Dear Friend,
It’s been impossible not to notice the huge climb in the price of gold over the last few months.
After all – the yellow metal is up more than 60% since last November – and it closed Friday at a whopping $1,151 an ounce.
Of course, even though that price is an all-time high for gold…it’s still trading well below its inflation-adjusted high of $2,290 an ounce, set in January 1980.
So with gold prices soaring – and the U.S. Government spending at an alarming rate – it’s fair to ask the question: Is gold a good bet for your money as a hedge against inflation?
Like most people, my instinct said the answer to this question would be “yes” – simply because that’s what the conventional wisdom has been for decades.
But then I did some research – and what I found out about gold, inflation and Warren Buffett was an eye-opener…
Welcome to the 1970s
The period of the 1970s is now known as the Great Inflation. Many economists say that the government’s monetary policy was the leading cause of out-of-control inflation. It started in the 1960s, when the Fed allowed the money supply to bulge in order to fund the Vietnam War and domestic spending. Inflation started to inch up, and by 1974 inflation hit double digits.
In 1980, the inflation rate, as measured by the Consumer Price Index (CPI), hit a record 14.8%. Prices rose not by a few cents here and there, but by whole dollars and seemingly all at once. It was the first decade since the Great Depression that Americans ended the decade poorer than when they began it. Prices exploded ever higher as businesses tried to recoup lost profits with immediate price hikes. Increasing government spending and out-of-control deficits caused the prime rate, which is the rate at which banks lend to their most creditworthy customers, to balloon to rates comparable to those offered by back-alley loan sharks. The prime rate hit a jaw-dropping 20.5% in the summer of 1981. Consumer confidence and consumption were down in the dumps. For many retirees and others living on a fixed income, canned cat food is what they called dinner, as the purchasing power of the dollar was cut in half.
From 1974 to 1981 inflation soared over 104%. Any investments made during that time period had to increase by at least the inflation rate or were losing money. Most investors were buying gold because they were told that historically gold keeps pace with inflation. And in fact during this eight-year period, it did its job. The value of gold rose by more than double the rise in inflation and actually increased purchasing power.
I wanted to see how the world’s greatest investor, Warren Buffett, fared when facing such headwinds as high interest rates, double-digit inflation, and a dollar that was losing purchasing power by the day. I looked at Berkshire Hathaway’s growth in book value and was prepared to be pleased, but instead I was pleasantly surprised. I know that Buffett stuck to investing in controlling positions in businesses and large positions in stocks. I assumed that he would at least outperform inflation, but I was blown away when I saw how well he did.
Over the eight-year period from December 31, 1973, to December 31, 1981, the price of gold rose 254.1%, while the book value of Berkshire increased by over 612%. What is even more interesting is that Buffett achieved that phenomenal growth not by investing in gold, silver, precious metals, artwork, rare coins, or the other investments gurus peddle during times of high inflation, but by investing in solid businesses when he could own them outright, and pieces of them, or stocks, when they were selling at a discount.
Not Such a Good Hedge
It appears that while most investors were concerned about hedging or protecting their portfolios, Buffett was focused on growing his. The media followed the price of gold on a daily basis, and things reached a fever pitch right after December 24, 1979, when the Soviet Union invaded Afghanistan. Prior to the invasion, gold was trading in the $470 range, but one week later it had shot up to over $600 an ounce. It continued to climb ever higher for the rest of December and into January.
Most gold bugs can remember when gold peaked on January 21, 1980, at $850 per ounce but fail to recall that it tumbled over 43% over the next two months to $481. The price of gold was not trading off of the economic fundamentals; instead, it was trading on emotion. Inflation continued to rise while gold was falling. It seemed that the price of gold became disconnected from inflation, and that left investors with big losses. Gold did not serve investors looking to hedge their portfolios during this period.
But that wasn’t the only time that gold did not protect investors from rising inflation. After gold reached an all-time high of $850 per ounce in January 1980, it took close to 18 years for gold to trade at $850 again, which happened in January 2008. Investors that bought and held gold, hoping that it would protect them against inflation, were very disappointed. Over a long period of time, gold does a miserable job of protecting investors against inflation and as an investment.
