My Own Reasons for Not Investing in Cryptocurrency
Why Cryptocurrency Doesn’t Fit My Investing Style
I have been investing in Indian stocks since 1993. My approach is to own businesses I understand, study their financial performance, and look for companies that can generate earnings and cash flows, earn attractive returns on capital, and create value over time. I want to understand how a business makes money, what could go wrong, and what its future earnings may be worth.
Cryptocurrencies do not fit comfortably into this approach. My concern is not simply that their prices can rise and fall sharply. Stock prices can be volatile, too. The difficulty for me is establishing the intrinsic value of a cryptocurrency and determining whether its market price offers a reasonable margin of safety. I do not have the same valuation framework that I use when investing in an operating business.
When I buy shares in a company, I acquire a stake in an operating business. The company may manufacture products, sell goods, provide services, or undertake some other productive activity for which customers are willing to pay. I particularly prefer businesses built around services or a franchise model, where the business can grow without necessarily requiring large amounts of capital for physical assets.
I can examine its revenue, operating margins, profits, cash flows, assets, liabilities, and capital requirements. I can assess its competitive position, management quality, and ability to reinvest earnings at attractive returns. I can also estimate how the business might perform under different economic conditions and determine what I would be willing to pay for its future earning power.
None of this makes investing in stocks easy or guarantees a return. A company can lose its competitive advantage, mismanage its capital, accumulate excessive debt, or fail to convert reported profits into cash. My estimates of future earnings can also prove wrong. But I have financial information and business economics to work with. The numbers, combined with an understanding of the business, provide a basis for estimating intrinsic value.
A well-managed business can also retain part of its profits and reinvest them in expansion, new products, better distribution, or other productive assets. If it earns attractive returns on that capital, its earnings and intrinsic value can grow over time. Shareholders may benefit from that growth through a rising value of their ownership stake and, where dividends are paid, direct cash distributions.
This is the reasoning behind my preference for owning businesses rather than merely buying instruments in the hope that their prices will rise. I have discussed this approach in my investment principles for preserving capital and investing in stocks.
What Does a Cryptocurrency Represent?
When I buy an ordinary share in a listed company, I acquire an ownership interest in that company, subject to the rights attached to the shares and applicable law. When I buy an unbacked cryptocurrency, I generally acquire a digital asset recorded on a network. I do not acquire a stake in an operating business merely by holding its token, nor do I automatically obtain a legal claim on the network’s revenue, assets, or the profits of businesses that use it.
That distinction matters to me. A cryptocurrency may be useful within its network, but the token holder’s position is different from that of a shareholder in a company that generates earnings and cash flows. The usefulness of the network does not, by itself, establish the value of the token or the economic benefits that its holder can expect to receive.
Cryptocurrencies and other digital assets are not all alike. Some tokens are linked to external assets, while others may carry specific contractual or governance rights. Those arrangements require separate examination. My concern here is principally with unbacked cryptocurrencies and native network tokens that do not provide their holders with an enforceable claim on underlying assets or business cash flows.
For such assets, I have to look elsewhere for a basis for valuation. That brings me to the arguments commonly made in their favor.
The Arguments in Favor of Cryptocurrencies
Digital scarcity
Some cryptocurrencies have predetermined issuance rules or limits on supply. Bitcoin, for example, is designed around a defined issuance schedule. Supporters argue that a scarce digital asset cannot be created at will like ordinary money and may therefore retain or increase its purchasing power as demand grows.
This is a legitimate argument to examine. Scarcity can contribute to value, and an asset does not necessarily have to produce earnings to be worth owning. Gold is an obvious example. It has no earnings or cash flows of its own, yet people value it for its physical properties, uses, scarcity, monetary history, and role in investment portfolios.
Cryptocurrency supporters make a similar case for digital assets, particularly Bitcoin. They believe that a scarce asset capable of being held and transferred digitally may develop a lasting role as a store of value. That possibility cannot be dismissed simply because the asset is digital.
Decentralization and digital transfers
Cryptocurrencies can enable transfers through networks that do not depend on a single central operator maintaining the transaction record. Depending on the network and the circumstances, this can offer an alternative way to transfer value across borders and reduce reliance on certain traditional intermediaries.
The original Bitcoin white paper proposed a peer-to-peer electronic cash system. The idea of enabling digital transfers without depending on a central financial intermediary was a meaningful technological development. Whether a particular cryptocurrency provides a practical, cost-effective, and reliable payment option depends on how the network works and how people use it.
Network adoption and practical utility
Some blockchain networks support programmable transactions and applications that operate through smart contracts. These programs can execute defined rules when specified conditions are met. Developers and users may find such capabilities useful for financial services, digital assets, and other applications.
Supporters also argue that a network becomes more valuable as more people use it. Greater adoption can attract developers, businesses, and users, making the network more useful and encouraging further adoption. These network effects can matter, particularly when a platform develops an established ecosystem.
