Investment 101 – Say “NO” to Crypto and The Difference Between Trading and Investing

It’s kind of funny sometimes to straddle the worlds of spirituality and finance. So many of my spiritual friends want to invest their money well, but they were never given an education about the basic principles of investment. I have read so many articles saying that “crypto is good because it opens up investment to people who never had an opportunity to participate in the market.” But this is utter nonsense. Crypto and meme stocks and the market around them are encouraging well meaning people to take huge risks with important assets. I know a lot of good people who have real money tied up in completely specious assets like crypto currency and meme stocks. Some of them may end up exiting their positions with a trading profit if they exit their positions at a market peak, but this does not mean that they are acting as investors. They are acting as traders, and there is a huge difference!

The difference between trading and investing.

Trading and investing are two completely different concepts. Trading is the practice of buying something and then trading it for something of higher value later. Baseball cards are a great example. If you have a deck of baseball cards, you can trade them with your friends. You can either trade them directly, my Hank Aaron for your Derek Jeter, or you can buy them and sell them. And baseball cards might even hold their value for quite a long time, so long as there are a lot of people out there who still want baseball cards.

Compare this to buying a share of a company like Apple, which the favorite stock of my favorite investor, Warren Buffett. When Warren Buffett buys Apple stock, he well knows that there may come a point in time where there is someone who wants to pay him a lot more for his shares than he thinks they are worth, and in that case, he might sell them. But that’s not why he bought them in the first place. He buys the shares because he wants to own a portion of the income stream produced by Apple’s business. He is buying the stream of income generated by Apple’s business. This is an investment in the underlying business of Apple.

Baseball cards, like crypto currency, do not actually produce anything at all. They may become more scarce as time goes by and copies of desirable cards are lost or destroyed, or locked away in collections that are out of circulation. This may cause the price of these objects to increase, but it’s not quite the same as producing anything of value. In actual fact, they only produce expenses and losses. If you have a big collection of items like cards, or stamps, or vinyl records, you have to take care of them. You will have expenses and occasional losses. But one thing you will never have is a revenue stream.

Investors make money even if they never sell

The key understanding about investing in stocks is that you are actually purchasing a portion of the underlying company’s revenue stream.. If you invest money in a business with underlying profit, you will participate in the earnings of the company, and you will make money even if you never sell. This gets a little confusing in today’s world because investors are highly motivated to avoid taxes, so companies are always looking for how they can return profits to investors while minimizing taxes. There are four essential ways for companies to return profits to investors.

Four Ways Companies Return Profits to Investors

The first way for a Company to use profits is for the company to invest the profits in assets for its own operations. They may use it to open a new factory or develop a new product line or even to make an acquisition of another company. If they do so, then the profits, which would be collected in the form of cash, are converted to long term assets of the company. This practice of reinvesting profits is very common in growth companies, and in this way profits will increase the value of each share of the company, because now each share is a small part of a larger company.

The next way to use profits would be to pay off some company debt by retiring some bonds or by paying off a loan. In this scenario, the “short term” asset of cash reduces the liabilities of the company. The profits came in to the company as cash and then flowed to decrease liabilities instead of to increase another asset. This will have the same effect on the value of each share as an asset purchase.

Third, they might decide to go into the stock market and buy back some outstanding shares of their own stock, if they believe it is trading below fair value. Berkshire Hathaway has been doing exactly this over the last couple of years. And if you really want a smart investing tip, simply do what Warren Buffett does. If Warren Buffett is buying shares of Berkshire Hathaway, and you have money to invest in the stock market, you might want to think about buying some Berkshire Hathaway shares yourself. When companies buy their own stock, they reduce the number of outstanding shares, and that changes the math a little bit, so every remaining outstanding share owns a slightly larger percentage of the company.

The last thing the board might decide to do is distribute the cash it earned to the shareholders in the form of a dividend. Most mature companies do pay a dividend. This directly profits each shareholder.

The first three of these strategies result in unrealized capital gain for the investors. The intrinsic value of their stocks have increased because the company balance sheet has improved. These profits are not taxable to the investor until they sell their shares. When a company pays dividends on the other hand, the money received is taxable to the investor. Until recently there was a penalty in the tax system for dividends, because they were taxed as ordinary income. As a result, companies would often have an incentive to buy back shares instead of paying dividends.

False Capital Gain from Trading Momentum

The real gains from companies that earn profits outlined above are very different from the unrealized gains many traders see in their personal stock or crypto accounts. When traders purchase stocks with the intent of selling them in the future at a profit, they are not so concerned with the earning of the company during their ownership period as they are with the price some future purchaser might be willing to pay. The more, the faster, the better. This is known as momentum, and investing in momentum never ends well.

