Bitcoin: whether you love it (like Twitter CEO Jack Dorsey and erstwhile cryptobull Steve Wozniak), hate it (like Bill Gates and Warren Buffett), trade it as a tacit political protest, a proxy for Beanie Babies, for Tesla stock, regard it as the bastard child of “gold and the Internet,” or a potential environmental catastrophe, it is a financial chimera for changing times.
And it’s up 90-plus percent year-to-date, trading above $13,663 per unit, against an all-time high of $20,000 in 2017.
But can it also be a value investment, and at what value? A hedge—and if so, against what?
Brian Estes, Chief Investment Officer of Off the Chain Capital, a $40 million long-only, non-leveraged bitcoin hedge fund that has outperformed all other crypto funds, the spot price of bitcoin and the S&P 500 over the past three years, views bitcoin as a combination of many (if not all) of the above: as a scarce asset (like gold) with at least as much intrinsic value as the U.S. dollar (which is to say, as did the St. Louis Fed, none), and which could be poised for a run higher in the coming year.
“What drew me to bitcoin initially was that I am very libertarian, so the idea of sovereign money was important to me, and the fact that for thousands of years before we had fiat money, we had hard assets as money, we had gold and silver for 3500 years,” he says, adding that while Bitcoin remains an important article of faith for the libertarian-inclined, its appeal transcends Republican-Democrat lines.
It also, increasingly, spans the Wall Street-Silicon Valley divide. Estes began his career in conventional Wall Street circles at broker-dealer AG Edwards, then left to manage assets in the endowments and foundations family office segment, ranking in the top 0.1% of Morningstar equity managers between 2004-2014.
After selling his business to Wells Fargo Advisors, Estes moved into the emerging cryptocurrency space, where he has helped finance and scale several blockchain companies valued at more than $10 billion. He also invested as a General Partner at Polychain Capital, which became the first $1 billion crypto fund in 2018.
Today, his fund invests in Bitcoin through a long-only, value lens: acquiring bitcoin assets at a discount to fair value from distressed sellers, and without leverage.
What is fair value?
While Bitcoin, to date, is officially regulated as a commodity and still struggles to gain traction as a fungible currency amid a limited number of use cases, Estes says a prudent way to value it is as a network, without correlations to traditional assets.
His fund relies on several different models to arrive at what they regard as fair valuation for bitcoin. The first is based on a ten-year price history for bitcoin, plotted on a logarithmic scale, with a linear regression line through the middle to indicate whether it’s over- or undervalued: a model that has correlated to 87 percent of its historic price action. According to that simplistic model, Estes says Bitcoin should be worth $35,000 at end of 2020, and $95,000 at the end of 2021, compared to the current price in the $13,000 range.
A second model, devised by Thomas Lee of boutique research and advisory firm Fundstrat, is based on Metcalfe’s Law in the financial valuation of networks. Basically, the number of network users is squared to determined the underlying network value, multiplied times the value of transactions flowing through the network. From 2014 end of 2017—when U.S. regulators permitted traders to begin shorting bitcoin using futures contracts—Estes says that model had a 97 percent correlation to the price of bitcoin, and today indicates that Bitcoin is fairly valued at north of $40,000.
Finally, he notes, there is the scarcity-based stock-to-flow ratio devised by the enigmatic, self-described “Dutch institutional investor” PlanB, which is based on the valuation model for a mined commodity like gold. The ratio is the proportion of the stock that has already been mined, to the flow, or amount of new asset mined each year. By that ratio, gold is the scarcest asset on earth with a multi-trillion dollar market value, but bitcoin is the second-scarcest and yet its $200 billion market capitalization is roughly one-sixtieth the size of gold.
And, per Brian Estes, bitcoin is within range of surpassing gold for scarcity. This is because bitcoin’s source code limits its once-and-future supply to 21 million coins—mined at a rate of 6.25 bitcoins every 10 minutes, or approximately 900 bitcoin per day. This amount is “halved” at every 210,000-block threshold, which works out to around once every four years, putting bitcoin on track to become the scarcest asset on earth at the next halving in 2024.
Yes, geopolitics
Bitcoin’s scarcity doesn’t simply come down to the time-intensiveness of doing hard math. The computing power required to “mine” bitcoin is costly. Per Brian Estes, the cost of mining one bitcoin comes out to $7,000, including the cost of electricity, cooling power, hardware, and manpower. Chief among these inputs is electricity, so production gravitates toward foreign jurisdictions where power can be accessed cheaply.
Where is power accessed cheaply? Numbers from the University of Cambridge Center for Alternative Finance indicate that 65% of the global hash power (or total bitcoin mining) is done in China. The U.S. is a distant second, mining just a tiny fraction of that amount. Three and four on the list are Russia and Kazakhstan. So is Bitcoin geopolitical? Maybe.
No matter where it’s mined, bitcoin drains power. According to the Cambridge Bitcoin Electricity Consumption Index (which is updated every 30 seconds), Bitcoin is currently using 5.6 gigawatts of the world’s electricity to produce. Over the summer, it was reported that Norwegian energy giant Equinor has begun converting natural gas outflow (or waste) from its operations at the Bakken oilfield in North Dakota into electricity for cryptocurrency mining. It remains unclear whether other energy and utility companies will follow suit.
Institutions still wary
Estes started Off the Chain Capital in 2016 to manage his family’s own assets, and decided to open the fund a year and a half ago to outside investments from endowments and foundations. He pitched bitcoin to this investor group as a non-correlated asset, pointing to his own fund’s relatively low-risk approach as a value investor. And while larger college endowments, including Harvard, Yale, Stanford, and MIT have made allocations to cryptoassets, smaller institutions have been extremely leery of the reputational and career risk associated with investing in a new asset class.
“As of today, I don’t see a lot of demand coming from foundations, endowments and large institutional investors, but that is changing. The conversations that we had a year ago are totally different from the conversations that we’re having today,” Estes says.
A five-year shakeout
While this could point to hidebound fiduciaries slowly coming around to crypto assets, Estes says this will take time. And the next five years will likely bring about a massive shakeout across the coin space, with a few winners, many losers—but bitcoin likely to remain as the “reserve currency of the Internet.”
Another weak point? Estes notes that Bitcoin’s memory size is not large enough to support a large number of transactions, and is slow, clearing only once every ten minutes. Online transactions using cryptocurrency will need something faster and larger: one such transactional layer could be Venmo (a blockchain application owned by Paypal), it could be Facebook’s Libra, or something like the U.S. Fed Coin or Chinese digital yuan that will be interoperable with public blockchains like Bitcoin. So Bitcoin will need a transactional partner, which means at least one other crypto payment modality will emerge.
A third “survivor” in the space could be a cryptocurrency for trading of smart contracts. Ethereum is the leader in this space, but it has several rivals, including relative newcomers Tezos and Tron.
“After the shakeout phase over the next 5 years, there will be very few winners. Bitcoin will be one, [there will be] a transactional layer, and one or two smart contract layers, and the others will go to zero,” he says.
