Two months ago, when gold prices were on the rise, I had a conversation with KRISTOFFER INTON, director of equity research for basic materials, at Morningstar.
He said something that really gripped by attention.
The current gold price is propped by investor demand—gold held in ETFs is at an all-time high. This is risky because today’s investment demand is tomorrow’s recycled supply when investors decide to pivot away from the safe-haven investment towards other investments.
Which brings me to a very pertinent question.
As a valuation-driven investor, how must I value gold? Normally, one would buy assets that are demonstrably below a reasonable estimate of their fair value and enjoy the benefits of long-term cashflow generation. How does gold qualify?
I reached out to DAN KEMP, Morningstar Investment Management’s CIO, EMEA. He was quick to assert that he does not consider gold to be an investment asset.
"An investment asset is one which generates a positive cashflow to the owner and hence can be ascribed a ‘fair value’ through fundamental analysis. Prices move above or below this fair value in the short term. But over the long term, prices tend to move towards it providing a consistent measure against which its current attractiveness can be judged,” he explained.
I get the point. There is no fair value to serve as a base to enable an investor make a buy or sell decision. At which price do you determine that gold is undervalued or overvalued?
To add to it, gold generates a negative cashflow. Should you buy actual bullion, you need to pay for storage (like a bank locker) and insurance. Or, as Dan Kemp reminded me, the cost could also be due to the opportunity cost of lost income (interest if the value was held in a bank deposit or bond, or rent if it was commercial real estate).
This reminds me of a quote by WARREN BUFFETT that neatly encapsulates the views of Kristoffer and Dan.
Gold is a way of going long on fear, and it has been a pretty good way of going long on fear from time to time. But you really have to hope people become more afraid in a year or two years than they are now. And if they become more afraid you make money, if they become less afraid you lose money, but the gold itself doesn’t produce anything.
In a Fortune article in 2012, Buffett tackled the subject of gold as an investment. He first categorised investments:
- Currency based investment
- Investments in productive assets (businesses, farms, real estate)
- Investments in assets that will never produce anything (art, gold, tulip mania in the 17th century)
So why are non-productive assets purchased? With the buyer's hope that someone else will pay more for them in the future.
This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce -- it will remain lifeless forever -- but rather by the belief that others will desire it even more avidly in the future.
Gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. If you own one ounce of gold for an eternity, you will still own one ounce at its end.
What motivates most gold purchasers is their belief that the ranks of the fearful will grow. Beyond that, the rising price generates 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.
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. At $1,750/ounce -- gold's price as I write this in 2012 -- its value would be about $9.6 trillion.
Call this cube A.
Let's now create 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 cube 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 jewellery 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 cube A will compound over the century at a rate far inferior to that achieved by pile B.
As mentioned above in the article written by Warren Buffet, the price of gold early 2012 was $1,750/ounce; it is now around $1,683.
So what is the reason people narrow down on gold?
As I explained in The psychology of investing in gold, the narrative that frames an investment in gold differs starkly from that of equity or debt.
DHAVAL KAPADIA, Director and Portfolio Specialist for Morningstar Investment Adviser India, looks at the most common reasons.
Traditionally gold has been viewed as a hedge against inflation and significant economic and financial market uncertainty. For instance, during the Global Finance Crisis, or GFC, in 2008, gold outperformed other asset classes generating a positive return of over 30% vis-à-vis global equity markets which corrected by 22% (US) to 57% (India), with Europe and other emerging markets witnessing corrections ranging from 34% to 43%. (All returns in INR).
Currently, inflation isn’t a concern in most major markets and hence it’s role as an inflation hedge is limited.
- Hedge against depreciation
For Indian investors, gold has historically acted as a currency hedge as well. The price of gold is determined in international markets in foreign currency and converted to the price offered in domestic markets (INR), besides local duties being applied. Other things remaining the same, if the INR depreciates vs the USD, the price of gold in the domestic market would rise.
Gold tends to perform well in low interest rate scenarios as the cost of carry is low. We consider inflation differential and currency valuation to derive return estimates for gold in INR terms. With the rupee having depreciated over the last year, the currency appears to be fairly / marginally undervalued, thereby moderating the case for gold investment in INR.
Summing it up
While there are undoubtedly periods when gold performs very well and its inclusion would benefit the short-term returns of a portfolio, these periods tend to be unpredictable due to the lack of the fair value anchor.
Individuals have various claims as to why gold must be part of the portfolio. The aspects they really need clarity on is:
- When to buy
- When to sell
- The exact allocation in the portfolio
- The vehicle (bullion bars, gold coins, ETF, gold mining stocks, jewellery)
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