@ mark

Author's note: I wrote this piece in July 2021 called "An Investor's Case for Bitcoin" as a guest article for a newsletter whose audience was not knowledgable about bitcoin or crypto. The price of bitcoin was $34k USD at the time.

The newsletter no longer exists so i'm sharing it here in case it's still helpful to anyone.

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An Investor's Case For Bitcoin

by Mark Mulvey

“If you wouldn’t hold something for 10 years you shouldn’t hold it for 10 minutes.” —Warren Buffett

I own bitcoin because I’m a value investor.

Let me explain.

The whole idea of value investing is to buy high-quality assets with strong fundamentals and proven potential, with a clear path to growth and profits over a long time horizon. You buy before price appreciates and the wider public comes to appreciate the value it holds.

And so, armed with a stoic attitude that encourages buying “when there’s blood in the streets,” value investors accumulate more shares and patiently wait for market prices to return to “true” value rather than chase the hot new thing on the run-up.

That’s what I do with bitcoin. In fact, it has overtaken my traditional buy and hold portfolio and swing trading activity as I’ve shifted my concentration to take advantage of what is right now a particularly special inflection point in its lifecycle.

If you’re not familiar with how bitcoin works and why I’m so bullish on it this may all sound very confusing. “Bitcoin is volatile and risky. It has no yield. It has no intrinsic value. It’s a Ponzi scheme. What if governments ban it? What if something better comes along? Bitcoin is the furthest thing from value investing!”

In fact, that couldn’t be further from the truth.

To start, it’s important to understand that value is subjective. The idea of “intrinsic” value is purely theoretical and somewhat nonsensical, since it’s up to individuals to determine whether or not—and how much—something is of value to them personally. This very dynamic is what makes trade and exchange possible at all.

For traditional investors and ordinary citizens, the main use of bitcoin is as savings technology and protection against inflation. It's a way to store and transmit value across space and time in a way that preserves its purchasing power instead of being inflated away.

Bitcoin has a number of qualities that lend itself to being a scarce and desirable store of value:

• It’s decentralized, with a geographically distributed network of nodes and miners who check every transaction against the agreed upon rules and secure the network with encrypted energy respectively. Everyone is checking everyone else like a Mexican standoff in cyberspace. This means no trust is needed for the system to work and for individual transactions to be confirmed, which is part of why it's such a profound invention.

• It has a finite supply, with only 21 million bitcoin tokens that will ever be issued within the network, distributed with a fixed issuance schedule that gets cut in half every 4 years, making it ever more scarce. Even the supply of gold today increases by about 2% per year, but bitcoin’s total supply is absolutely fixed. And if miners want to work even harder to get even more of it, an automatic difficulty adjustment kicks in to keep things in check, ensuring that blocks of transactions are steadily added to the chain every ~10 minutes like clockwork

• It’s easily divisible into 100,000,000 units called satoshis, or “sats.” Part of gold’s shortcoming, aside from the hassle of having to melt it down in order to verify its authenticity, is that it can’t easily be divided up for use as a medium of exchange. This is why paper notes were originally issued, to be “backed” by gold should they ever want to be redeemed. Those were the days. The US dollar was taken off the gold standard back in the early 1970's and we've been dealing with the consequences of a free-floating fiat currency ever since.

• It’s secured by the processing of the most powerful computer network in the world, with individual miners distributed all over the globe expending energy and converting it directly into a store of value token as efficiently as possible. This is what "backs" bitcoin. It’s the physical energy expenditure of miners that enter each individual transaction into blocks on the network, with a chain of blocks growing ever larger and more immutable as independent nodes on the network check and validate all the work along the way. Bitcoin has passed the size at which someone (or some government) could coordinate an attack on it because the amount of processing power, money, and coordination needed is effectively out of reach now. Even then, it would simply allow an attacker to do a single double-spend transaction. Game theory suggests it's far easier and much more profitable to just buy some instead.

