Despite a tumultuous 2020, one investment stood head and shoulders above all others: bitcoin.
The largest cryptocurrency in the world by market cap has more than quadrupled in value over the trailing-12-month period through Jan. 17. It's up a cool 9,310% over the trailing five years. Bitcoin blows pretty much all other equity investments out of the water, in terms of total return, since the beginning of 2016.
Bitcoin enthusiasts continue to point to its scarcity -- a maximum of 21 million tokens will be mined -- and growing adoption among merchants as reasons for its outstanding performance.
While there are smart ways to get rich from bitcoin, I believe there are also three awful ways to invest in this craze.
There's no shortage of publicly traded cryptocurrency stocks that rode bitcoin's astronomical rise to big gains of their own. Cryptocurrency mining company Riot Blockchain (RIOT 6.38%) is a perfect example. Riot's shares have soared over 1,700% in the past year, bestowing a $1.7 billion valuation on the company. But dig a bit deeper and you'll see that even a tenth of this market cap might be too aggressive a valuation.
As a cryptocurrency miner, Riot uses a system of high-powered computers to solve complex mathematical equations that validate groups of transactions on bitcoin's underlying ledger (its blockchain). For being the first to solve a block of transactions, cryptocurrency miners like Riot are given a block reward of 6.25 bitcoin. This 6.25 bitcoin is worth more than $224,000 as of Jan. 19.
Though it's a pretty straightforward business model, it's also highly capital-intensive and extremely competitive. Riot Blockchain generated only $6.7 million in revenue through the first nine months of 2020. It's produced the same net loss ($16.6 million) through September that it did in the first nine months of 2019. Put another way, Riot may not even hit $10 million in 2020 sales, but it carries a $1.7 billion market cap.
Further, Riot Blockchain's business model is only minimally driven by product development. Rather, it's inherently reliant on sustained bitcoin euphoria. History has shown that interest in bitcoin ebbs and flows. With bitcoin interest again peaking as it makes a second run at $40,000, experience suggests that cryptocurrency miners like Riot Blockchain are headed back into the doldrums sooner than later.
Grayscale Bitcoin Trust
Investors would also be wise to avoid buying into Grayscale Bitcoin Trust (GBTC 4.73%).
Grayscale Bitcoin Trust is the first publicly traded bitcoin basket security. Since the U.S. Securities and Exchange Commission hasn't given the green light to bitcoin-based mutual funds or exchange-traded funds, the Grayscale Bitcoin Trust has been a popular purchase among investors. As of Jan. 19, Grayscale owned 632,761 bitcoin tokens, which were cold-stored with the Coinbase Custody Trust Company. With Grayscale regularly updating its outstanding share count and bitcoin per share, investors can easily calculate its net asset value (NAV).
Though buying a security on the over-the-counter exchange probably sounds a lot easier than buying and storing bitcoin from a cryptocurrency exchange, there's one big problem: The Grayscale Bitcoin Trust is pretty much always valued at a premium.
Years ago, it wasn't uncommon to see the Grayscale Bitcoin Trust at a 30% to 120% premium to its NAV. Things aren't that bad these days, but it was still valued at an 11.7% premium to NAV on Jan. 19. As if it's not enough that investors are grossly overpaying relative to the value of the underlying "asset," the Grayscale Bitcoin Trust charges a mind-bogglingly high 2% annual fee for doing who knows what exactly.
Suffice it to say that this is not how to invest in bitcoin.
Finally -- and who couldn't see this twist of fate coming? -- I believe buying bitcoin directly on cryptocurrency exchanges is a bad idea.
Last week, I laid out the case for why ancillary bitcoin stocks are much smarter and safer ways to play the euphoria surrounding the largest digital token in the world. I also maintained my stance that bitcoin is the most dangerous investment of 2021.
Though bitcoin enthusiasts won't admit it, their digital gold mine is full of potential flaws. For example, it's fueled by the idea of false scarcity. For now, code limits bitcoin to 21 million tokens. However, community consensus has the potential to increase this token count. With so many investors "HODL-ing" their bitcoin and refusing to spend it, the only way for bitcoin to obtain utility is through a big increase in its circulating supply.
Bitcoin lacks game-changing utility. It's seeing plenty of daily trade volume as day traders and computer trading programs dice in and out of the highly volatile cryptocurrency. But only 2,300 businesses in the U.S. accept bitcoin as a form of payment. That's out of approximately 7.7 million businesses with at least one employee.
Bitcoin isn't unique. There were more than 10,000 blockchain companies established in China last year alone. With essentially no barrier to entry in developing blockchain, there are no guarantees that this next-generation technology will even need bitcoin or crypto tokens to transform payment processing or supply chains.
I suggest avoiding direct investments in bitcoin. Instead, buy the ancillary businesses that benefit no matter what happens to the world's largest cryptocurrency.