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The Science of Hitting
The Science of Hitting
Articles (454) 

A Case of Speculation Masquerading as Investment

August 01, 2012 | About:

Paul R. La Monica, who is an assistant managing editor at CNNMoney, recently penned an article entitled Why Warren Buffett May Be Wrong on Gold. I’ve been reading Paul’s work for years, and have generally enjoyed his writing, and while this piece was still an interesting read, I have a couple counterpoints that I think are worth discussing:

He starts off in the right direction, which is a step ahead of most of the gold bugs who write about Warren’s "blind spot": The fact of the matter is that gold is not a productive asset like stocks.

Here is what follows: “But what if Buffett is wrong? Have you noticed what gold has been doing lately? The metal is once again above $1600 an ounce and back in positive territory for the year… gold has been on a bull run that has outpaced stocks for more than a decade. It's not, to use a gold metaphor, a flash in the pan. Some think gold will soon outshine stocks once again.”

This is a line of reasoning that people constantly fall back on – that which has done well will continue to do so, and that which has underperformed is fundamentally broken (just listen to commentators discuss how MSFT and INTC are dead despite strong fundamentals over the past decade). Ironically, this is the exact opposite of what intuitively makes sense: Investors looking for undervalued securities should be pursuing companies making 52-week lows, a list that is likely to house the hated and misunderstood.

Another way to think about this line of logic is in terms of bubbles: by definition, these are the instances where valuations have ascended with the most fervor, which correspondingly makes them attractive by the criteria presented above; in the case of tulip bulbs, dot-com stocks, and housing, the price action alone has justified the meteoric rise – until it didn’t.

Paul continues his piece with the usual gold bull talking point: central bank stimulus. He quotes Jeffrey Nichols, senior economic adviser to Rosland Capital, who says the following: "If gold goes higher in the short-term, it will be because the Fed and ECB stepped on the gas,” a move that he thinks could drive gold back to record highs in 2012 or 2013.

Whether or not loose monetary policy would push gold higher is not the question to be asked. Mr. Nichols' argument follows the framework of macroeconomists who forecast a certain event and use that as justification for calling the indices higher or lower in the coming months/years: that prediction has no use in a vacuum; it is only useful in the context of the fundamentals underlying the asset in question. This argument is the equivalent of saying that Microsoft stock will underperform in the future due to weakness in PC demand – without ever looking at the current valuation. Investment cannot just focus on the price or the value – it must look at both components. This reasoning disregards the relationship altogether, and simply assumes that whatever the price is today ($20, $200 or $2000 per ounce), central bank policy alone is enough to make gold attractive.

The piece continues with Steve Feldman, CEO of Gold Bullion International, who said the following: "In the U.S., we are very much in love with our house, stocks and bonds. But that is a very American-centric investing approach not shared around the world.” His belief, in a nutshell, is that global demand will outweigh supply, making gold a compelling investment.

There’s a clear difference between the two groups discussed: For gold, it is supply and demand, no more, no less (an estimated 10% of new gold is for industrial use, with the remainder for jewelry or investment). This is not the case with the other assets mentioned: Houses, stocks, and bonds all have value tied to the cash generating capabilities of the asset. If you currently own a house bringing in $20,000 per year in cash, free and clear, you have a good idea of what that is intrinsically worth (in comparison to the other productive assets mentioned), and shouldn’t care if the property is appraised at $50,000, even if it was “worth” $100,000 yesterday.

This is not the case with gold: It is non-productive, and has no value beyond what the next person is willing to pay for the pleasure of holding it; this is little more than a “greater fool” game, like the tulip bulbs of the seventeenth century.

In the closing, the author quotes Jeff Sica (who thinks gold is going to $2,000 by year end), president and chief investment officer of SICA Wealth Management: "People that spend their lives looking at stocks and bonds think gold is this barbaric metal… Gold getting the respect of Wall Street? That's never going to happen. It's always going to be under constant scrutiny."

If by scrutiny he means the requirement of a fundamentally based argument on the merits for gold at the current valuation, then yes, it will continue to be scrutinized by members of the investment community that demand a margin of safety in investment operations, as opposed to price targets pulled out of thin air; if those simple requests can be met, Mr. Sica, I would love to hear the basis for the $2,000 price target.

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. As it relates to portfolio construction, my goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach to investing is "patience followed by pretty aggressive conduct". I run a concentrated portfolio, with a handful of equities accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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