Joining the (indirect) bandwagon

Henry Birt, JM Finn

06 May 2021

Owning an asset directly is not always achievable or in line with your overall investment objective. Henry Birt uses the current Bitcoin rally to explore how else investors might join the bandwagon.

Bitcoin’s meteoric rise continues, seemingly unabated by the crypto-sceptics who have been foreboding that another 2017-style crash is imminent. Talk of cryptocurrencies pervades institutional circles, characterised mostly by scepticism and mistrust. Yet, this is no new phenomenon and it wasn’t long after the creation of the first digital coin that sceptics became vocal: Soros and Buffet have both at points voiced their crypto-disapproval.

Despite this, bitcoin has captured the market’s imagination. The claims from the crypto-acolytes that bitcoin presents a genuine gold alternative have started being listened to more seriously and inevitably, as prices have continued to climb, previous sceptics are beginning to look for other avenues to gain indirect access to what could result in the creation of a whole new asset class.

Funds and Trusts

One option that has recently become available are bitcoin exchange traded funds (ETFs), where the responsibility of holding actual bitcoin is transferred to a fund manager. North America’s first bitcoin ETF, making its debut in early 2021, had a characteristically frenzied first day of trading. Just under 10m of the Purpose Investments bitcoin ETF shares changed hands, which was enough to raise the fund into the day’s top-ten most actively traded securities on the Toronto Stock Exchange.

Prior to the inception of bitcoin ETFs, investors could still gain access to cryptocurrency trusts in the less regulated over-the-counter market. One provider of these trusts, Grayscale, witnessed inflows of c.$6bn last year.

Direct Equity Exposure

For many investors however, this once-removed exposure to cryptocurrencies via trusts and funds remains too volatile a prospect. For more distanced exposure to bitcoin, investors are increasingly turning to direct equities. In search of direct exposure to cryptocurrencies via stocks, investors are looking to three broad categories.

Firstly, via companies that are integral to the mining of bitcoin. New bitcoins come into existence when bitcoin ‘miners’ (computers) solve a complex algorithm and are rewarded with a fixed amount of the digital coin. The algorithm is designed so that as the computing power of the network increases, so does the difficulty of the algorithm, thus preventing the supply of bitcoin increasing dramatically as miners are added to the network, which subsequently prevents currency depreciation. The rather serendipitous outcome for computer hardware producers is that this creates an ever-growing demand for faster machines in greater volumes.

Because bitcoin mining requires so much computational power, many miners use graphics cards and thus the producers of such hardware have benefitted from this augmented demand.

Nvidia, a semiconductor company, is a prime example. The company is best known for its Graphics Processing Units (GPUs), which are increasingly used by bitcoin miners. Nvidia doesn’t have visibility over the end use of the Central Processing Units (CPUs) it sells into the consumer gaming market, but analysts estimate that crypto-mining contributed somewhere between $100m to $300m to their Q4 revenue, a relatively small portion of overall gaming revenue. However, in January they announced the release of a new line of CMPs or crypto-mining processors, specifically designed to mine Ethereum, the second largest cryptocurrency by market capitalisation. So, whilst bitcoin’s effect on overall revenue is currently small, Nvidia’s product development suggests they see further commercial opportunity in catering to the cryptocurrency market.

Beyond hardware producers, there is a second group more actively engaging with cryptocurrencies: digital payments companies. PayPal, the fintech stalwart, announced in October of last year that it would begin to offer support for cryptocurrencies, including at the checkout. The announcement followed the approval of a conditional ‘Bitlicence’, enabling the Silicon Valley company to trade and hold cryptocurrencies. Whilst this is unlikely to be a revenue-generating addition to the offering, it will feed into PayPal’s super app ambitions; PayPal claims 50% of its crypto-investing users reported doubled app usage after beginning to trade bitcoin.

PayPal’s competitor, Square arguably provides more material access to the crypto theme though. The company, co-founded by Twitter boss Jack Dorsey, has offered bitcoin support via its Cash App for over two years. In January, Cash App achieved its highest monthly total of new transacting active customers for its bitcoin products. Square, similarly to PayPal, views bitcoin as an important avenue for user engagement and acquisition. On the face of it, bitcoin’s contribution to Square’s performance looks material, with $4.57bn bitcoin revenue recorded in FY20, c.50% of total revenue. However, whilst the sale of bitcoin to users on its cash app is recorded in the revenue line, the cost of buying this bitcoin is also recorded in the cost of revenue. Therefore, the contribution to gross profit derived from the small margin Square charges for holding the coin and the change in the price between Square purchasing and selling the bitcoin to its users is minimal, at $97m in FY20.

