Cryptocurrency, Bitcoin, (unprofitable) billion dollar stocks and other madness

Do you realise that $10,000 invested in Bitcoin 5 years ago would be worth over $1.2 million today? Makes you think, right?

With lockdowns occurring almost everywhere around the world, no one is travelling and AirBNB’s business has been decimated. Yet, its share price has risen by more than 40% over the past year, and it is currently worth nearly $160 billion. That is $10 billion more than Australia’s most valuable company, CBA. Oh, by the way, AirBNB lost $5.8bn in the 2020 fiscal year. In fact, it’s never reported a profit after tax. By comparison, CBA makes nearly $10 billion profit per year.  

The big questions are; is this the new normal? Is digital currency the next ‘big thing’? Are profit and cash flow no longer important metrics when valuing a business? 

Cryptical cryptocurrency

I am no expert when it comes to cryptocurrency. In fact, I admit that I know very little about it. But, then again, I have never spent much time researching it because it fails a few basic fundamental tests.

When contemplating an investment, it is important to form a view about the future demand for the product or asset involved. It’s not enough that its currently popular. You must ensure it will continue to be popular. Therefore, we must ask ourselves; who’s using cryptocurrency today and why? As far as I can see, at the moment, cryptocurrency is held solely for speculative purposes. Very few people are actually using it as a substitute for traditional currencies. The one exception to this may be money launderers.

According to the theory of diffusion of innovation, for cryptocurrency to become a sustainable alternative currency, it must be widely adopted.  Renowned author, Dr Geoff Moore argues that there is a large chasm between ‘early adopters’ and the ‘early majority’.  A product must cross this chasm in order to become self-sustainable.

There are two major impediments stopping cryptocurrency from crossing the chasm

Firstly, cryptocurrency is extremely volatile. The share market’s volatility rate is approximately 20% p.a. compared to Bitcoin at just shy of 50% p.a. On average, Bitcoin’s daily volatility rate is 3% i.e. the price changes on average by 3%. Therefore, if you agree to buy some goods, when it comes to paying for them in 7 days’ time those, goods could end up costing you nearly 20% more!

For cryptocurrency to achieve wide adoption, its volatility rate needs to be around 4-5% p.a. – one tenth of what it currently is!

Secondly, one of cryptocurrency’s selling points is its anonymity. You can hold cryptocurrency without revealing anything about your identity. That makes it a perfect exchange for criminals to use. Governments around the world would have a lot to lose if cryptocurrency was widely used. It would be difficult to operate their tax surveillance activities and it would make policing criminal activity more difficult. If this occurred, governments would start regulating cryptocurrencies in the same way they regulate traditional currencies.

A market dominated by speculators

You must invest in assets that have application other than wealth accumulation. For example, investing in property in a location that is dominated by owner-occupiers is a wise strategy. If the investment market dries up for any reason, demand for property in that location will remain largely intact.

The same is true for cryptocurrencies. At the moment, the market is dominated by speculators and maybe money launderers. There are very few actual users. And cryptocurrencies are a long way away from achieving wide acceptance, and probably never will.

If you are going to indulge in pure speculation, only do so with money you can afford to lose.

Tech valuations aren’t based on profit and cash flow

When considering a private equity investment opportunity on behalf of my clients almost 10 years ago, an investment banker told me that “you cannot value tech companies the same way you value traditional companies”. He was suggesting profitability didn’t matter. Anyway, I declined the investment opportunity and the business went into liquidation a few years later.

Prior to starting ProSolution in 2002, I worked for Deloitte preparing business valuations for listed companies. It is widely accepted that the value of a company is equal to the present value of its future cash flows. If it has no future free cash flows, it arguably has no value. An exception to this is where a company owns an asset it can sell such as patents or software (intellectual property).

In the year 2000, at the height of the dot-com bubble, the universally held view was that US tech company, Cisco Systems Inc. was going to be the first company in the world to reach a $1 trillion valuation and that would happen within the next 10-15 years. At the time, its market capitulation (value) was circa $500 billion. More than two decades later, Cisco is worth less than $200 billion. The market was wrong!

Fundamentals never change

To suggest that the ‘new economy’ requires new valuation methodologies is absolute nonsense. There are certain fundamentals that a business must possess to be considered investment grade including predictable and stable cash flows, strong profitability, a solid balance sheet and a history of wisely reinvesting profit or paying dividends. These metrics apply to all industries. They always have. And they always will.

So, why is the share market valuing AirBNB at $160 billion? It’s not the only non-profit-making company with insane valuations – there’s lots of them e.g. Tesla, Afterpay… the list is long.

There could be many reasons for this. Firstly, the influx of novice share investors around the world has been cited for creating some unusual behaviour. With casinos closed, people are turning to the share market. Secondly, low interest rates entice investors to mis-price risk. Thirdly, the work-from-home trend imposed due to lockdowns makes technology a popular investment.

Irrespective of the cause, if you are going to invest in a stock that has no fundamentals, you must time your investment perfectly. Popularity is fleeting. It can change overnight. So, your investment returns are dependent on you selling before any change in popularity.  

Alternatively, if that feels too risky, stop speculating and start investing.

Investment fads come and go. They always have. There’s always an asset that promises better than average returns – read: get rich quick. However, the true rewards go to the investors that can ignore the shiny objects and stick with fundamentally sound investment for the long run. Popularity is a wonderful driver of value in the short term, but unfortunately it never lasts, only fundamentals do.

Fundamentals will be popular again one day soon.