The SportsFolio Journal - May 21, 2021

To Understand Bitcoin, We Must Understand Gold

Russell Okung, an offensive tackle, jumped on the Bitcoin train early. He got his wish, and right before the New Year, he became the first known athlete to have his salary paid in Bitcoin. Technically, that statement is not fully correct as Okung still received his salary in USD and used a conversion mechanism;  he converted half of his 13-million-dollar salary to Bitcoin through a company called Zap.

This past week was not Bitcoin’s best. First, Elon Musk said that Tesla has halted purchases of vehicles with Bitcoin due to energy concerns. 

A few days later, Musk suggested that Tesla may have sold its Bitcoin already, something we may not really know before Tesla files its quarterly report. 

Then, China signaled a crackdown on crypto. 

Prices of cryptocurrency have skyrocketed and plummeted recently, and speculative trading has bounced back. This seriously harms the safety of people's property and disturbs normal economic and financial orders. 

“Harms the safety of people’s property…” Sounds a lot like Munger’s “contrary to the interest of civilization” comment just a few weeks earlier. When Buffett’s right-hand man, a great investor in his own right and America’s biggest competitor on the world stage agree on something, that should be a warning sign. 

Bitcoin took a hit this week when it sunk to a recent low of $30,000 and change, though it has since recovered some and at the time of this writing, it was hovering around $37,000.

Okung, however, does not seem worried. 

The world of finance has seen its share of disagreements, but not on this level. If we really want to understand why there is a deep split on this, we have to go back to the basics. Equally important, we have to question everything we know. More specifically, we have to be honest with ourselves about what gold is and what it isn’t because to understand Bitcoin, we must understand gold. 

Let’s start with this video. Many things can be entertaining or educating, but when it’s both, we have found a gem (warning: some adult language in this one)

Funny, isn’t it? The message is clear: gold is not, and has never been a financial asset. It is true that it has a floor value because you can make desirable jewelry out of it. Beyond that, it obviously was an explicit part of the monetary system in the U.S. at some point. But there is an even bigger factor in play here:

Gold is arguably the best adoption story of all time. 

There are so many people out there that have positive feelings about gold and the “gold as an investment” story persisting for so long, it is almost universally accepted that gold is an asset. 

Which, of course, is a myth, at least if we are talking about financial assets, which means assets that generate cash flows. 

One person, who doesn’t really get enough credit for this line of thinking is Aswath Damodaran. When he started thinking hard about Bitcoin a few years ago (at least that’s when he went public with his views), he had no trouble concluding that Bitcoin is NOT a financial asset. It is generating no cash flows after all. At the same time, he was presumably hearing a lot about Bitcoin really being digital gold. At that time, Damodaran had already concluded that gold is impossible to value and you cannot invest in it, you can just trade it (though he was of the view that gold may have a place as an insurance mechanism.) Thus, the digital gold narrative was a moot point for Damodaran, to the extent that it implied having an asset characterization. Therefore, when he followed his argument to its logical conclusion, he had no trouble stating what he had already concluded: Gold is not a financial asset, either. Damodaran still holds the same view for Bitcoin: it is just a speculative exercise

If this sounds obvious to you, that’s great, but this begs the question: Why are there still a lot of smart people that denounce Bitcoin but stop short of declaring gold as a non-asset? One example is Nouriel Roubini. If you have 25 minutes and want an interesting set of observations on a potential market crash, gold, Bitcoin, currency wars (i.e. USD vs. China’s RMB), you might want to watch this video

Now, there is not a whole lot here we disagree with Roubini on, but one thing stands out: Roubini is applying different standards to Bitcoin and gold.

This is the key takeaway:

Stocks give you a dividend, bonds give you coupons, loans give you interest, real estate gives you rent or housing services. Gold doesn't have income, but it has uses in industry. It has utility because it has been used as jewelry for thousands of years. It has been a stable store of value whenever there is inflation, deflation, financial crisis, geopolitical problems ...

So far so good. He is honing in on cash flows, which is the right thing to do. That gold doesn’t generate cash flows is a fact. Gold had staying power, that is also a fact. 

But where things break down is when Roubini builds a bridge into assets and investments when that bridge is not there. He refuses to go where his argument takes him.

