“There’s gold in them thar hills!” Gold fever seems to be taking the markets by storm. I knew it was both time to write about it and that it has gone way too far when I heard an ad on the radio for buying gold coins. (By the way, these gold sellers must not have to register with the SEC, because if we said the stuff they say, we would end up in jail. Frankly they should, but that isn’t likely to happen.)
I digress. The question is: Should one invest in gold? I believe the answer to that question lies in the very definition of investment. Benjamin Graham, the father of security analysis and Warren Buffett’s mentor, defined an investment as follows: “An investment operation is one which, upon thorough analysis, promises safety of principal and satisfactory return.” Does gold promise safety of principal and a satisfactory return?
Safety of principal is provided by what Graham referred to as the “margin of safety.” The margin of safety is calculated by subtracting the current market price of an item from the actual intrinsic value of that item. This is the principle on which pawn shops operate. Sure, they will give you money for that watch, but they are not going to give you what it is actually worth. They can safely loan you money because if you fail to repay them, then they can sell the watch for far more than they gave you. They have a large margin of safety.
A pawnbroker may know the actual value of a watch, but how are we supposed to know the actual value of an investment? The intrinsic value of an investment is the present value of all future cash flows. One must project what those cash flows will be, but the math itself is pretty simple. If your investment is an office building, one just projects the lease payments from the tenants out into the future and does the math for what that cash flow is worth today; that is the actual value of the building. If the market price for the building is less than that amount, a margin of safety exists. On the other hand, if the market value is higher, then there is no margin of safety, and purchasing the building would be very risky speculation.
Stock in companies works the same way; one projects the cash flow of the business and does the math to determine the actual value. If the market price is below that value, then a margin of safety exists. So this is how one determines the safety of principal; what about the adequate return?
The return of an investment can only truly be known after the fact. The investor subtracts the original value she paid from the current market value and divides that number by the original investment amount. So if our investor paid $5 for a stock which is now worth $10, then 10 – 5 = 5 and 5/5 = 1 or 100%. She experienced a return of 100 percent, or in other words, doubled her money. The problem is, we don’t have a time machine and there is really no way of knowing what the future price will be. So when the investment is made, one must project an expected return. The expected return is based on the price we think the investment will sell for in the future, and the best guess for that price is the calculated intrinsic value.
For something to qualify as an investment, there must be a calculable intrinsic value. Gold has no intrinsic value. Gold is gold. It was gold when Solomon used it in the Temple and it was gold when James Bond saved the world from Auric Goldfinger, and it will be gold forever. Nothing more and nothing less. There is no intrinsic growth, no cash flow, nothing that gives it intrinsic value. It has value to the extent that other people want it because it is pretty.
If that is true, how do I explain the huge success of gold investors as described by the charlatans who peddle the stuff in advertisements? By telling the truth. In January of 1980, gold sold for $2,257.64 an ounce. This morning it sold for $1,934.00 per ounce. Losing $300 over 40 years does not seem like a great deal to me, especially when compared to the growth of almost any investment. Should we “invest” in gold?
James Bond: “What do you know about gold, Moneypenny?”
Miss Moneypenny: “The only gold I know is the kind you wear. You know, on the third finger of your left hand.”
I think Miss Moneypenny had it right. The only gold one should buy is the kind he wears.
James Bond: “One day we will have to look into that.”
Miss Moneypenny: “Oh James….”
Warm regards,
Chuck Osborne, CFA
Managing Director
