John Rogers' Ariel Investments Monthly Commentary for December

The mere suggestion that a flower could bring down a whole economy seems absurd to a reasonable mind, however that is exactly what happened during the famous tulip bulb market bubble that occurred in Holland during the 1600s. Increasing demand for rare varieties caused the price of bulbs to surge, with many people bartering their homes and land for the ‘wise investment’ with the simple expectation that the exuberant market behavior would continue and the bulbs could be resold at a greater price. As happens in all speculative frenzies, prices got so high that when people began to take profits, panic selling began. In no time, bulbs soon were trading for “no more than the price of a common onion.”1

Technology has advanced but human behavior remains the same. The idea of digital money has been a hot topic since the start of the Internet. The excitement surrounding bitcoin today has enthusiasts referring to it as digital gold. Rising valuations for cryptocurrency liberated from the oversight of governments and banks is generating increasing media coverage world-wide, further intensifying demand and creating big profits for early bitcoin investors. Driving us to ask the question, what do investors in bitcoin actually own?

As bottom-up value investors, our research begins with clearly defined differentiation parameters. We look for companies with a unique position of strength, which in turn creates sustainable competitive advantages that also distinguish them from their competitors. We like companies with strong brands and franchises that produce or deliver high quality products or services. We prefer companies that have formidable moats that create significant barriers to entry. Bitcoin may have solved one of the core challenges of designing a decentralized digital currency by verifying and validating transactions and recording them on a real time public ledger called the “blockchain” to prevent double-spending. However, bitcoin’s birth certificate published on October 31, 2008 by the pseudonymous “Satoshi Nakamoto,” outlined the design of the blockchain, enabling others to copy it.2 Therefore, it’s hard to identify a moat when there are 1,384 cryptocurrencies with a combined market cap that exceeds $760B, trading on algorithms based on bitcoin’s blockchain.3 While bitcoin’s founder may have created a potentially transformative infrastructure for a digital economy with the blockchain technology, bitcoin investors are not rewarded for other uses of the technology.

Furthermore, once we have identified a good company, we will complete an in depth analysis on its overall financial structure. We take our time to determine if a potential investment has developed and is executing on a set of strategic imperatives that will create long-term shareholder value. In addition to intelligence and integrity, we seek robust corporate governance practices. We evaluate a company’s financial statements, with an eye toward conservative accounting practices, prudent financial policies, solid cash flows and relatively low debt. Our research extends from directly meeting with a company to interviewing adjacent corporations as well as direct competitors, while also developing and cultivating independent sources of verification to ensure a balanced perspective. Our goal is to truly understand the company’s business model and the dynamics of the marketplace in which it operates.

Bitcoin did not pass our first lens of assessment and it is clear that cryptocurrencies are not tangible investments. And although many can speculate on conventional investments like stocks and precious metals, it’s important to know all that glitters is not gold. Bitcoin does not generate earnings or pay dividends. So how does an investor value them if they have no intrinsic or book value? In fact, the strong parallel between the cautionary tale of the tulip market bubble and bitcoins market value more than doubling over the last eight weeks without any material change in its underlying success or application is alarming. The sage of Omaha perhaps

put it best, “the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As ‘bandwagon’ investors join any party, they create their own truth – for a while.”4

In the meantime, as value investors, we will continue to patiently wait for a price dislocation that will enable an attractive entry point for validated investment theses that have passed our rigorous research process. We will leave speculative investments to others.

Past performance does not guarantee future results. The opinions expressed are current as of the date of this commentary but are subject to change. The details offered in this commentary do not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular security.

Investing in equity stocks is risky and subject to the volatility of the markets. Investing in small cap and mid-cap stocks is more risky and more volatile than investing in large cap stocks. Investments in foreign securities may underperform and may be more volatile than comparable U.S. stocks because of the risks involving foreign economies and markets, foreign political systems, foreign regulatory standards, foreign currencies and taxes. The use of currency derivatives and exchange-traded funds (ETFs) may increase investment losses and expenses and create more volatility. Investments in emerging markets present additional risks, such as difficulties in selling on a timely basis and at an acceptable price. The intrinsic value of the stocks in which Ariel’s portfolios invest may never be recognized by the broader market. A value investment strategy seeks undervalued stocks that show a strong potential for growth. The intrinsic value of the stocks in which a value strategy invests may be based on incorrect assumptions or estimations, may be affected by declining fundamentals or external forces, and may never be recognized by the broader market.

While potentially high returns have recently resulted from investing in Bitcoins, there a numerous risks associated with such an investment, including price volatility risk, valuation risk, risks of fraud or theft and no insurance (e.g., through the Securities Investor Protection Corporation), regulatory risk, security risk, tax risk, and other unknown risks of a new and developing type of investment.