Previously by Robert Blumen: The Age of Gold
Jeremy Grantham, a highly respected and successful value investor, wrote:
I would say that anything of which 75 per cent sits idly and expensively in bank vaults is, as a measure of value, only one step up from the Polynesian islands that attached value to certain well-known large rocks that were traded.
Elsewhere, Grantham when discussing his recent purchase of a few ounces of the despised commodity, sarcastically said:
I hate gold. It does not pay a dividend, it has no value, and you can't work out what it should or shouldn't be worth…It is the last refuge of the desperate.
Exhibit B: Warren Buffett, who needs no introduction, when asked by an eight grader whether gold should be part of a value portfolio, said:
I have no views as to where it will be, but the one thing I can tell you is it won't do anything between now and then except look at you. Whereas, you know, Coca-Cola will be making money, and I think Wells Fargo will be making a lot of money and there will be a lot – and it's a lot – it's a lot better to have a goose that keeps laying eggs than a goose that just sits there and eats insurance and storage and a few things like that. The idea of digging something up out of the ground, you know, in South Africa or someplace and then transporting it to the United States and putting into the ground, you know, in the Federal Reserve of New York, does not strike me as a terrific asset.
Exhibit C: James Grant publisher of Grant's Interest Rate Observer, is less well known among the general public but has achieved cult-like status among professional investors. Grant does not hate gold; he might even be called a gold bug. He shows his customary wit in referring to the yellow metal "the value investor’s guilty pleasure." We like it but we shouldn't.
Why do value investors hate gold? Does that mean that you should hate it too? To understand this, let’s first look at how value investors think, and then understand why they hate gold. Value investing is based on the premise that financial securities – or really any kind of asset or business – have two prices: the market price and a theoretical price arrived at through analytical methods known as intrinsic value. Value investors believe that the market should – and probably will – value an asset at its intrinsic value; when an asset trades at a much different price than its intrinsic value, the market is making a mistake. These errors are usually temporary in nature, giving the value investor an opportunity to capture a profit.
There are three ways to capture this differential: buying undervalued assets, short selling over-valued assets, or doing both at once. That there are differences between these methods is primarily due to the technicalities of managing short and long positions. For the purpose of this article, we will focus on the long-only strategy; many of the most successful value investors over the years have used this method.
An entire discipline has grown around the analysis of intrinsic value, but to keep things simple all methods come down to either assigning a price to the cash flows produced by the security or breaking the security up into assets and liabilities that can be priced on external markets.
To understand valuation by cash flows, consider a bond that pays interest and principal payments. The calculation of intrinsic value relies on a best guess of the future payments emanating from the bond and applying the appropriate discount rate applied to derive present values from future cash flows. (Without going into too much detail, prices may be averaged over time to remove transient effects.) The discount rate could be the individual investor's own subjective rate of time preference. For example, a person who needs cash right now for some other reason might assign a very high discount rate to any investment opportunity. A more objective approach is to use interest rates or yields prevailing in the market (possibly averaged over a suitably long period of time) for similar assets to arrive at a comparable price for the cash flows of the asset being analyzed. Comparing interest rates is essentially the same as comparing the prices of other securities that offer similar cash flows.
Breaking a company into smaller pieces that can be priced individually is the other major approach to valuation. A corporation has assets and liabilities. The assets may represent entire business units or individual properties that can be priced on an external market for similar businesses or properties. This approach is an alternative to the cash-flow based approach for projects that do not yet have an income stream, but still have economic value because the assets have the potential to produce economically valuable outputs in the future.
The founder of value investing, Benjamin Graham, preferred to buy companies that traded at less a market capitalization less than the value of their cash on the books. These companies were the safest, he thought, because there is little difficultly in valuing cash itself, and even less in arbitraging it. It does not require the investor to make too many assumptions, other than, that the management will not find a way to waste the cash by purchasing something with no economic value.
Assets other than cash can be valued when there are external markets that provide a price. To take the gold-mining industry as an example, a deposit can be valued based on the market valuations of the ounces or pounds of a defined resource (in the ground) for similar deposits to the properties being valued. A factory can be valued based on the land and the structures.