• It’s also clean: bitcoin miners are incentivized to find the cheapest energy possible, which is mostly non-rival or stranded energy sources too far from human population centers to be used otherwise. Miners are also the buyer of last resort for renewable power sources on-grid, helping to subsidize energy costs for large power plants looking to monetize these intermittent, non-reliable sources. There are even companies like Crusoe who are capping otherwise wasted flared gas and reducing carbon emissions in the process. Have a look at any gold mining operation to compare the difference. (Or the emissions and energy profile of the US military industrial complex, which currently backs the US dollar.)

These qualities have many people initially understanding bitcoin as “digital gold” or “Gold 2.0” and will give it a portfolio allocation accordingly. But bitcoin improves on gold by at least an order of magnitude, since it’s optimized for transferring value not just across time (preserving its value from the past into the future) but also across space. Gold is terrible at the latter.

Moving gold across town let alone across national borders is a time consuming and expensive hassle, but with bitcoin you can send billions worth of real-world value from one continent to another at the speed of light—with final settlement—for a tiny fraction of the cost. It’s a bearer instrument that requires no one’s permission, and you don’t even need a bank account to buy and hold some. Seeing as much of the world's population is entirely unbanked and unable to even participate in the global financial markets let alone open a PayPal account, the subjective value of this innovation to them should be immediately apparent. You can buy a piece of it like a plot of land in cyberspace, holding the private key in your mind and travel freely knowing your property can’t be confiscated in transit.

But the Bitcoin network itself is also being used today in some game-changing ways. Just look at Strike, the company founded by Jack Mallers that is solving the problem of global remittances. Many people in developing countries are forced to leave due to violence or lack of opportunity, earning money abroad and then sending it back home to family. This is a huge market, and currently companies like Western Union take a major cut (upwards of 20% on each end). Those back home still have to travel long distances and risk carrying cash on their way back from the nearest Western Union storefront in order to receive it. But Strike leverages the Bitcoin network as the rails of a free and open payment system. Using Strike, dollars in the US get converted to bitcoin and sent abroad to a recipient’s wallet in another country before being converted back into dollars (or the local currency), almost instantaneously and with near-zero fees. The price that bitcoin is trading at is irrelevant because the conversion happens in a split second. Both users don’t even know they’re using bitcoin, they just see US dollars get sent from one digital wallet to another.

All of this is made possible via the Lightning network, which is a layer 2 protocol that sits on top of bitcoin and allows it to function as a kind of bar tab, batching transactions between trusted parties before settling against the main bitcoin blockchain. Layer 2 solutions are what will help bitcoin scale and remain economical in the years ahead. Layered architecture is not only how networks like the internet function but it’s how monetary systems function too. (See Nik Bhatia’s excellent book Layered Money). Some compare Bitcoin to the "IP" part of TCP/IP, which was an internet protocol developed back in the 1960’s but is still the base layer of the same internet that lets you play Call of Duty with friends across the world and stream Netflix into your connected TV.

So what is Bitcoin worth? Well, after 2020 saw the unrestrained printing of trillions of dollars (and Euros) by central banks, a deflationary asset with a fixed supply and unchanging monetary policy became quite attractive to investors who started worrying that maybe the prices of their stocks weren't growing, but the purchasing power of the dollars used to price the stocks were shrinking. Governments have been debasing their currencies ever since, which is actually reflected in the credit default swap (CDS) market where traders began to view inflation and sovereign default as an increasing concern, and viewing things like bitcoin as insurance.

