Value Investors Hate Gold
by Robert Blumen
by Robert Blumen: The
Age of Gold
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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
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
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.
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
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.
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.
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.
Blumen [send him mail]
is an independent software developer based in San Francisco.
© 2011 by LewRockwell.com. Permission to reprint in whole or in
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