Thursday, March 22, 2012

On Gold and Inflation

I typed this up in late February and just found it as a 'draft' in my blogger.   I thought I posted it already but didn't.  So here it is:

So Buffett has a nice tutorial on investing in the most recent letter to shareholders (2011), available for free at the Berkshire Hathaway website.

He says that gold is just an object and doesn't produce income; that he'd rather own farmland, several Exxon Mobiles and $1 trillion of spare cash rather than own all the gold in the world.

Of course, this has gotten some of the predictable responses.  I've even read some investment managers respond emotionally and angrily to Buffett's views on gold.  That he just doesn't get it, that he is so smart but just has no clue about gold etc...

Well, first of all, when people respond with anger and emotion, it's usually not a good sign.  Most people wouldn't care what others think of their investment ideas.  That is the most important part of succussful investing; being able to think independently.  Not seeking others who agree and dissing people who disagree etc...  As Benjamin Graham says, you are right not because people agree with you, but because your facts and analysis is correct.

So when people respond emotionally and with anger when Buffett calls their favorite investment idea just a 'thing' and not a good investment, this tells me more about gold and the people who favor it.

This is not too dissimilar to what happened in the late 1990s too.  People said Buffett just doesn't get it.  I heard the same thing.  People were even telling *me* that I should know better since I work in finance and deal with stocks that this internet thing is for real.  I too faced anger and ridicule when I said most of these internet stocks will go to zero or at least down 90% or some such. 

People really got mad when I said that. I do remember that well.  I knew then that I was going to be right.

People who are confident and right don't care if others disagree with them.  In fact, most of my best investments were the ones people would look at me incredulously.  One of them went up 20-fold; someone called it just junk.  Another one was a 10-bagger and my broker came back to me with the buy ticket and asked me, "Are you sure you want to buy this?  Did you read the newspaper this morning?  I don't thnk it's a good idea".

Making the right trade is always going to be hard.  People are always going to disagree with you.  If you are upset that the whole world agrees with you but one or two prominent people say it's a bad idea and that bothers you enough to write about it, that's a big problem to say the least!

Anyway, I already talked about gold and how I think at these levels and this level of sentiment and the inevitability in the bulls' eyes that it must go higher (in every conceivable scenario) it's not such a great idea.

But let's get back to the simple question.  What about inflation?  Yes, the Fed is going to keep printing as will other central banks around the world.  Doesn't this make gold a must?

Well, let's think back for a second.

I found this great data at the Coca-Cola website and thought I'd use it as an example of what I always talk about.

Let's say that back in 1919 you were worried about inflation.  In fact, the Fed was just created in the world looked like it was going to print a lot of money every time something bad happened.  The world looked just as unstable then as it does now.  In fact, it looked worse.  You were looking at another world war in the not too distant future. 

If you had predicted in 1919 what was going to happen over the next 90 years, you would have wanted to own gold.  Almost certainly.  Even I would agree.

What was on the agenda for the next 90 years?

Well, we had World War II.  The boom/bubble bust and great depression. We had the cold war.  We had FDR and socialism.  We had the U.S. going off the gold standard.  We had high inflation in the 1970s.

It was certain that the value of the dollar was going to go down by 90% or more. 

Of course, knowing all of that, most people would opt for gold.

So let's say you bought gold at $20.67/ounce.  Over the next 90 years, you would've been happy to see your gold get up to over $1,700.    All your predictions came true and you made a nice return on gold.

How about another person that had the same view, but decided to buy a stock? 

This person in 1919 would have seen that despite the problems, the U.S. has a great system that will work well over time, and if you own a piece of a good business, you should do well.

So this person buys a single share of Coca Cola at $40/share. 

If this person reinvested dividends for the next 92 years until the end of 2011, what do you think the value of this stock would be?


Yes, that's not a typo.  A $40 investment in a single share of Coca Cola stock turned into $9 million!  Compare that to an investment in gold. A $20.67 investment turns into a whopping $1,700.

OK, OK, you say.  But who'da thunk Coke woulda been such a hit?  You coulda invested in a company that went bust.

Fair enough.  But we know that if you just owned the stock index, you also would have returned 10% or so per year.  (I didn't check specific end points, but I think it's safe to say that stocks returned 10%/year in the 20th century).  So a $20.67 investment in stocks would be worth $132,882 in 92 years.  Not quite $9 million, but way better than $1,700 (that gold would be worth).

So what's the point?  The point is that yes, gold will hold it's value over time on an inflation basis, but it's still just an object.

When you own a piece of a business, and it's a good one with good products, they should have pricing power.  When you have pricing power, you just raise prices as the value of the dollar goes down.  If it's a good business, you can grow it too over time so the value of the business grows.

So there are many levers to increase the value of the business.

Gold just sits there.  A business is a group of people working hard, full time every single day trying to increase the value of the business, and they can change and adjust as circumstances change.  Gold can't do that.

This is why businesses increase in value over time more than commodities, and this is what the inflationist gold bugs totally miss and why Buffett says what he says about gold (versus producing assets).

1 comment:

  1. Backreading a lot of your stuff. Good analysis as usual.

    I personally think gold is not a good long-term investment because as Buffett points out, it produces nothing. I think it can be a kind of refuge in the short-medium term as we see this global deleveraging unfold, understanding that politicians almost always choose to print money when the coffers are empty.

    In other words, you would only hold gold over a very specific period of time -- when you think things are about to get bad very, very quickly and fear will reign. Timing THAT, though, is probably unrealistic for most people, so owning equity would probably be much better, all things equal.

    Not that it won't cause your stomach to churn if inflation does come, as the 70's amply illustrated.