What Gold Isn’t
Owning gold in order to protect you from inflation presents other problems as well. If you went out and bought gold bullion, you would be investing in an asset that has the risk of theft, and if you store it at home, most likely your homeowner’s policy will not cover its theft. If you store it at a bank, you will need to pay storage fees. When you buy or sell gold, be prepared to pay a high markup, usually 5%, and of course gold doesn’t pay any dividends or interest.
If you buy gold mining stocks, even if gold rises, your shares may go down because of unprofitable mines or large investments in equipment that eat into earnings. Exchange traded funds, or ETFs, don’t track the price of gold accurately and are subject to the rise and fall of the stock market. Since gold futures are bought with leverage, you can rack up big losses rather quickly if gold doesn’t go your way.
Gold is an asset whose only value is what people can do with it, and it has very limited industrial applications. Dramatic and brief price spikes, followed by long periods of decline, define the price of gold. Given the huge quantity of stored gold, compared to the annual production, the price of gold is mainly affected by changes in sentiment, rather than changes in annual production.
Buffett himself emphasized the nonproductive aspects of the yellow metal in a speech at Harvard University in 1998. He said,
“It gets dug out of the ground in Africa or someplace. Then we melt it down, dig another hole, bury it again, and pay people to stand around guarding it.”
On the other hand, stocks represent a claim on real assets; in other words, as a stockholder you own a percentage of a business and its assets. You also receive a percentage of the future stream of earnings and dividends that the business generates. As the company grows and generates cash, a stockholder sees the stock price rise with the worth of the underlying business.
Buffett learned early on to make a purchase only when he gets more value than what he is paying. If the cost to produce one ounce of gold was trading below the cost of extracting and refining it, perhaps Buffett might be interested in buying gold. In the summer of 1997, Buffett did invest 2% of Berkshire’s investment portfolio in silver. He had watched the price carefully for more than 30 years before making his purchase. Only when he came to the conclusion that current inventories of silver were way below the current mine production and user demand did he make a purchase. In other words, it was a good value.
Most investors confuse storytelling for history. Prior to doing my research I too fell into the trap of believing firmly entrenched stories, like buying gold during times of inflation. But as history teaches, it’s not really so and stocks are a much better alternative.
By investing in financially strong companies that are simple to understand, have top-notch management and a competitive advantage, and can be purchased at a fair price is an approach that has successfully worked during difficult economic scenarios. This approach should continue to work simply because it is both logical and rational.
Limited Time Offer: Try My
Hidden Values Alert FREE for 30 Days!
So where do you find these financially strong companies – those that are priced at a discount and simple to understand?
I’d like to show you…
Each month – in my Hidden Values Alert advisory letter – I provide two thoroughly researched “extreme value” recommendations.
But rather than just tell you about my Hidden Values Alert – I’d rather let you see for yourself…with a FREE ISSUE.
So right now – for a limited time – I’m offering you a no-risk, FREE trial to Hidden Values Alert …my highly successful advisory service that serves as the Ultimate Insider’s Guide to Value Investing.
Click on the link below to claim your FREE 30-Day PREVIEW of Hidden Values Alert. Then you can decide if the service is right for you before you ever pay so much as a dime.
No gimmicks…no catches…and no tricks.
Just click here now to claim your 100% RISK-FREE trial subscription to Hidden Values Alert-and get immediate access to my complete list of open recommendations.
Sincerely,
Charles Mizrahi, Editor
Hidden Values Alert
P.S. The only companies who make it into my Hidden Values Alert portfolio are great businesses trading at deep discounts – and as you just saw…those businesses provide a much greater return than gold – even during periods of high inflation. I’d like you to try my wealth-building service RISK-FREE with this special 30-day FREE preview. Click here to begin your journey right now!
This post was originally sent on 11/22/09 to the Hidden Values Alert email list