There are many ways you can try to calculate bitcoin’s expected value. Here are a few:

• Greg Foss, a former bond trader and 30-year veteran of debt markets, has a long-term valuation formula to understand the asymmetric return potential for a small allocation to bitcoin today: The total value of all global financial assets—including all debt, real estate, equities, art, and gold—is ~$900T USD ($400T if you don’t include debt, i.e. the bond market). If bitcoin becomes a global reserve asset, say because energy is priced in bitcoin instead of the US dollar, it’s not crazy to think that 5% of that global wealth would be stored in bitcoin. 5% of $900T is $45T. Divide that by 21 million and that puts you at ~$2M per bitcoin

• Some prefer the logic of Lyn Alden, an investment strategist and prominent writer on macroeconomics, who looks at the market cap of gold which is about $12T right now. Bitcoin’s price of ~$34k at the time of this writing puts its current market cap at about $600B, so a $12T market cap would mean bitcoin trading at ~$500,000 per coin.

• NYDIG calculates bitcoin's value by applying Metcalfe’s Law, which states that a network’s value is proportional to the square of the number of its users. Historically this has proven to be pretty accurate. Their November 2020 calculation using 15%-25% network growth per year suggested a price level range of $51,611 - $118,544 in 5 years.

• And Cathie Wood, CEO and founder of ARK invest, bases her $400,000 price target on the premise of every member of the S&P 500 allocating 5% of their balance sheet to bitcoin.

My sensible case for buying bitcoin simply argues that as the US dollar continues to be debased by the trillions, then protecting your purchasing power becomes increasingly crucial. Any other investment needs to clear a hurdle rate that is ticking further and further up, and your risk-free rate of return (formerly the 10-year US Treasury) is no longer a trustworthy yardstick against which to discount equity valuations. But with an asset like bitcoin that’s approaching the elbow of a parabolic curve upward (the hallmark of exponential growth driven by network effects), a little can go a long way. Given its profile, I think it’s more of a risk not to own at least some. The opportunity cost of missing such a trade is high compared to almost anything else you can invest in.

People will sometimes point to bitcoin’s dollar-denominated price volatility as evidence of it being risky or not useful, but any asset in the early stages of monetization necessarily involves volatility as people try to understand what it’s worth to them. All the best outperforming assets have been volatile in early growth stages. Amazon had multiple drawdowns of >50% on its path to becoming the most valuable company in the world, reaching as deep as 80-90% in the aftermath of the dot com bubble. Volatility is not the same thing as risk. I would rather have an upwardly trending volatile asset than a downwardly trending stable one. Position sizing is also important when it comes to risk management.

Bitcoin has actually been the best performing investment so far in terms of risk-adjusted returns. Since 2010, the Sharpe ratio of bitcoin (1.24) is a tick under the Sharpe ratio of a simple 60/40 portfolio of stocks/bonds (1.25), but bitcoin’s 255.6% compound annual growth rate (CAGR) since inception crushes the 10.3%. of the traditional 60/40. Given that much of bitcoin’s appreciation occurred when it was growing from zero, the more realistic CAGR percentage to use is closer to ~120% based on more recent timespans. Over long periods of time this will slowly go down, and I personally use 100% CAGR when running expected return models. And if I'm wrong by half it would still be my best performing investment.

Even if you bought some bitcoin at the worst possible time you would have done better than most of your other investments. Measured using 5 year holding periods, bitcoin's worst annualized return has been +28.8% so far.

My investment strategy for bitcoin is simple: 1.) I buy a little bit every day in order to dollar-cost average my overall allocation. 2.) I don’t use leverage. 3.) My time horizon is measured not in months or quarters but in years. That’s it.

At the end of the day I do believe that a diversified portfolio is important, but I also think it’s important to have at least one investment for which you have deep conviction and continue learning about and contributing to. That’s what investing is all about. We should all be investing in quality assets, people, and relationships. We don’t diversify our spouses, and we shouldn’t outsource all of our serious commitments to indexes.

For me, bitcoin is a worthy investment. If it’s not for you that’s okay too, but I still encourage you to find something that deserves your conviction. Conviction is what allows you to weather the volatility necessary for anything of significant future value to prove itself and grow. Without it, you’ll let it go at the first sign of trouble.

This isn’t me as a Bitcoiner talking, it’s me as a value investor.

“Diversity is for people who don’t know what they’re doing.” —Warren Buffett