Value investors usually look for established patterns over a period of time to give confidence in their assumptions. A business that generates steady revenues over a period of years is likely to do so in the future. The development of a mineral deposit into a mine is much more uncertain. But modern value investors have developed methods that incorporate risk into the valuation model. Suppose, for example, one in five natural resource properties at a specific stage of development go on to become mines. Then the market “should” price the property – and therefore the stock – at 1/5 of the value of a similar operating mine (discounted for development time). If the analyst shows that the property is trading at 1/10th its mine value, then the property is considered theoretically under-valued even though there is still a lot of risk involved. An investor would be taking a lot of risk by putting all of their capital into a 1/5 event, but a large enough portfolio of 5:1 odds purchased for ten cents on the dollar is likely to do quite well as the winners more than outperform the losers.
With an understanding of intrinsic value, it should be clear how the investor can profit from it. All valuation ultimately derives from cash flows returned to the investor. Even assets that are priced on external markets derive their value on those markets for their ability to generate cash flows in the present or in the future. If an asset truly has the ability to deliver the investor a present value of $10 per share, and if the investor is willing to hold it for long enough, they should eventually receive the $10 (it may be more than $10 by the time they get it depending on how long the wait). If the analysis is correct and the asset is really worth $10, then eventually the market "should" eventually figure this out and then reprice the asset to $10, short-circuiting the waiting time of the investor.
It is the ability of the asset to deliver the dollars to the investor that should make the price converge to intrinsic value. Given a correct analysis of intrinsic value, then in the worst case, the investor might have to wait for a while. A better outcome from the investor's viewpoint is that the market understands the earning power of the asset sooner rather than later, and the market price reflects this. Some corporations try to force the market to revalue the asset by issuing or raising a dividend or by spinning off subsidiaries into stand-alone firms. Each firm then must have its own price while before they may have been lumped together.
Here is the reason that Grantham and his ilk are so disdainful of the yellow stuff: they cannot value it the way that they value stocks and bonds. Grantham and the like hate to buy anything they can’t value because they might be over-paying for it. Buying something without a quantification of its worth falls into the category of irrational speculation, not much different than tossing a coin. In their terminology, it has no intrinsic value. For an asset to have intrinsic value, it must have something that can be priced on a market external to itself (either cash flows or a balance sheet); gold has neither.
But if gold has no “intrinsic value” does that mean it has no economic value? Should the wise investor only purchase assets that can be valued by Graham's methods? Does that make the gold buyer a crazy speculator?
I have observed that some value investors identify value investing with economic rationality itself: any purchase that is not backed up by an intrinsic value is not only baseless speculation but an act of pure irrationality. In my view, their mistake is that value investing is not reality, it is a model; it works, like any model, subject to certain assumptions; one must take care to apply the model within its boundaries. Intrinsic value is a term of art within the domain of value investing. A good has economic value because it is scarce and meets human needs in some way. A good may not have intrinsic value (in the analytical sense of the term) but that does not mean it has no economic value.
Value investing is a rational approach, but economic rationality is more than value investing. Economic rationality means using logic, evidence and good judgment to allocate resources. It is rational to apply value investing within its sphere of applicability and equally rational not to apply it outside of the conditions where it can work. Even the estimation of intrinsic value depends to a large extent on the wisdom and good judgment of the analyst in identifying which prices are comparable and which cash flows are sustainable. And we can act rationally even in areas that cannot be fully quantified.
As noted above, no raw commodity has an intrinsic value because commodities do not have cash flows or a balance sheet. Yet commodities do have economic value and do have market prices. Their prices are driven by economic cause and effect and the factors driving them can be understood, at least to an extent. A rational person can still develop a logical point of view about the price direction of a specific commodity using facts and evidence. The relevant facts are the commodity's past prices and the supply and demand fundamentals. Breaking this down further, the fundamentals on the supply side are: the present production volume, the lifetime of operating mines, new mine supply coming on line for the next few years, the pipeline of in-ground development projects, the cost of production of existing supply, and quantities stockpiled in warehouses. Demand side fundamentals are: the uses of the commodity and the quantities required for those uses, unique properties of a particular commodity, the availability of substitutes, anticipated changes in the demand for consumer or capital goods using the commodity, and new scientific research identifying properties of the commodity that are not currently exploited.
