value like gold. It is an interesting assertion. Let us examine it. Bitcoin’s proponents claim that unlike gold, Bitcoin has a finite predetermined supply. Many objects have a limited supply and might be very ordinary and have little or no value. 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 very likely the value of future iterations of cryptocurrencies will improve upon the technological architecture and security of Bitcoins. Indeed, as blockchain adoption gains increased usage you may eventually have governments launching their own cryptocurrencies and legislating them as legal tender, immediately bestowing those currencies with a competitive advantage over Bitcoin and undermining its value.

I recently attended a talk in which a Bitcoin proponent showed a startling chart showing Bitcoin had achieved a 2000% gain in value over the last 12 months. I corrected the speaker, it 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, its flagship fund, Deep Value Fund has returned +588.45% since inception and achieved a net compound annual rate of return of +24.41%

MAM

Microequities asset management has been specialised in Microcaps for over 10 years. We invest in ASX listed companies with a market cap below $300m and global listed companies with a market cap below US$300m. We are long term value investors looking for highly undervalued businesses that should meet a very demanding investment criteria from our Microcap specialist investment team. We manage funds exclusively for wholesale & sophisticated investors as defined by the Corporations Act 2001.



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