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  Buffett, Bitcoin and bubbles

BENJ GALLANDER and BEN STADELMANN

Friday, February 28, 2014

The year 2013 was not a good one for hedge funds; the vast majority were trounced by their benchmarks.

However, there was one sparkling exception: a Cyprus-based fund that recorded a 5,556 percent moon shot, the biggest payoff since — well, forever.

How is such a mindboggling fountain possible? You have to put aside such traditional asset classes as stocks and bonds and instead think of something that combines a payment system, a currency, a libertarian fantasy and a government nightmare. In a word, Bitcoin!

The reaction to the emergence of the crypto-currency, both from the general public and the establishment, has ranged from skepticism to fear and outright condemnation.

Economist Paul Krugman, in his New York Times op-ed "Bitcoin is evil," questioned how it could be a store of value and aligned himself with those who believe it is a weapon designed to undermine central banks and the state's ability to collect taxes. Besides, isn't it just another crazy tulip bubble?

Bitcoin's price has indeed crashed again and again over the past three years, including the bear market of 2011, when it dropped by a whopping 94 percent. Technical issues have hurt the currency, most recently the "transaction malleability" flaw that felled the Mt Gox exchange. Other challenges have come from external sources — such as when Chinese Internet giant Baidu instituted a Bitcoin ban.

In each case, it has picked itself off the pavement and, within a few weeks or months, has roared back stronger than ever. That's a different pattern from any bubble we've ever heard about.

Criticisms suggesting Bitcoin is a scam or Ponzi scheme can be easily dismissed as a product of closed-minded ignorance. But the question of what exactly creates Bitcoin's "store of value" — a key ingredient of money — is not so easy to answer, even by its supporters.

One method is to apply the classical cost-of-production theory of value. This can easily be done by looking at a Bitcoin mining profitability calculator website. The technical details are not too important; the salient concept is that the cost of mining is essentially the relationship between the capacity of the computer hardware used, its power consumption, and the local cost of electricity.

The "difficulty" parameter ensures that new Bitcoins will progressively require more resources to create, mimicking the physical world's miners, who must work harder to extract from low-grade ores.

An indication that this currency is no passing fancy is that an arms race has developed among manufacturers to design the most powerful and efficient hardware for mining Bitcoins. It is also expected that mining operations will eventually move to remote regions with low electricity prices, as is the case with aluminium smelting.

But Bitcoin's market price has appreciated too fast to be explained by mounting production costs. The subjective theory of value holds that individuals place a value on a product based on its utility to them.

The ability to transfer money cheaply and with privacy across the Internet is a benefit, perhaps not to everyone, but to a sufficient portion of people that this need creates intrinsic value. It is the appreciation of the persistent advantage of a decentralized e-currency that has drawn speculators to Bitcoin, causing its wild volatility.

Bitcoin as an investment?

Before charging off in this direction, our suggestion would be to dig in and learn about it, just as would be prudent with any other alternative asset class, be it fine art or farm land.

At the very least, it would be a good idea to stick a toe in the water and buy some Bitcoin, use it to purchase something, then convert the "change" back to conventional currency. Transactions in this virtual world are different and take some getting used to; by understanding the mechanics, a better assessment of its potential future utility can be made.

The stock market offers few opportunities to invest in companies that will profit from the rising popularity of Bitcoin, though it's probably just a matter of time until "pure plays" become available. One current possibility is Overstock.com, an online discount retailer that has been around for a long time but has fallen out of favour.

The company grabbed headlines in January when it announced that it will accept Bitcoins for purchases. That did little to distract from disappointing fourth-quarter results due to rising marketing expenses and a $6.8 million hit when the corporation lost a legal battle.

Nonetheless, it still managed to record a healthy $88.5 million profit for the year with the assistance of a tax credit. Revenues came in at $1.8 billion, up 18.6 percent over 2012. The stock is currently around $18.50, down about 40 percent since the start of the year. Back in the heyday of 2004, it crested the $70 mark.

It is worth noting that Overstock is a favourite of noted value investors Prem Watsa and Francis Chou. There is also a connection to Warren Buffett. Overstock's CEO Patrick Byrne ran an apparel unit within the Berkshire empire before transforming bankrupt retailer D2-Discounts Direct into Overstock in 2002.

Byrne is something of a Wall Street renegade, crusading against the practice of naked shorting and firing off lawsuits against "predatory" hedge funds. It's no wonder that he's on the vanguard of the Bitcoin revolution.


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