“Last year, we purchased 111.2 million ounces [just less than a third of the market]. Marked to market, that position produced a pre-tax gain of $97.4 million for us in 1997. In a way, this is a return to the past for me: Thirty years ago, I bought silver because I anticipated its demonetization by the U.S. Government. Ever since, I have followed the metal's fundamentals but not owned it. In recent years, bullion inventories have fallen materially, and last summer Charlie and I concluded that a higher price would be needed to establish equilibrium between supply and demand. Inflation expectations, it should be noted, play no part in our calculation of silver's value.”
The price per ounce of silver in 1997 ranged from $4.4 to $6.2 as the graph below shows. Buffett likely purchased the silver closer to the $4-5 range and that would have produced a pre-tax return of about 15%. The magazine Time wrote a piece on this particular investment and noted he had increased his stake to 129 million ounces in 1998.
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This may come as a surprise to some as Buffett has tended to shy away from commodities and gravitated towards cash flow producing assets. The valuation of commodities is all the more difficult and you certainly won’t find any explanation of that topic in Security Analysis. However, commodities like all assets are governed by the basic laws of economics. If household formations significantly outnumber housing starts over a period of time you can bet in the long run, house prices will rise. Buffett had used this logic in predicting house prices increases in the next year or so. In the latest shareholder letter he also commented on the low price of natural gas. Low prices naturally attract consumers and he made the safe bet that we’ll likely be using more natural gas in the near future.
Silver and other commodities are no different. Quoting from the Time piece, “Buffett says in a statement that he saw a huge imbalance between the amount of silver available and the demand for it to make things like jewelry, photographic supplies, electronic components, mirrors and batteries. So he began buying because "equilibrium between supply and demand was only likely to be established by a somewhat higher price."
Buffett regularly comments that he invests in companies and their industries in which he can have a good idea of what the economics will look like in 10 years. Economics is an integral part of business and one often overlooked. I see this deficit of economic understanding most clearly in the gold and commodities euphoria of present day. The John Paulsons, Seth Klarmans and Jim Grants are all notable investors who have championed gold recently. But the most seasoned of investors has been sitting out the gold and commodities boom.
Disclosure: Long Berkshire Hathaway