Our thoughts on Mr. Buffett’s thoughts on gold
If one does a search for ‘Gold’ in this letter, one gets 16 hits. Page 18 contains his famous illustration on how the gold pile could be converted into something more valuable like crops, etc. In case someone is too lazy to search, here are the relevant portions:
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.
Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.
Our first two categories enjoy maximum popularity at peaks of fear: Terror over economic collapse drives individuals to currency-based assets, most particularly U.S. obligations, and fear of currency collapse fosters movement to sterile assets such as gold. We heard “cash is king” in late 2008, just when cash should have been deployed rather than held. Similarly, we heard “cash is trash” in the early 1980s just when fixed-dollar investments were at their most attractive level in memory. On those occasions, investors who required a supportive crowd paid dearly for that comfort.
My own preference – and you knew this was coming – is our third category: 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.
Unfortunately, there are many intellectual flaws in this reasoning.
(1) Everyone knows that gold has no intrinsic value because it is an asset that produces no cashflows. Therefore, most of us know that it is bought when there is ‘fear’ of something. When we fear something (inflation, war, worthless paper money), we try to protect ourselves against ‘that’. That is, we buy insurance. Investors therefore have to treat gold as insurance and most do so. It is simply wrong to compare an insurance contract to investment assets. That is why it is wrong to put all savings into gold, unless one is driven by extreme fear. If we get rid of all assets, there is no need for insurance.
The only decision on an insurance contract is whether the premium being charged is too high, compared to other alternatives. Second, whether the premium is high or low depends on the value of the assets that are being insured. It is not based on the absolute amount of premium payable.
(2) Regardless of the societal utility of farmland, for an investor to buy farmland today, she has to take into account the question of whether the price of that land today already discounts the utility/cashflows that she would derive from that in the years ahead. In other words, the same ‘bubble’ analysis that Mr. Buffett subjects gold to (and wrongly, in our view, because it is not an investment asset) should be applied to the so-called farm assets that he extols.
(3) Gold has no nationality. Crop lands are located within national borders. Not all can buy land everywhere in the world. Land prices are not cheap in many parts of the world, actually. Perhaps, they are cheap in some parts of the US. Further, crop lands are lumpy assets and cannot be easily converted into cash, when needed. Gold can be bought in small quantities and is easily sold.
(4) We all know that gold prices crashed and remained in a state of coma from 1982 until 2000. We also know that they stirred and roared from then on. As investors, we simply have to ask ourselves the reasons for Gold’s staggering underperformance in the 1980s and 1990s and its staggering rise in the first decade of the New Millennium.
In the last two decades of the last millennium, commodity prices were slumping. Technological developments raised productivity. Measured inflation rates were low in the US and in most of the developed world. There was peace dividend with the collapse of the Berlin Wall and the disintegration of the Soviet Union. The United States ran fiscal surpluses in the second half of the 1990s and the dollar was strong for at least ten out of those eighteen years. The perception of the United States as the world’s unquestioned political, military and economic power was quite high. Therefore, no one questioned the strength of the US dollar. The Federal Reserve, under Mr. Volcker first and then Greenspan later, enjoyed high credibility. It is a different matter that history would judge Greenspan harshly.
To conclude, we reiterate that gold is an insurance asset. If its price already reflects the risks of inflation and fiat money (paper currency) debasement and that these risks would only be receding from here on, investors could sell gold.
Put differently, there is no need for insurance if we judge that there is no risk to protect against. That would dictate whether we retain gold, buy gold or sell gold. That is a matter of judgement.
Yours truly is happy to retain and buy.