Given the trend of monetizing fiscal deficit, gradually rising inflation, social-political problems, geopolitical problems, the gradual weakening of the value of the U.S. dollar, and potentially other risk-off episodes, I would be slightly overweight in my portfolio into gold assets … We had COVID-19, but there will be other risk-off episodes where there is a correction of U.S. and global equities when gold is then a safe asset.

Roubini is not the only one who refuses to fully walk through the door that logic opened for him. Watch this video of Bob Doll, former Nuveen Senior Portfolio Manager (now retired):

His views on Bitcoin:

You buy this because you think it’s going higher because somebody else will take it off your hands at a higher price. It is a speculation.

Spot on. 100%. Nailed it. 

This market has to mature before it becomes real investment and not a speculation. 

Negative. As currently designed, Bitcoin does not generate cash flows, and thus, one cannot invest in it. The fact that it might get adopted by the masses is not going to change that fundamental truth about investing. 

If cash flow is what makes something an asset, then gold fails that test, too. Does the fact that gold has other uses matter? Of course it does. It provides a floor to gold’s price. Does adoption matter? Of course it does. It increases that floor price a bit higher. 

That said, none of that changes the fact that gold is not a financial asset, and one cannot invest in it. It does mean that gold has a lower risk profile as a speculative tool than Bitcoin. But less speculative does not mean you are investing. Remember, you need BOTH cash flows AND margin of safety for something to be an investment. 

Let’s bring this home by way of specific examples: 

  • Stocks don’t always have cash flows but that is a choice, not a feature. As such, they are presumed to have cash flows at some point, and since valuation is all about bringing future flows to the present, that should be considered a pass. At the right price, stocks also have margin of safety. 

  • Debt instruments have cash flows, and at the right credit rating, they also have margin of safety. There is a reason why we have the phrase “investment grade” after all.

  • An event contract, e.g. a traditional sports bet has cash flows but no margin of safety. One of the parties loses everything. 

  • Gold arguably has some margin of safety, at least if we consider that to mean having some level of comfort against sudden price drops. That is, again, partly due to its industrial uses, and partly due to its widespread adoption. As Damodaran once observed, it is unlikely that we will all wake up tomorrow and the world will denounce gold wholesale. That said, it still has no cash flows.

  • To this point, Bitcoin has neither cash flows or widespread adoption. We have our doubts about true adoption when the whole thing seems to be against the existing government interests (i.e. why not a digital dollar or Euro), but theoretically, at least, it can reach a level of what one could consider significant adoption. As designed, it will not have cash flows (and no, interest payments to Bitcoin do not count, that’s not Bitcoin generating cash flows, but a debt instrument denominated in Bitcoin). 

The fact that gold has other uses (jewelry etc.) is not insignificant. By one estimate, that’s the majority of what makes gold an $8 trillion market. We can also debate those numbers. What’s not up for debate, in our opinion, is that once we put those “other uses” aside, gold and Bitcoin look quite similar. Neither of them produces cash flows. Neither of them is an asset. You cannot invest in them, but you can speculate on them. 

Gold has shown that it has staying power. Bitcoin is not there yet. 

Roubini and Doll are 95% there but are hesitant to make that final jump into denouncing gold as a non-asset. Roubini says it explicitly. Doll doesn’t say that, at least not in this video, but we think it is reasonable to infer that him thinking Bitcoin may be an investment one day is that he thinks that gold has already become one. Gold has arguably matured but Bitcoin has not.  

We understand it is hard to refuse something that you’ve believed your entire life. That said, if that’s where logic takes you, then so be it. Not accepting the fact that we have misunderstood gold all our lives actually emboldens Bitcoiners - it essentially takes away any ammo when they say that Bitcoin is digital gold. That is a key part of that argument: gold is an asset → Bitcoin is digital gold → Bitcoin is an asset. This argument is internally consistent. It fails because the starting point is wrong. As such, if you use cash flow as a test (rightly so), but stop short of unmasking gold because you have a vested interest in it (either because you have a financial and/or emotional interest), then you are not being completely honest with yourself. 

The bottom line is that if we are not ready to de-escalate gold into what it truly is, we are making it easier for Bitcoin to escalate to higher highs. 

Now, you can say this discussion is academic and we are splitting hairs, but we couldn’t disagree more. Agreeing on definitions and an honest and consistent conceptual framework is of utmost importance; it tells us what kind of society we want to be. 

For what it's worth, America’s biggest competitor on the world stage, China, is going in the opposite direction ...