- Value investors dismiss gold before even analyzing it because of worship bias of their idols.
- Most investors don't understand the intrinsic value of gold.
Monetary Inflation Erodes the Fiat Store of Value Over Time
The primary objective of bottom up value investors is to estimate the intrinsic value of a publicly listed company in order to calculate the margin of safety, which is simply the delta between the estimated intrinsic value and the prevailing market price. For both book and earnings based valuation methodologies, cash is assumed to be the most reliable unit of value.
In fact Warren Buffett has built a $125 billion war chest of cash equivalents at Berkshire Hathaway, with 81% of that $125 billion in “risk-free” U.S. Treasury bills which amounts to nearly 4% of the $2.6 trillion T-Bills in public hands. In any boom-bust cycle, cash reserves are paramount, providing the strategic investor access to bargain opportunities during a crisis.
However, only a minority of value investors have ever examined the true nature of fiat cash, let alone attempt to estimate its intrinsic value. Fiat cash is implicitly assumed, with the absence of any deep thought, to have 100% face value. The disease of sovereign insolvency that is unfolding before us has reached the base level of finance and will create a global financial crisis centered around challenging the intrinsic value of fiat cash itself, specifically the dollar reserve fiat currency. We cannot assume all denominations of fiat cash will retain 100% of its purchasing power.
Bottom up value investors have willfully neglected these underlying shifts in the macro environment under a narrow herd mentality that fixates on focusing exclusively on company analysis. This s a blindsided attitude that produces fiduciary negligence. The preservation of wealth in real terms during the upcoming monetary reset, relies on limiting exposures to the wave of fiat currency devaluations relative to the re-established monetary anchor.
If Warren Buffett still holds dollar denominated assets and cash reserves before the rebalancing act in the monetary system, he will not retain sufficient purchasing power in the post reset system to buy listed companies denominated in foreign currencies. Furthermore, we all know that the purchasing power of fiat currency erodes stealthily over time due to inflation. Running a simple thought experiment and projecting this trend into perpetuity should quickly reveal that, as Voltaire once said, “all paper money eventually returns to empty intrinsic value, slowly at first then all at once.”
Gold Increases in Value Over Time Relative to Fiat Currencies
Gold, one of the most misunderstood asset classes, on the other hand increases in fiat value over time. The vast majority of the public, including most investment professionals, miscategorize gold as a commodity. Its industrial uses are highly limited, unlike any other stand alone commodity. Rather, gold’s primary function for the past 5,000 years in human history has always been monetary in nature. This is the reason why central banks and monetary authorities store gold on their balance sheets as a monetary reserve. During the gold standard and the Bretton Woods era, gold always had a fixed ratio relationship with the money supply. After the abandonment of the fixed exchange relationship, the money supply and aggregate credit was able to expand freely, allowing the US to run fiscal deficits without constraints. This was the primary rationale behind moving to a global fiat system in the first place. Despite the explicit departure from the gold standard, central banks still retain gold reserve as a tier one capital equivalent for commercial banks, operating a shadow gold standard on a fractional reserve basis.
Another issue that people misunderstand is the price of gold. Price is the relative value that tells you what the market will pay now, but price never tells you anything about its intrinsic value. Buying simply because prices go up makes you a speculator. The reason why gold prices increase relative to all fiat currencies is simply because the supply of fiat increases over time relative to the fixed supply base of gold. Rapid expansions of the money supply because of central bank interventions as a response to financial crises, increasing the relative scarcity of gold and thus becomes more valuable relative to fiat. If you do your homework and perform fundamental analysis on gold, you can estimate its intrinsic value based on the historic average of gold to money supply ratios during the gold standard.
Unfortunately the two role models in the value investing world are well known critics of gold. The principle tenant of value investing has always been to do your own homework and let the evidence lead to you your own conclusions. As a corollary, value investing teaches us never to follow the herd and to be aware of our psychological biases. Yet many self-proclaimed value investors do not practice the gospel in the same way most people do not do what they actually say. Instead, many of us resort to shortcuts and assume that our idols are infallible. Many value investors have become victims of this group think and idol worship to rationally analyze the fundamentals of gold in a rational way. It is dismissed as a barbarous relic.At Berkshire's 2018 annual meeting, Buffett compared $10,000 invested in stocks and gold in 1942 (the first year he invested in stocks). That money invested in an S&P 500 index fund (there were none at the time, he noted) would've been worth $51 million in 2018 while a gold investment would've been worth only $400,000. His partner Charlie Munger publicly stated that no civilized person would buy gold. Indeed at a cursory glance, if we take Buffett’s view and compare gold to the S&P 500 dating back further to 1896, it validates his narrative of gold of severely underperforming equities as shown in the graph below.
Comparing gold to equities however is disingenuous at worst, and at best an analytically false comparison due to ignorance. In the same way you would never benchmark the S&P 500 to the dollar, gold is also money and should be compared to other currencies. Furthermore, if you understood the full history of gold, you should see the degree of bias embedded in Buffett’s assumptions.
Before 1971, gold did not have a market price and was fixed to $32 an ounce. In other words, the price of gold was “fixed” and it not have a real market price as it does now that is allowed to float freely against other currencies. Gold is not an investment that compounds in value, but rather money that serves as a store of value throughout boom and bust cycles. But despite being money that does not have the ability to generate cash flows the way a business is able to, gold has actually outperformed equities and most active portfolio managers since 1971 when it was allowed to be priced freely by the markets. Given the degree of monetary debasement that has occurred since then, gold has appreciated in dollar terms by +3,850.26% from August 15, 1971 to May 7, 2020 compared to the S&P 500 which has appreciated +2,835.31% in the same time period.
As a capital allocator, Berkshire holds a significant amount of cash. But it is falsely assumed fiat cash will retain its value after the financial crisis, which still remains undiagnosed as a sovereign debt led currency crisis. Second level thinking expands Buffett’s tactical approach towards cash allocation in dollars towards cash allocation in safe haven currencies, gold being the ultimate currency. Additionally, equity investors should pay special attention to the denomination of their equity exposures, a hidden risk that is overlooked by most investors.
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