Wednesday, September 28, 2011

The Golden Age Of Investing

A few short years ago, major media outlets would post daily articles reporting the price of oil and how demand is far exceeding supply. Not long before that, these same outlets were saying things like "they're not making any more land" as housing prices rose through the roof. A few years before that, the rising stock prices of technology companies were making daily headlines as the stock market had entered what was claimed to be a "new paradigm shift, where traditional methods of valuation no longer apply". Today, it's the price of gold that is the talk of the town.

Why does the topic of gold garner so much interest today from major media outlets and bloggers alike? Because so many readers are interested (thus generating traffic), and the readers are likely interested because they own gold themselves. Indeed, demand for this asset has risen to such an extent that the price of gold has been rising to new all-time highs for much of the last few years:

Does this represent an asset bubble? To answer that, we must try to determine the intrinsic value of gold. The intrinsic value of any investment is the sum of the discounted future cash flows the investment will generate. Unlike a bond or a stock, however, there is no future cash flow expected from a bar of gold. In effect, the only reason one would purchase it as an investment is because one believes someone else will be willing to pay even more for it in the future.

In his book Margin of Safety, super-investor Seth Klarman argues that this form of investing is not really investing at all, but rather speculating. As the price of any asset rises, speculators enter the market expecting to unload the asset on someone else at a future date at a higher price. While this process can go on for months and even years, with speculators accumulating small profits along the way, eventually a large group of buyers will be left holding the bag when the party is over, with massive losses.

There are, of course, industrial and commercial uses for gold. But has the supply/demand dynamic for this metal changed so much in the last few years so as to warrant the large price run-up? Not likely. Therefore, the price has been pushed up by speculators.

Gold bugs/speculators argue that gold acts as a safe haven when currencies lose value. As central banks around the world add liquidity to stimulate the world economy, currencies should be worth less, they argue. However, due to the fact that the velocity of money has slowed (i.e. money isn't changing hands as quickly as it did during the boom) and capacity utilization is low, inflation numbers are tame despite the large amounts of currency being generated. Therefore, gold is running up on the expectation that the Fed will not be able to control inflation later. Even if one is correct about this (and it is far from a foregone conclusion), how does one quantify what gold is worth under such a scenario? When one buys a security without knowing its underlying value, one is susceptible to large losses. Buying "because the price is going up" is not an acceptable reason to buy for the Intelligent Investor.

For value investors, it is wise to avoid falling prey to these psychological frenzies. Investors should stick to buying securities which trade at discounts to their intrinsic values, where intrinsic values can be conservatively estimated. As such, gold is currently not an area where the value investor should foray.

Disclosure: None


obtuse_investor said...

Hear, hear.

Anonymous said...

But what about investing in gold mining *companies*? Those investments are more rational for a value investor, since mining companies generate cash flows that don't rely on the price of gold increasing from their present value.

The problem I see, however, is that the underlying commodity they're mining has no actual use for human beings - unlike a copper mining company, for example.

- aagold

juan said...


The expected returns of gold mining companies (and thus their value) depend to a large extent on the expected price of gold.

You still have the problem.

Saj Karsan said...

Hi aagold,

Yeah I'd agree with Juan on that. No disrespect to your name, though.

Anonymous said...

But that argument applies to *any* producer of a commodity. For example, does that mean value investors should never buy oil/gas or industrial metal mining companies? The expected returns from all commodity producers depends to some extent on the expected return of the commodity itself.

- aagold

Anonymous said...

The difference is the global economy has a lot of demand for oil/gas and industrial metals just to function, to produce other goods that are consumed. Demand for them can't just disappear whereas it might for gold.

Is the chart inflation-adjusted?

ThinkingAlsoHelps said...

question, since you're such a seth klarman fan; does he have any gold mining stocks and gold investments? if yes (and yes is the answer) why does he have those investments?

regurgitating things you read in books is a bad way to go about investing

Taylor said...

Here is a chart depicting the demand sources for gold

Saj Karsan said...

That's right, aa. Here my thoughts on the subject.

Anonymous said...


I think you're going to far in saying that *any* investment in a company that produces commodities should be avoided by value investors. It's one thing to say that gold miners should be avoided, since the gold itself has no actual use for human beings (i.e., it's inherently speculative), but it's quite another to make that claim in regard to companies such as oil/gas producers and industrial metals miners.

It seems like your basic argument is that rising commodity prices and rising profit margins tend to mean revert because people and technologies adapt. Ok, that's true. But that basic property of mean reversion occurs in *all* industries. Rising profit margins result in increased supply, which eventually causes margins to decline; when profit margins decline too much it causes a decrease in supply, which eventually causes margins to increase again. The overall effect is that any "moat-less" company is worth its replacement cost. A commodity producer should be worth its replacement cost, just like any other firm. Yes, technological obsolescense can take place in the commodities space, but that can happen in any industry - it's not specific to commodities.

- aagold

Saj Karsan said...

Hi aa,

I don't dispute that the companies have some value. But I would argue that determining this value is a lot more difficult than it is for companies with steady prices. Since a value investor is trying to buy with a margin of safety, I believe he can be much more certain that he is getting a margin of safety when a company is easier to value (e.g. a company that sells screwdrivers versus one that sells oil).

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