Why Value Investors Should Avoid Gold

Not long ago, major media outlets would post daily articles reporting the price of oil and how demand is far exceeding supply. Not long before that, these same outlets were saying things like "they're not making any more land" as housing prices rose through the roof. A few years before that, the rising stock prices of technology companies were making daily headlines as the stock market had entered what was claimed to be a "new paradigm shift, where traditional methods of valuation no longer apply". Today, it's the price of gold that is the talk of the town.

Why does the topic of gold garner so much interest today from major media outlets and bloggers alike? Because so many readers are interested (thus generating traffic), and the readers are likely interested because they own gold themselves. Indeed, demand for this asset has risen to such an extent that the price of gold now flirts with its all-time high:

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Does this represent an asset bubble? To answer that, we must try to determine the intrinsic value of gold. The intrinsic value of any investment is the sum of the discounted future cash flows the investment will generate. Unlike a bond or a stock, however, there is no future cash flow expected from a bar of gold. In effect, the only reason one would purchase it as an investment is because one believes someone else will be willing to pay even more for it in the future.

In his book Margin of Safety, super-investor Seth Klarman argues that this form of investing is not really investing at all, but rather speculating. As the price of any asset rises, speculators enter the market expecting to unload the asset on someone else at a future date at a higher price. While this process can go on for months and even years, with speculators accumulating small profits along the way, eventually a large group of buyers will be left holding the bag when the party is over, with massive losses.

There are, of course, industrial and commercial uses for gold. But has the supply/demand dynamic for this metal changed so much in the last few years so as to warrant the large price run-up? Not likely. Therefore, the price has been pushed up by speculators.

Gold bugs/speculators argue that gold acts as a safe haven when currencies lose value. As central banks around the world add liquidity to stimulate the world economy, currencies should be worth less, they argue. However, due to the fact that the velocity of money has slowed (i.e. money isn't changing hands as quickly as it did during the boom) and capacity utilization is low, inflation numbers are tame despite the large amounts of currency being generated. Therefore, gold is running up on the expectation that the Fed will not be able to control inflation later.

Even if one is correct about this (and it is far from a foregone conclusion), how does one quantify what gold is worth under such a scenario? When one buys a security without knowing its underlying value, one is susceptible to large losses. Buying "because the price is going up" is not an acceptable reason to buy for the Intelligent Investor.

For value investors, it is wise to avoid falling prey to these psychological frenzies. Investors should stick to buying securities which trade at discounts to their intrinsic values, intrinsic values which can be conservatively estimated. As such, gold is currently not an area where the value investor should foray.

Disclosure: None

Comments

[swsprime:]

You think Oil is a busted bubble and Gold is the new bubble?

Tell us the truth Sej, you've really just landed from another planet and discovered the Wall Street Journal.

So go for it, grab as many assets as you can based on 'Honest John' Bernanke's fiat printing press, whilst we grab the gold.

Oct 01 09:18 AM

[The Economi...:]

Really... call me whatever you like (value investor) but when the currency craps on itself and our economy collapses, my gold will still be worth something. Either to barter with or trade......

Sure I am a value investor. When the apocalypse comes my INVESTMENT of gold will be one of the few things with any VALUE.

Oct 01 09:22 AM

[Hot Richard:]

In global collapse, some part of all things valuable gets destroyed. It will most likely be a contest of "what gets destroyed the least".

Value investors (and I'm not entirely sure I know what this means anymore) should be in gold. Most every other investment opportunity has been made into pure speculation due to the State giants tossing bowling balls of currency printing and assaults on capitalism.

Oct 01 09:44 AM

[Original Sc...:]

I just have to disagree with Mr Karsan. The US$ and banks are joined at the hip. The banks are hiding trillions is toxic assets and they continue to fail on a weekly basis.

Gold is money. Fiat is an act of faith. To measure the value of gold by its fiat trade cost is just succumbing to the man behind the curtain.

Oct 01 11:59 AM

[E.D. Hart:]

If all you have is a a hammer, you look to fix things with a nail. If all yu understand is discounted cash flow analysis, all your investments are stocks and bonds.

Try learning some macroeconomics and find out that there are long periods when gold outperforms all other asset classes.

Oct 01 12:12 PM

[Graham and ...:]

Gold is a protection against the chicanery of governments and the foolishness of central banks. As such, it performed poorly in the 1980s and 1990s when these things were in relatively short supply. It is performing well in the current decade because these things are now in abundance. Look at the world around you!

Oct 01 12:13 PM

[auto44:]

If you take all the gold in the world and divide it equally amongst tall the people in the world you will need a microscope to see your share. Please don't try to tell me it is overpriced for the long haul.

Oct 01 01:15 PM

[dsylexic:]

saj is trying to apply textbookish cash flow model to value gold. is that what they teach in b schools these days?.
they ought to teach monetary history of the world for starters.the pure fiat regime is only 38 years and saj thinks we are in a new era- forever?
value my friend,is in the eyes of the beholder.a great company earning in worthless dollars is of no use.zimbabwe had the greatest stock market return of the year.i am sure they unlocked a lot of value.eh

Oct 01 01:19 PM

[Donald Ingram:]

Gold is as gold does. Preserve wealth. Its not that gold is worth more, its that the dollar is worth less. Soon to be worthless, along with most other fiat currencies. So, you be the "value investor" that you are and keep your wealth in fiat money. We shall see who is "worth" more at the end of the trip!

