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Ben Graham’s Curse on Gold

February 20, 2012

This week we have a shorter Outside the Box, from my friend David Galland at Casey Research, with an interesting insight into why gold can be considered as a poor investment by some rather influential investors (like Warren Buffett) while others may see it as the core of a diversified portfolio. As usual when I use someone's material for an OTB, I include a link at the end, if you want to look deeper. The rather large team at Casey Research specializes in gold, natural resources, and energy-related investments, for those with such an investing bent.

As a quick note, the feedback on this weekend's letter on taxes has been substantial, and a great deal of it is quite good and worth thinking about. Many bring up real problems with the position I took in my letter, and I may surprise you by agreeing with some of them. My intention right now (barring something happening between now and Friday night) is to take some of the better statements and questions, and answer them. I am not married to any specific plan. I just want to solve the problem and am open to anything that is politically feasible and makes sense, as long as we solve the basic problem of the deficit. I think it will make for a very interesting letter. I do read your feedback, by the way. So if you wanted to respond and wondered if I might actually read it, the answer is yes I do, and this week will answer as many as I can.

And to answer a question I get a lot, I buy a little physical gold every month. I don't even look at the price. The check is written the same day each month, for the same amount. I take delivery. I hope the price of gold goes down so I can get more gold per dollar. I also hope it ends up being worthless, as that will mean everything else has worked out just fine. But my gold is there just in case my crazy gold bug friends are right and we can't actually trust the government to find a reasonable solution to our dilemma. And maybe because deep down I really don't trust the (insert your favorite expletive). Just a little insurance, you understand.

So, until we connect this weekend, have a great week!

Your I am not a gold bug analyst,

John Mauldin, Editor
Outside the Box

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Ben Graham's Curse on Gold

It seems that the mainstream investment community only takes a break from ignoring gold to berate it: one of gold's most outspoken critics, uber-investor Warren Buffett, did so recently in his latest shareholder letter. The indictments were familiar; gold is an inanimate object "incapable of producing anything," so any investor holding it instead of stocks is acting out of irrational fear.

How can it be that Buffett, perhaps the most successful (and definitely the most well-known) investor of our time, believes that gold has no place in an intelligently allocated investment portfolio?

Perhaps it has something to do with his mentor, Benjamin Graham.

Graham, author of Security Analysis (1934) and The Intelligent Investor (1949), is correctly respected as one of history's most knowledgeable investors. Over a career spanning 1915 to 1956, he refined his investment theories, in time becoming known as the father of value investing. Much of modern portfolio theory is based upon Graham's work.

According to Graham, while no one can tell the future, there are periods when the valuations of stocks and bonds would deviate from fair value by becoming excessively over- or undervalued. To enhance returns and reduce risk, investors should alter their portfolio allocations accordingly. A quick look at a long-term chart supports Graham's theory clearly shows periods when one asset class offered a better value than the other:

But what of the periods when both stocks and bonds stagnated or fell together? For much of the 1970s and again from 2001 through today, any portfolio allocated solely between stocks and bonds would have at best treaded water and at worst drowned in a sea of stagflation. To earn any real return, an investor would have needed to seek alternatives.

It's clear from this next chart that gold was exactly that alternative, a powerful counter-trend investment for periods when both stocks and bonds were overvalued. Yet gold is conspicuously absent from Graham's allocation model.

But this missing asset class is entirely understandable: for most of Graham's adult life and the most important years of his career, ownership of more than a small amount of gold was outlawed. Banned for private ownership by FDR in 1933, it wasn't re-legalized until late 1974. Graham passed away in 1976; he thus never lived through a period in which gold was unmistakably a better investment than either stocks or bonds.

All of which makes us wonder: if Graham had lived to witness the two great bull markets in precious metals during the last 40 years, would he have updated his allocation models to include gold?

We can never know.

We can know, however, that given Graham's outsized influence on investment theory, there is little question that his lack of experience with gold, and therefore its absence from his observations, has had a profound effect on how most investment professionals view the yellow metal. This, in our opinion, goes a long way toward explaining the persistently low esteem in which gold is held by the mainstream investment community. And, as a consequence, its widespread failure to even be considered as an asset class.

A couple of takeaways: first, perhaps now you can stop wondering why your broker, the talking heads in the financial media, and Warren Buffett continue to misunderstand gold as a portfolio holding. More importantly, however, is that in order to have sustained, long-term investment success, one must accept that an intelligent portfolio allocation needs to include not two but three broad categories of investment – stocks, bonds and gold, with the amounts allocated to each guided by relative valuation.