If you want to do some research, you can start with the Dutch Tulip Bulb mania of 1534, dramatic rise, crash of the South Sea Company in the year 1711 in London, the tech stock bubble of 1999 to 2000, or the leveraged residential real estate bubble of 2007. There have been many changes in Human circumstances but not much improvement in the madness of crowds.

Crypto Currency Has No Intrinsic Value

It is important to understand the difference between the market value and the intrinsic value of an investment. Crypto currency and Meme stocks have market value. There is no doubt about this. You can go and buy or sell 10 bitcoins for about $39,000 each, and net a cool $390,000. If you only paid $3,000 for them, well then you just put $360,000 in your pocket. But the only reason a bitcoin has value is because someone is willing to pay for it. Bitcoins do not actually produce anything. On the contrary, they require huge resources just for a computer network to “remember” that they exist and who owns them. A company’s shares have market value as well, but underneath the market value is a going concern that actually makes things. The intrinsic value of a share is what an investor should expect to receive in future profits over the remaining expected life of the company.

To illustrate this, imagine what would happen if a large number of bitcoin holders decided to take their profit out of bitcoin at once. There would be a game of musical chairs as people tried to liquidate their holdings into a vacuum of buyers. The first sellers would satisfy the highest price orders, and then the price offered by the next willing buyer would be lower, and so on. The “market value,” which is simply the number of bitcoins multiplied by the last sale price, would rapidly head for zero. In the end, all that would be left would be a bunch of idle computer servers with no cash flow to keep the power on, and bitcoin would just be gone. There is no intrinsic value left for the small group who end up owning all the bitcoins.

Compare this to a hypothetical crash of Apple stock. Imagine if everyone wanted to sell their shares of Apple at the same time. The last buyers, who would undoubtedly include Warren Buffett, would then own a giant company with amazing Human capital and technology and plants all over the world that makes a staggering number of devices each year. There might be a musical chairs for the shares, with everyone trying to get out at once, and the market value might crash, but this would not in any way change the essential value of Apple as a going concern. At the end of the market route in the share price, the remaining stock holders would own a great company and billions of dollars in cash flow. Apple has intrinsic value, bitcoin does not.

Meme stocks are similarly detached from intrinsic value

A meme stock is one step up the food chain from crypto, because at least there is some enterprise behind it. However, the shares are traded like baseball cards as well, because the prices they trade at have no connection to the underlying business’s performance. Let’s look at GameStop for an example. I cannot think of anything to explain why someone would think a brick and mortar store to sell video games is a good idea. I was driving down south Dixie Highway in Miami today and saw that the old Specs Records and Tapes building was torn down for a new project, and so went the days of the brick and mortar store for selling music. Remember Blockbuster? I have not heard any explanation for why GameStop is a winning business model. But sometimes people are motivated by other forces such as nostalgia. I would imagine that many millennial aged men spent a lot of their free cash at GameStop when they were young, and so now they remember the store fondly, and they were therefore inclined to buy the stock.

Tesla is a good company with a very expensive stock

Tesla stock is another interesting example because it actually has a very good business and a credible story for why it will continue to grow into the future, but its stock price is extremely high relative to the expected earnings of the company. So the analysis with Tesla is more nuanced. I love the company personally, but I do not own the stock because I believe it is considerably overvalued. Elon Musk himself has specifically acknowledged that the share price is high, and he has also sold, and caused Tesla to sell, a huge number of shares since Tesla tock price started its most recent surge. On the other hand, Tesla is revolutionizing the entire transportation industry. Also, I drive a Tesla, and I believe in owning stock in the companies I do business with.

But Tesla stock is currently down roughly 1/3 from its all time high and it is still trading at 276 times its earnings. This means that it would take 276 years for the company to earn its own value at the current rate of earnings. That’s a long time to wait to get your money back, especially with inflation now running above 5%. Tesla is definitely a growth stock, and who knows, maybe they go parabolic in their business. I would celebrate that. But Apple posted record earnings as well, and it only takes them 28 years to earn back their own market value. Berkshire Hathaway stock is selling at under 9 times earnings. So if you invest $1,000 in each of these shares, it would take 276 years for you to earn $1,000 from Tesla, 28 years to earn it back in Apple, and 9 years to earn it back with Berkshire Hathaway. We can all talk a lot about the future, but in ten years, shares of Berkshire Hathaway will have earned their own value back. It takes a very compelling story about the future to make me want to wait another 266 years.

What do you do now?

If you are trading stocks and crypto for fun with money you can afford to lose, then enjoy your hobby. But remember this kind of trading is a zero sum game. For every winner there is a loser of the same amount. If you have real money that you need for your future invested in crypto, you might come out ok. Maybe this time really will be different. But you might also lose your entire investment. My preference is to invest where I believe the intrinsic value of the company is higher than the current stock price. I may not make the most return, but I sleep soundly. If I inherited an account full of crypto and meme stocks tomorrow, I would immediately sell all of it and invest it in good profitable companies with reasonable share prices.

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