Square’s largest exposure to crypto does however come through its cash reserves, c.5% of total cash/investments. Square has invested a total of $220m in bitcoin, which it ‘expects to hold as a long term investment’. Bitcoin is defined as an indefinite intangible asset and thus increases in its value can only be recorded once it has been sold. The $50m bought in Q4 for example, was reported to be worth $136.5m at the end of the quarter but remained as $50m on the balance sheet.

Whilst this remains a relatively small portion of total cash/investments and the contribution to gross profit is small, Dorsey is effusive about cryptocurrencies and so it seems they will continue to become an increasingly integral part of the business.

The third and final group of bitcoin-exposed companies includes the likes of Square within its ranks. These are companies which have used cash reserves to buy cryptocurrencies. This trend was kick-started in August 2020, when business intelligence company Microstrategy disclosed it had invested $250m of its excess cash reserves in bitcoin, as a hedge against the dollar. Since then they have ramped up purchases and in FY 2020 $1.125bn was purchased, including costs and expenses.

Microstrategy’s sizable commitment to bitcoin was then eclipsed when Elon Musk, Tesla founder and CEO, revealed he had ploughed $1.5bn of Tesla’s reserves into the currency, representing 11% of the electric vehicle maker’s cash reserves. This was accompanied by Tesla’s plans to allow payments in crypto-currency for its cars also.

The investments of both Microstrategy and Tesla do represent sizable commitments to the currency. Moreover, as with Dorsey, Musk is a disciple of the crypto-sphere and so Tesla’s engagement with bitcoin and other cryptocurrencies is only likely to grow. Therefore, for those looking for access to the currencies, these names may become a serious proxy bet in the future.

The but…

As exciting as cryptocurrencies may appear, a few caveats must be applied. Firstly, the jury remains out on whether bitcoin does represent a store of value and whether it will ever replace fiat currency, as its founders envisaged.  Bitcoin’s price rise is not completely free from the shadow of its previous falls and a repeat of 2017 would hurt its reputation and thus hurt those companies gaining exposure to bitcoin’s rise. 

For those companies benefiting as a by-product of the increasing demands of the mining process, a sharp fall in the value of the coin would in turn affect them negatively. If the value of a cryptocurrency falls, naturally the incentive to mine it does too. It then follows that the demand for CPUs and GPUs, which derives from the urgent need for more computing power, will also fall.

The digital payments companies also leave themselves exposed to depreciation in the currencies and are more vulnerable to hacking risk. This could lead some users nursing heavy losses or losing trust in the platforms, although admittedly this probably doesn’t present too material a risk.

For those companies investing their cash reserves in the digital coins – they quite obviously are directly exposed to bitcoin’s value. In times when the traditional investments of company treasuries deliver very poor returns, the move to crypto looks attractive. However, when the tide turns, crypto-investing may start to look reckless.

The second and arguably more important point is that for the moment gaining access to the cryptocurrency ascension through equities is pretty difficult. All three of the aforementioned groups of companies are currently only marginally exposed to the rise and fall of bitcoin. Crypto-mining isn’t yet one of the key drivers of semiconductor company performance and it still only represents a marginal part of digital payments platform’s performance too.

Companies investing their cash reserves into cryptocurrencies do present a slightly material exposure and this only looks likely to increase into the future. However, for the moment it remains a slightly tenuous link to the currency.

It seems then that if an investor desires exposure to bitcoin, equities might be a slightly convoluted way to do that. Whilst this may change in the future, don’t expect to see bitcoin-like returns from those companies that are only mildly exposed to the digital coin. On the upside however, you might not see 2017-like drops if history repeats either.

Henry Birt, Research Assistant

This article is intended for educational purposes and should not be viewed as a recommendation or invitation to transact in any Cryptoassets or associated investments. JM Finn cannot advise on, facilitate or execute any transactions in cryptoassets and might not be able to advise on, facilitate or execute any transactions in other securities mentioned. The price or value of any Cryptoassets can rapidly increase or decrease at any time (and may even fall to zero). All views expressed are those of the author.