[JFM here: I would suggest additional broad categories of investments depending on your personal situation. Alternative investments like commodity trading funds. Low leveraged income oriented real estate consistent with your ability to handle the ups and down of the rental/leasing market and shorter term carry costs. I for one am not psychology capable of dealing with renters, of whom I am one. I want service and you to pay for major maintenance, and the ability to move at the end of my lease. My choice, not dependent upon your cash needs. But I know of plenty of people who can do that and have amassed considerable portfolios over time. Perhaps your own small business that has the potential to grow. Investments outside of your country of residence. Etc.]

Investors who understand this tenet have an almost unfair advantage over other investors as it allows them to get positioned in gold ahead of the crowd and enjoy the bulk of the ride, while others sit on their hands.

So when you hear commentators ridiculing gold as a barbarous relic, lamenting that they cannot eat it or smugly asserting that it produces nothing, rest contently in knowing that they're operating with a severe handicap in their own portfolio. Meanwhile, we'll prosper, armed with the understanding that gold fulfills a very important and specific purpose in a portfolio, namely as real money that protects net worth during periods marked by excessive government debt and currency debasement such as we are currently experiencing.

Given the powerful influence of Ben Graham and his disciples, his curse on gold will not go quietly into the night. But it should.

David Galland is managing director of Casey Research, which provides independent investment analysis on a subscription basis to a global network of over 180,000 self-directed investors and money managers. Recognizing the emerging bull market in gold early on, in the late 1990s, Casey Research formed a metals and mining division that has grown into a leading provider of actionable gold and resource intelligence. For investors looking to become familiar with the asset category, Casey Research offers a monthly newsletter, BIG GOLD (try it risk-free for 90 days), focusing on undervalued opportunities in mid- to large-cap producers, as well as best practices in buying, holding and selling precious metals. Learn now why it's more important than ever to invest in gold and gold-related equities.

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Mike McBride

Feb. 24, 2012, 11 p.m.

There is another “Ben” who I don’t believe thinks too much of gold. This would be Ben Bernacke, who recently indicated to Ron Paul during a Senate hearing that he doesn’t even consider gold to be “money”. To me, this is a much bigger issue to be concerned about than what Warren Buffet thinks. Having a Fed Chairman say that caused me to increase my holdings of gold. As he continues to devalue the US Dollar, he will simultaneously increase my investment in gold. Go Ben….
Mike McBride - New York

Ronald Nimmo

Feb. 24, 2012, 10:08 p.m.

Regarding Russ Abbott’s comment: Gold’s value is not only because of its rarity. It has tremendous industrial value, although because of its scarcity and high price, it’s use for those purposes has decreased a great deal. Gold is extremely malleable without losing tensile strength; it is almost invulnerable to rust and corrosion; it is an electrical superconductor; its density and molecular structure allow components it to be used for long periods of time with little disintegration or decomposition. Never has there been a substance more effective than gold been found for dental fillings and crowns or for jewelry (for which purpose its beauty and durability make it irreplacable). s density and durability make it ideal as as money. A real gold bug could post a much more itcomprehensive list of the attributes which give gold intrinsic value.

Edward Henig

Feb. 22, 2012, 12:14 a.m.

Graham espoused the philosophy that the price of an an asset represented the present value of a stream of future earnings. And that sometimes that price was unreasonably high, sometimes unreasonably low.  Some assets do not generate a stream of earnings as stocks and bonds do.  The present value of these assets is the expectation of the selling price of the asset in the future, discounted.  Paintings, sculpture, precious metals are in this category.
Graham did not exclude gold because it was illegal.  He excluded it because it did not generate a stream of earnings and was, therefore, incapable of being analyzed by his methodology.
Whether gold’s price rises because fiat currencies collapse or because we are in a bubble (or both) doesn’t matter.  We are making a calculation about the future selling price, no more, no less.
Investors in stocks and bonds are also making a calculation (knowingly or not) on the future value of fiat currency.  Some, including JM, are hedging that bet.

Russ Abbott

Feb. 21, 2012, 11:04 p.m.

A number of different issues are mixed up here.

1. As Buffet said, gold has (very little) intrinsic value. It has some industrial value, but it’s price is not linked to that value. To make things simple, let’s ignore it’s cosmetic/aesthetic value also. So for the sake of this conversation, let’s assume it has no value.  That’s what Roget Tauss was getting at when he said he didn’t know how to value it. Peter Conner’s answer, that gold is gold, doesn’t help. So what? That still doesn’t give it a value, where value means what can it be traded for.

2. Then why buy gold? Because apparently there will always be a greater (or lesser) fool to sell it to. For whatever reason, it seems that there will always be a market for gold. The fact that gold is rare seems to guarantee that. People value things that are rare, just because they are rare. If we discover enormous amounts of mineable gold on comets, which seems likely, what do you suppose will happen to its price? My guess is that it will crash. But until then, there is nothing wrong with putting part of one’s investment capital into the gold bubble. Gold is a bubble. It’s a bubble that won’t completely deflate as long as it remains rare. But it’s a bubble in that its price is linked to nothing other than the fact that it is rare.