Oct 01 02:11 PM

[Ramzi:]

those (aka gamblers) escaping from the presumed trashing of the dollar have bought and driven up the price of gold that gold became the bubble and dollar the undervalued currency of the two.

Oct 01 03:09 PM

[JAMES CARLINI:]

Geez

Another column today more or less hints to invest in Gold because it is going to $3000 (I can "triple" my money) and this column says to avoid it.

More of the same. Expert contradicting experts. Maybe there are no experts in this industry - the best you can be is a good student - always learning (and studying the market trends)

Oct 01 03:14 PM

[chux08:]

I don't consider gold to be an investment. If anything, it's more akin to disaster insurance. Are your other such insurance policies (for the most part) considered investments? Neither should gold.

It's been pointed out already (and I agree too) that the undeniable truth is: Gold is money...and you forget that at your own peril.

Oct 01 03:25 PM

[Slvrizgold:]

Value investors should avoid FIAT TOLIET PAPER CURRENCIES. That's one reason why the stock market hasn't imploded completelyt despite the crappiest economy in almost 80 years. Furthermore, the stock market still has RISK. Gold has no risk of anything more than a normal correction. Longer term (more than 3-6 months for today's ADDHD investors - gold will shine. AND SILVER WILL DO EVEN BETTER. Accumulate as much physical silver as you can while it's still under $20, there is no better form of cash. People do not understand that every year industry chews up every single ounce of silver produced and the once massive overhead supply of silver inventory has been depleted. Just wait and see the shortage that will result as investors keep accumulating.

Oct 01 03:28 PM

[Tony Daltorio:]

One of the most nonsensical articles I have ever read - trying to apply cash flow models to gold? WOW!

And if you are looking for a bubble, Saj, look no further than the Treasury market. It is the biggest bubble I have seen in nearly 3 decades in the investment industry.

Final point - gold is NOT an investment, it is an insurance policy, much like your homeowners or health insurance.

Oct 01 03:51 PM

[Kevin_T:]

This is really the point of gold, an insurance policy. Gold performs well in times of crisis.

Holding some gold could be expected to soften the blow on your portfolio of, say, a major and rapid dollar devaluation which could devastate bonds and equities.

Current reckless fiscal policy here in the U.S. may make it insurance worth considering.

>
> Final point - gold is NOT an investment, it is an insurance policy,
> much like your homeowners or health insurance.

Oct 01 04:38 PM

[Celcius:]

Saj, if gold is not a sound preservation of wealth than every bank and central bank on the planet would have sold all of their gold holdings.

A sound investor will, like a bank, keep a percentage of their wealth in gold bullion. It is the base asset in the financial pyramid relative to risk.

Oct 01 05:12 PM

[starkoski:]

I agree - don't buy gold but buy silver - it is a sure thing in the future with supply and demand. All paper money is dying and real assets will be of value. And a bonus is the BRICK story along with resource depletion. WOW

Oct 01 07:19 PM

[ed233:]

I wonder if Mr. Karsan would have any idea what a standard bar of gold would be worth in a country like Zimbabwe? Gold looks a lot more healthier than their currency. There was a time in Germany when gold would have saved your life. Better read some books about gold and investing in gold. James Turk & John Rubino published a book, "The Coming Collapse of the Dollar and How To Profit From It." They don't teach this material in MBA courses unfortunately. LOL Looking after your money.

Oct 01 10:08 PM

[esotericist:]

Money is supposed to serve two purposes.

1. Medium of exchange
2. Store of wealth

Paper money fails the second test.
Gold fails the first in this digital age.

That is why my savings are in gold, my medium of exchange a debit/credit card + some paper cash and kept in digital ones and zeros in my 'bank'.

Every paper money standard in history has returned to its intrinsic value. That of the paper upon which it is printed. NOTHING.

www.gold-eagle.com/edi...

It will take about $1650 paper money to buy an ounce of gold on this run.

Oct 03 07:47 AM

[Laurence Hunt:]

I think you have just elucidated why Warren Buffett chose the Euro over gold (Euro bonds pay interest).

May I submit that gold doesn't have to pay interest because...

1. It is not subject to arbitrary increases in supply.
2. It is not declining in inherent value due to (monetary) inflation (unmodulated increase in supply).
3. Those who value it know what it is worth to them.
4. While all currencies are somewhat arbitrary, gold is the least arbitrary currency of them all (based on historical precedent and practice).
5. Gold actually is valuable as a material, due to properties of ductility, conductivity, corrosion resistance, aesthetics, etc.
6. Scarcity is scarcity is scarcity....

Not good enough for you?

Don't worry, its good enough for 4 billion Asians, as well as an increasing cohort of Western investors.

But yes, gold is not a value investment. It is a store of value. So maybe that's what we need to be thinking about now....

Oct 05 11:01 PM