Warren Buffett on Investing in Gold

Warren Buffett on Investing in Gold

The price of gold has has risen sharply in recent years going from $400 an ounce in 2003 to $1325 today in 2014 and by many it is seen as a good hedge against inflation, particularly in the non-Western countries.  Even so, Gold is not quite the investing opportunity it seems.

So why is Buffett not into gold?  

Buffett speaks about his policy on gold investment in his 2011 letter to shareholders in which he divided investments into three classes:

  • investments denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments
  • investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century. These are speculative endeavours.
  • investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment. Farms, real estate, and many businesses such as Coca-Cola, IBM and our own See’s Candy meet that double-barreled test.

Gold is in the class of speculative investments and although it does have a productive quality (very limited use in manufacture), it still carries the risk that the expectation that others will bid the price up will not be fulfilled. Gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end, it does not produce anything.

What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, 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.

Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the ‘proof’ delivered by the market, and the pool of buyers – for a time – expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: ‘What the wise man does in the beginning, the fool does in the end’.

Buffett argues his case presenting the rational investor the option of looking at the total value of the world’s gold and comparing it to what would happen if you put that amount into productive assets for investment such as farming land and quality businesses. Gold produces no income and the gold owner has to rely upon the ability of others to pay more for his ounce of Gold. Farms produce crops which can be sold at a profit and quality businesses sell things which produce dividends and earnings. Over time, Buffett says, the total return from the productive assets must exceed any increase in the value of the gold. If you purchase a business or farm land in the end the investment’s success wil be rated by the return of earnings and management of capital to shareholders such as buybacks, and dividends.

Investments in productive assets generate earnings, Gold does not.

Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A.

Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?

Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion. Buyers – whether jewelry and industrial users, frightened individuals, or speculators – must continually absorb this additional supply to merely maintain an equilibrium at present prices.

A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.

History is on Buffett’s side Between 1900 and 2011 investment in equities (5.4% per year) outperformed bonds, housing and gold (1% per year) in real inflation adjusted returns..

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