Buffett Waxes Poetic on Gold and Other Asset Classes

Thanks to Tadas @ AbnormalReturns for bringing this Fortune piece by Warren Buffett to my attention.   The post is an excerpt from Buffett’s upcoming shareholder letter, which is always a good read for free, plainly spoken insights on the investing world (I liken Buffett’s annual letters to Steve Wynn’s earnings conference calls.)  I think there’s a lot of interesting stuff in here, including:

“Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge.”

Buffett proceeds to get into a discussion about the devaluation of the purchasing power of the U.S. Dollar.   Jumping ahead:

“Beyond the requirements that liquidity and regulators impose on us, we will purchase currency-related securities only if they offer the possibility of unusual gain — either because a particular credit is mispriced, as can occur in periodic junk-bond debacles, or because rates rise to a level that offers the possibility of realizing substantial capital gains on high-grade bonds when rates fall. Though we’ve exploited both opportunities in the past — and may do so again — we are now 180 degrees removed from such prospects. Today, a wry comment that Wall Streeter Shelby Cullom Davis made long ago seems apt: “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.””

That covers his views on the first category of investments – currency based investments. Next:

“The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else — who also knows that the assets will be forever unproductive — will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.

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.”

Goldbugs will get all defensive here, but just listen to what Buffett is explaining, emphasis mine:

“The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, 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.  During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated 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.”

Buffett agrees with you that the dollar’s value is of questionable staying power – he’s not arguing that with you (and when I say “you” I’m speaking to those who are reacting defensively as they read this – you know who you are).  You might respond that dollars are also not of much use nor procreative – and I don’t think he’d disagree with you!   Well, dollars are sometimes procreative – in periods of positive interest rates – but not currently.

Buffett then gets into his old analogy about how all the gold in existence would fit into a big useless 68 foot cube, and instead of buying that big useless cube you 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.”

He can’t fathom how an investor could chose the cube over the other portfolio of productive assets.  Then he points out this reality:

“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.”

Then back to productivity of assets:

“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 ($XOM) 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 {the gold cube}  will compound over the century at a rate far inferior to that achieved by pile B {the farmland & 16 $XOM plus walking around money}.”

So if Buffett doesn’t like currency based assets, or gold, you can guess where he stands:

“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.”

Before goldbugs respond that the dollars produced by such companies will be worthless, Buffett pre-empts that point with this salient observation/claim/investing thesis, emphasis mine:

Whether the currency a century from now is based on gold, seashells, shark teeth, or a piece of paper (as today), people will be willing to exchange a couple of minutes of their daily labor for a Coca-Cola or some See’s peanut brittle. In the future the U.S. population will move more goods, consume more food, and require more living space than it does now. People will forever exchange what they produce for what others produce.”

Just in case it wasn’t clear:

“Our country’s businesses will continue to efficiently deliver goods and services wanted by our citizens. Metaphorically, these commercial “cows” will live for centuries and give ever greater quantities of “milk” to boot. Their value will be determined not by the medium of exchange but rather by their capacity to deliver milk. Proceeds from the sale of the milk will compound for the owners of the cows, just as they did during the 20th century when the Dow increased from 66 to 11,497 (and paid loads of dividends as well).”

The concise conclusion:

“Berkshire’s goal will be to increase its ownership of first-class businesses. Our first choice will be to own them in their entirety — but we will also be owners by way of holding sizable amounts of marketable stocks. I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we’ve examined. More important, it will be by far the safest.”

I think this piece by Buffett is very well written – and I’m not any sort of Buffett disciple.   Investors of all stripes would do well to simply consider his points, even if they are contrary to your own investing philosophies.   Buffett is not saying that the dollar is king (in fact, he says the opposite) .  He’s not saying that the dollar maintains its purchasing power (in fact, he says the opposite).   Buffett merely points out the truth that when you’re dealing with non-productive assets, you’re relying on the greater-fool theory to some degree, whether you realize it or not, and no matter how much you want to deny it.


disclosure:  I have a long $GDX vs short $GLD pairs trade, and a long $PPLT vs short $GLD pairs trade on currently.  I’m actually slightly net long gold exposure on balance, as part of my short $GLD is hedged with $SPY instead.



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