The difference between fundamental analysis of the commodity and a security is that none of the data can provide a number for the future price; however rationality extends to things that cannot always be quantified. But analysis of supply and demand can provide the investor with some rational reasons for expecting the future direction of the price to be higher or lower, which is enough to make an investment decision. Is it totally irrational to think, for example, that a commodity that has no new mines coming on line, declining supply of existing mines, and increasingly popular uses will rise in price? If the people who built mines were strict value investors who insisted on an intrinsic value for every decision, then no mines would ever get built.
I have been discussing the valuation of commodities in general by supply and demand fundamentals, but when it comes to gold (as I have written in a recent TDV guest post) production and consumption are not the fundamental drivers of the gold price because mine supply is quite small compared to existing stock piles and only a tiny fraction of it is consumed. The gold market is dominated by the demand to hold existing gold, which competes against the demand to hold fiat money and demand for other assets. The demand to hold gold is based on its historical use as money and its current function as a shadow money that competes with global fiat currencies for remonetization should the fiat money system shoot itself in the head. The more suicidal the fiat money system becomes, the greater the demand to hold gold as a store of value should fiat money fail in this function.
Investors can make a rational decision about gold. Clearly, analysis of the gold price must be based on a forecast of demand to hold the metal itself, competition from demand to hold other assets, and demand to hold fiat money. Some of the metrics that fit this approach (and have been used by others) are: the growth over time in the quantity of gold compared to the quantity of fiat money; the DOW index-to-gold-ounce ratio over time, and the total value of gold portfolio holdings compared to the capitalization of other financial assets globally. Typically these measures showed historical extremes in gold's favor in the late 90s/early 2000s and have moved back closer to historical averages.
Is there any reason to think that gold should revert to historical means, or even overshoot them, in the same way that we think that an asset "should" trade at its intrinsic value? What keeps the value-pricing model in line with market pricing is the economic arbitrage: the investor can always hold the asset and eventually receive the intrinsic value, if they wait long enough.
Is there an arbitrage that will bring gold back in line with past measures of purchasing power? Or are we just looking at historical trends that might or might not recur? My answer to this has two parts. Measuring gold against the money supply or the DOW is a measure of purchasing power. To the extent that gold is valued as shadow money, we can expect its purchasing power to converge on a value approximating its historical purchasing power as money, adjusted for the growth in the size of the world's economy relative to the quantity of gold.
Beyond the purchasing power argument, here is a more profound and less easily quantifiable argument for holding gold. Earlier in the current article, I mentioned the finite limits in the domain of applicability of value investing. Value investing is an example of what the economist Ludwig von Mises called economic calculation. What Mises meant by this was the allocation of scarce capital goods toward the greatest expected profits using estimates of future market prices. Because economic calculation relies on prices, and prices are expressed in terms of money, calculation depends on a reasonably stable monetary system. As the monetary system is becoming increasingly chaotic, economic calculation is disrupted and investment decisions more and more irrational. We are sliding out of the zone where the inputs of value investing – prices – have any meaning.
During a monetary breakdown, variations in the supply and demand for money itself drive prices more than the supply and demand for goods.
Value investors like Grantham only want to buy something when they have a quantitative estimate of its intrinsic value. While this rule works well enough during periods of stability, it provides no guidance for rational action when the monetary system is no longer able to provide reliable money prices. Value investors have successfully invested in countries experiencing a monetary breakdown by using an external stable currency to calculate prices. The present crisis, which is global, threatens to disrupt all of the external stable currencies, making them less useful for this purpose.
As a shadow money, gold is a hedge against times when value investing becomes difficult or impossible because money has become too unstable. During those times, gold is a way of preserving purchasing power until the some stability returns. The disruption of the price system and resulting misallocation of capital will undoubtedly create many opportunities for value investors, once the monetary crisis is over and the monetary system is stabilized. Having some asset that can then be converted into stable money (which may be gold itself) will give value investors the ability to take advantage of these opportunities when they emerge.
Robert Blumen [send him mail] is an independent software developer based in San Francisco.