Timeless Reading – Part I – Warren Buffett On Gold

This is part one of a ten part series on some of the most important and educational literature for investors with a focus on value. Across this ten-part series, I’m going to take a look at ten academic studies and research papers from some of the world’s most prominent value investors and fund managers.

All of the material can be found under the ‘Timeless Reading’ tab on the menu bar at the top of this page. And if you don’t know where to start, we’ve put together a ‘Value Investors Must Read List’ of resources, which once again can be found under the Timeless Reading tab.

Timeless reading — Part one: Warren Buffett on gold

To start this series, I’m taking a look at an article published in Fortune during February 2012 and penned by Warren Buffett titled: “Why stocks beat gold and bonds”. The article, which can be found here, and is now archived on the Davis Funds website, is more than just an insight into Warren Buffett’s thoughts on gold. Indeed, the article draws a line between the two different disciplines of investment and speculation.

Warren Buffett begins:

“Investing is often described as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power — after taxes have been paid on nominal gains — in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.” — Warren Buffett

Warren Buffett goes on to say that at Berkshire, the riskiness of an investment is not measured in the traditional Wall Street way of beta, but rather by probability — the reasoned probability that the investment will cause permanent capital loss to the investor. This is a crucial factor. Investments can fluctuate in price are not always risky, while some investments that are considered risk-free, because their prices do not fluctuate on a day-to-day basis, can be laden with risk.

Buffett believes that there are three main investment categories.

Warren Buffett: Risky currency

Firstly, “safe” Investments denominated in any given currency can be inherently risky. These include mortgages, money-market funds, bonds and bank deposits. Governments ultimately control the value of money and occasionally policies designed to control or stimulate inflation get out of control.

“Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire…Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power.”

“For tax paying investors…the picture has been far worse. During the same 47-year period, continuous rolling of U.S. Treasury bills produced 5.7% annually. That sounds satisfactory. But if an individual investor paid personal income taxes at a rate averaging 25%, this 5.7% return would have yielded nothing in the way of real income.” — Warren Buffett

Income tax paying investors would have seen 1.4 points of yield taken away by tax and a further 4.3 points in inflation.

As a result of these dismal figures, Buffett and Berkshire will only purchase currency-related securities if there’s the possibility of an unusual gain. The most common situations are credit asset mispricings or because rates rise to a level that offers the possibility of realizing substantial capital gains when rates fall.

“Today, a wry comment that Wall Streeter Shelby Cullom Davis made long ago seems apt: “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.” — Warren Buffett

Assets that will never produce anything

The second category of assets, which seem to be safe investments at first glance but are in fact inherently risky, are, according to Warren Buffett:

“…assets that will never produce anything, but that are purchased in the buyer’s hope that someone else — who also knows that the assets will be forever unproductive — will pay more for them in the future.” — Warren Buffett

Tulips are of course the most famous of this asset class. Buffett continues:

“This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce — it will remain lifeless forever — but rather by the belief that others will desire it more avidly in the future.” — Warren Buffett

This is where Buffett begins to criticize gold as an investment. It is the favorite bastion of safety for investors who are afraid to hold almost all other assets. However, gold’s most pressing shortcoming is the fact that it does not grow. If you buy one ounce of gold and hold it for eternity, at the end, you’ll still be holding one ounce of gold.

In his article, Buffett goes so far as to state that gold was in a bubble, similar to the dot-com or housing bubbles, at