3. Is gold a store of value? I have a hard time seeing that. What value does it store? Since it has no intrinsic value, no operational use, it has no real value. Should the apocalypse occur and you were stranded in a wilderness, which would you rather have: a bar of gold or a pocket knife, some rope, and some matches. I think the answer is clear.  The only reason to have gold is on the theory that you will be able to trade it to someone for something useful.  But who would want it just because it’s gold? No one who hasn’t swallowed the story that some greater fool will show up to give you something of value in exchange.

Brian Hunsaker

Feb. 21, 2012, 10:39 p.m.

Buffet admits to being influenced by Graham but come on I think he can come to his own conclusions.  Just like all bubbles this will end badly.  PS.  Previous post was cut and pasted from Fortune/CNN Money online:  I did not write the post.  Warren Buffett: Why stocks beat gold and bonds
February 9, 2012: 5:00 AM ET

Brian Hunsaker

Feb. 21, 2012, 10:31 p.m.

“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.
Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the “proof ” delivered by the market, and the pool of buyers—for a time—expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: “What the wise man does in the beginning, the fool does in the end.”
Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce—gold’s price as I write this—its value would be about $9.6 trillion. Call this cube pile A.
Let’s now create a pile B costing an equal amount. For that, we 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 (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?
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.
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 will compound over the century at a rate far inferior to that achieved by pile B.
Our first two categories enjoy maximum popularity at peaks of fear: Terror over economic collapse drives individuals to currency-based assets, most particularly U.S. obligations, and fear of currency collapse fosters movement to sterile assets such as gold. We heard “cash is king” in late 2008, just when cash should have been deployed rather than held. Similarly, we heard “cash is trash” in the early 1980s just when fixed-dollar investments were at their most attractive level in memory. On those occasions, investors who required a supportive crowd paid dearly for that comfort.” 

Warren Buffett: Why stocks beat gold and bonds
February 9, 2012

Brian Hunsaker

Feb. 21, 2012, 10:28 p.m.

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.
Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the “proof ” delivered by the market, and the pool of buyers—for a time—expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: “What the wise man does in the beginning, the fool does in the end.”
Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce—gold’s price as I write this—its value would be about $9.6 trillion. Call this cube pile A.
Let’s now create a pile B costing an equal amount. For that, we 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 (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?
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.
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 will compound over the century at a rate far inferior to that achieved by pile B.
Our first two categories enjoy maximum popularity at peaks of fear: Terror over economic collapse drives individuals to currency-based assets, most particularly U.S. obligations, and fear of currency collapse fosters movement to sterile assets such as gold. We heard “cash is king” in late 2008, just when cash should have been deployed rather than held. Similarly, we heard “cash is trash” in the early 1980s just when fixed-dollar investments were at their most attractive level in memory. On those occasions, investors who required a supportive crowd paid dearly for that comfort.

Jeffrey McClure

Feb. 21, 2012, 8:20 p.m.

John,

Your commentaries, and those of your guest writers, are normally thought provoking and constructive. This is the first exception I have found. The supposed “Bonds vs. Stocks - Adjusted for Inflation” chart is fundamentally inaccurate. First, the records for the Wilshire 5000 stock index do not go back to 1901. Second, the chart appears to mysteriously exclude dividends. I can find no other reference to a real total domestic stock market return from the beginning of the 2oth century of 2%. There are ample records of real returns of about 6% to 7% over the period. Either the chart, and this document, is presenting incorrect evidence or virtually all the academic studies to date are incorrect.

Steve Herr

Feb. 21, 2012, 6:51 p.m.

It is interesting to me that in the first paragraph we were told that it was Obama and his cronies that were destroying the value of the dollar, but from the third graph it is obvious that ALL of the destruction of the value of the dollar in the last 12 years happened between 2000 and 2008.  So lets call it like it is, it was Bush and his cronies that destroyed the value of the dollar.  I am no fan of either President, I prefer someone like Ron Paul, but let’s call it like it is.  Looking back on the last 2000 years of history we see this pattern over and over.  It is war that destroys empires.  The sooner our country can come to grips with this and revolt against the military industrial complex the sooner we can face the truth and seek realistic solutions.  I keep hearing that it is Medicare, and social security that will destroy our country, and I agree that we must face this FUTURE threat to our nation.  The truth is that both of these funds have been a source of SURPLUSES over the last 40 years.  They are not to blame for our CURRENT crisis.  The greatest general of the “greatest generation”  President Eisenhower warned of exactly this outcome over 50 years ago.  Those that cannot learn the lesson of the past are destined to repeat them.

jacques proulx

Feb. 21, 2012, 6:18 p.m.

you forget the way how gold was trading and graham knew,and warren buffet knows it too,lol.your research is very very incomplete,sorry.

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