There is merit in examining these possibilities. The issue is not whether cryptocurrency networks can be useful. The issue is whether their usefulness and adoption translate into a value for the tokens that I can estimate with sufficient confidence to justify an investment.
Why These Arguments Do Not Settle the Valuation Question
My difficulty begins when I try to translate scarcity, utility, and expected adoption into an estimate of intrinsic value. In a productive business, I can examine its earning power, estimate future cash flows, and consider how much capital it may need to generate them. I cannot apply that same analysis directly to an unbacked cryptocurrency that gives its holder no claim on business earnings or cash flows.
Scarcity alone does not solve the problem. A limited supply tells me something about how many units may exist, but not how much those units should be worth. Demand matters just as much. An asset can remain scarce while demand for it declines, and a fixed supply does not guarantee that future buyers will be willing to pay more than I paid.
The same applies to network adoption. A growing user base may make a network more useful, but the economic value captured by a particular token depends on the network’s design, the role of the token, the supply of tokens, competition, and the rights of holders. A useful application does not automatically make its associated token a good investment at any price.
Some investors use measures such as transaction activity, network adoption, token supply, or comparisons with monetary assets to estimate cryptocurrency value. These methods can help assess a network and the forces affecting demand. I do not claim that such analysis is meaningless. But it requires assumptions about future adoption, user behavior, competition, and the role a token may eventually play. I find it difficult to rely on those assumptions to establish a value with the confidence I seek before committing long-term capital.
Market sentiment also plays a role. Confidence in a technology, expectations of wider acceptance, changes in investor appetite, and competition can all influence what buyers are willing to pay. These factors can affect the value of businesses, too, but a productive company gives me another reference point: its financial performance and potential to generate cash over time.
Warren Buffett made a similar point when discussing Bitcoin and other non-productive assets:
When you buy non-productive assets, all you’re counting on is whether the next person is going to pay you more.
Warren Buffett, CNBC’s Squawk Box interview, May 7, 2018
I have a similar preference when evaluating other assets that do not generate cash flows. In my article on gold as an investment for a value investor, I explain why the ability to estimate intrinsic value matters to my approach. That does not mean gold and cryptocurrencies are identical. Their histories, uses, and economic characteristics differ. The point is that I need to understand what supports an asset’s value and what assumptions I am making about its future.
I do not need to prove that a cryptocurrency has no value. I need to decide whether I can estimate its value well enough to invest my money with a reasonable margin of safety. For the unbacked cryptocurrencies I am concerned about, I cannot do that to my satisfaction.
Blockchain Technology Is a Separate Question
Acknowledging the potential usefulness of blockchain technology does not require me to invest in cryptocurrencies. A technology and the assets associated with it are two different things.
For example, smart contracts on Ethereum are programs that run on a blockchain. They can support applications that execute predefined rules and interact with other programs. Such capabilities may have useful applications, although their suitability depends on the problem being solved, the cost of using the network, security, reliability, and the available alternatives.
Even if blockchain technology proves useful in many areas, that does not mean every blockchain project will succeed or that every associated cryptocurrency will increase in value. A network may provide a useful service without its token capturing enough economic value to justify a particular market price. Competition may also emerge from other blockchains or from technologies that do not require a blockchain at all.
I am open to the possibility that blockchain technology will find lasting applications. I do not have to reject that possibility simply because I choose not to invest in the tokens associated with it.
Why I Stay Away From Cryptocurrencies
I am not claiming that cryptocurrencies will fail, that their prices cannot rise substantially, or that nobody can make money investing in them. Their future role in finance and the wider economy remains an open question. Some networks may develop durable uses, and some digital assets may acquire a lasting place in the financial system.
My decision is narrower. I prefer to invest in businesses whose operations, financial performance, capital requirements, and future prospects I can study. I want to make a reasoned estimate of intrinsic value and compare it with the price the market is asking me to pay. I want the opportunity to benefit from earnings growth, cash generation, and the reinvestment of profits at attractive returns over many years.
The Indian rupee and the U.S. dollar are sovereign currencies, supported by their respective legal and monetary systems. Bitcoin and similar decentralized cryptocurrencies have no sovereign issuer standing behind them and no government obligation to redeem them. This is another reason I am reluctant to treat cryptocurrency as a substitute for conventional money.
With unbacked cryptocurrencies, I find it difficult to establish a comparable basis for valuation. I would have to place much greater reliance on assumptions about future demand, adoption, scarcity, and what other market participants may be willing to pay. That is not the approach with which I am comfortable investing my long-term capital.
So I choose not to invest in cryptocurrencies. This is not a prediction about their future price or a dismissal of the technology behind them. It is a decision based on the kind of assets I understand, the way I estimate value, and the standards I use before committing my money. I would rather concentrate on productive businesses that I can analyze and own for the long term.