September 8, 2015

The Value Investor’s Case for… Bitcoin?!

Stylized views of value investing often invoke low accounting multiples, but we try to take a broader definition of “value” in our pursuit of assets trading at substantial discounts to their intrinsic value. Our approach is a probabilistic one, meaning that we try to think about various potential states of the future that could affect an asset’s value. We then determine what an asset could be worth under a handful of representative scenarios, multiply each scenario’s value by the probability we think it could occur, and sum up the values to get a “central tendency of value.” Our thought process on Bitcoin is a representative example of our probabilistic value approach, even though the asset may not hit the radar screens of more traditional value investors. So, we will first briefly introduce Bitcoin and then talk about a framework for valuation.

Bitcoin is an electronic peer-to-peer currency with no central authority. A community of developers manages the protocols governing the currency, and they also process transactions in exchange for additional units of Bitcoin. The record-keeping of these transactions is Bitcoin’s technological breakthrough and its most fundamental differentiator from traditional currencies — the community of developers maintains an open ledger called the “blockchain,” which tracks all Bitcoin transactions since inception. The open ledger combined with the complexity of transaction data makes Bitcoin a very secure method of payment relative to someone’s credit card, which relies upon one simple set of numbers to effect many transactions. One of Bitcoin’s biggest advantages over other payment networks like Visa (V) and MasterCard (MA) is minimal transactions fees. While other payments networks typically charge the greater of ~3% and $0.15, Bitcoin’s transaction fee tends to be a negligible fraction of the transaction, if any at all. Lower transaction fees not only enable buyers and sellers to transact at prices that are better for both parties, but they could enable micropayments in markets that are not otherwise compatible with a $0.15 surcharge on low-price, low-margin goods and services. Another unique aspect of Bitcoin is its fixed supply. While there are currently 14.6M Bitcoin in circulation, the total supply limit is 21M. A fixed supply and democratized authority prevent any one regime from altering the system to its own advantage; indeed, every participant is also incentivized to maximize the value of Bitcoin.

We use the aforementioned background as a starting point for a valuation case. The technological breakthroughs, security, low transactions costs and decentralized nature of the system all mean that no one knows how valuable the system may become. However, if adoption grows, so should its aggregate value as a payment system. A growing system value, measured by the market capitalization of Bitcoin, should mean a growing value of Bitcoin given the limited supply of the denominator.

We think Bitcoin could have enormous upside if it catches on, but we acknowledge that numerous hurdles mean that it is more likely than not that the experiment fails. Still, it is important to think about how valuable Bitcoin could be if the adoption continues to grow and the currency thrives. The grandest dream for Bitcoin would be for it to achieve the store-of-value status of gold. There are clearly issues with this analogy, as Bitcoin can’t be made into jewelry (on the other hand, you can’t buy goods and services with a gold ingot while you can with Bitcoin). According to the World Gold Council, less than 175,000 tonnes of gold have been mined since the beginning of existence. At a spot price of $1,133 per troy ounce, that means an aggregate value of $6.4 trillion for all gold ever mined. If Bitcoin achieved that capitalization on a base of 21M coins, each coin would be worth ~$314,000, or 1,365x the current price of $230. Still, we acknowledge this is a stretch and a highly unlikely possibility, so let’s assume there is a 0.25% chance it occurs. Another fantastic outcome for Bitcoin would be the replacement of higher-fee processors like Visa, MasterCard and American Express, which have a combined market capitalization of almost $350M today. If Bitcoin were to capture that value, one Bitcoin would be worth almost $17,000. This is still unlikely but more likely than the value-reserve status of gold. Let’s assume a 2.5% chance this occurs. That leaves us with a 97.25% probability that Bitcoin is a failure and worth nothing. However, using the aforementioned assumptions, the probability-weighted value of the cryptocurrency would be $1,210 today, or an intrinsic value over 5x greater than where it currently trades.

One other point of comparison may also suggest the currency is meaningfully undervalued. The total value of all outstanding Bitcoin is $3.4B, which puts the stock of the cryptocurrency between the total money supply of Fijian dollars ($3.1B) and Haitian gourdes ($3.5B)1. Bitcoin has far greater potential than either of these currencies, yet Bitcoin is valued similarly despite being much more liquid with a tighter bid/ask spread.

While the mechanics of Bitcoin make it problematic to own in our strategies, the thought process above helps explain why we both own Bitcoin personally. The high probability of it being worth nothing would imply a small weight for most investors looking to add Bitcoin to a diversified portfolio, but it seems like a compelling value proposition nonetheless given the currency’s massive potential.

1CIA World Factbook. The outstanding value of the money supply of Barbados, Eritrea, Gabon, Burkina Faso and many other countries also rank above Bitcoin.

The views expressed are subject to change at any time. LMM disclaims any responsibility to update such views. The presentation should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results, and there is no guarantee the views expressed will turn out to be correct.

©2015 LMM LLC. LMM LLC is owned by Bill Miller and Legg Mason, Inc.

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