Warren Buffett recently released the annual report for his company, Berkshire Hathaway. You can read that report in its entirety here. In it, Buffett gives us his insight into investing in the modern times. Buffett has a long history of being extremely successful in the investing world, a reputation that we would be crazy to ignore. However, like any human being, Buffett has biases, biases that might negatively affect his ability to accurately examine the world and accurately deploy capital in an attempt to gain a significant return on investment. Any time you read the opinion of someone on anything (including the one you’re about to slog through), it’s important to understand the motivations and biases that said person might be trapped by.
I don’t make it a habit of reading Berkshire’s annual report though I may start. However, I ran across it this year when Kent Beck linked to this excerpt and cited it as an example of persuasive writing. Since I’m both a writer and an investor in gold, I was naturally intrigued to see what Mr. Buffett had to say about the topic. Sadly, I fail to concur on both points. The writing is clearly done by someone with a somewhat outdated understanding of the current economic system and someone who has clear biases against investing in commodities, particularly the supposedly non-productive metal gold. The excerpt linked above is only a part of Buffett’s delineation of three categories of investments. While it’s nice to excerpt only the part you find mentally comforting, it’s far more important to read the entire section to get an idea of what Buffett is saying.
Starting on page 17 of the report, Buffett details the three main categories of investments he defines: currency based assets, non-productive based assets and productive based assets. Examples of these classes are (1) money market funds and bonds, (2) gold (and poorly, tulips according to Buffett) and (3) most everything else including farms, real estate and stocks. The excerpt linked above deals only with the section on gold but let’s take a look at the classes and Buffett’s writing in their entirety.
Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge.
Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as the holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur. Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control
Buffett opens up with this description of the first class of assets, namely currency denominated assets. There are several key ideas here to glean from Buffett’s writing. The first is that contrary to popular wisdom he feels that currency assets are actually quite dangerous and from the standpoint of a long term view point with the greatest return on investment, they are very dangerous. The ugly spectre of inflation, insidious and often silent, will destroy any perceived value of these investment vehicles because as Buffett so aptly points out “governments determine the ultimate value of money.” So we can assume that Buffett is keenly aware of the negative influence on inflation and manages Berkshire in a way to exceed the negative inflation tax. The second interesting thing to note is Buffett’s choice of time frame. “Over the past century” is certainly a long time frame, one that is undoubtedly picked because it fits the narrative Buffett is trying to create. This is the first example we see of a specific period of time and it’s worth a small discussion.
As always, the discussion and interpretation of time is fundamentally dependent on the context of the parties being discussed. Six months might be long term for a terminal cancer patient while sixty years might be long term for an entity like Berkshire Hathaway. More importantly, time frames on the individual level are qualitatively different that time frames from an organizational or societal level. An individual investor has a long term time frame of 30-40 years to acquire enough wealth to satisfy any financial goals he might set for retirement. Unfortunately, at the macro level where the statistics are often quoted, 30-40 years is a tiny fraction of a time slice as evidence by the Dow over the past 12 years being essentially flat with a annual negative return once inflation is considered. A full 25% of a long term investor’s time frame has returned nothing if said investor had the misfortune of being born in a period where the Dow just didn’t appreciate. The usage of a century as the time frame for examining the performance of this first class of assets is convenient for Buffett’s argument but meaningless for anyone who is interested in investing at the individual level. One hundred year time frames tell you and I almost nothing.
Continuing with his discussion of the first class:
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. It takes no less than $7 today to buy what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. Its managers would have been kidding themselves if they thought of any portion of that interest as “income.”
For tax-paying investors like you and me, 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. This investor’s visible income tax would have stripped him of 1.4 points of the stated yield, and the invisible inflation tax would have devoured the remaining 4.3 points. It’s noteworthy that the implicit inflation “tax” was more than triple the explicit income tax that our investor probably thought of as his main burden. “In God We Trust” may be imprinted on our currency, but the hand that activates our government’s printing press has been all too human
Again, there is a wealth of information here. First, we notice that Buffett has now narrowed his time frame to the 47 years he’s been investing. This is much more useful as it’s a time frame we can understand and profit from as individual investors. Explicitly showing how inflation destroys the value of savers wealth, we begin to get a fuller picture of Buffett’s ideas. It’s clear he does not trust any government, much less the United States, to preserve the value of its currency and because he cannot trust them, he views the instruments they control as poorly suited for his hard earned investments.
This is a critical point because it directly contradicts what he goes on to discuss in the following section on so-called non-productive assets. We now know that Buffett distrusts governments and their currencies as investment vehicles because throughout history, both at the individual and macro level, governments have never shown an interest in preserving the value of their currency. Exactly the opposite, all fiat currencies throughout time immemorial have lost value. Some times quickly, sometimes slowly, almost never orderly, the value of any given governmental currency has disappeared over time.
However, it is interesting to note that while Buffett is disdainful of this class of asset, he states that at times in the past, Berkshire has discovered mispriced markets and profited in this class based on that mispricing. While largely focused on the long term, Buffett works on a daily basis on the short term, especially as it relates to the economic outlook of a given time. This points out yet another contradiction in the coming discussion of gold. While over the long term, investing in currency based assets has been detrimental and destructive to an individual’s capital, in the short term there have been opportunities to capitalize on market irrationality and profit in this class. This is also true for gold and it seems inconceivable to Mr. Buffett that we might currently be in a time when we can profit from exposure to metals in our portfolios.
Let’s turn to the second class of assets Buffett discusses.
The second major category of investments involves 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. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.
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 even more avidly in the futur
This is only a partial representation of this class and unfortunately, it is poorly represented by the example given by Buffett of tulips. I would argue that there are two subclasses of this class. The first subclass represents those items that have a shelf life. Examples are food commodities, cattle and of course, tulips. These items have value because somewhere at the end of the buying chain lives a person who is willing to pay retail price for the item. No one invests in tulips with the express intent of storing wealth over time.
The second subclass is represented by things without a shelf life at least in human terms and includes things like metals and oil. This class can be thought of not only as investments but as stores of wealth. A store of wealth is an alternative to currency and actually encompasses most things we buy. For example, I have a set of noise canceling headphones on my desk. At some level, they are a store of wealth in that at no point in the future will they have a value of zero. We can assume that if they continue to work, I can always sell them to someone even though the sale price may be a tiny fraction of the price I paid. A tulip clearly does not fit into this category. The problem with the headphones is that once I took them off the proverbial lot, they have depreciated in value at every single moment since and will continue to depreciate unless some strange confluence of events emerges that misprices the market for old headphones.
Hard commodities like oil and the metals on the other hand have throughout time, both long and short term, experienced periods where economic factors have created an increase in value of their wealth. We are experiencing one currently. This happens for a variety of reasons but it is often related to that very fear Buffett outlines in his section on the first class of assets, namely that governments cannot be trusted to preserve the value of their particular currency. Gold, as a store of wealth, has no overseer other than the market and the price that market is willing to support. It is fundamentally different in type from tulips and shouldn’t be discussed in the same way at all.
Further on, Buffett details what he believes motivates the buyers of gold:
What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth – for a while
First off it’s important to note the pejorative distinction of bandwagon investors. The scare quotes alone are enough to tell us what Buffett thinks of those people currently buying gold in today’s market. There are two fundamental things wrong with this usage. First, at some level, all investors are bandwagon investors unless they are exceptionally lucky or exceptionally foresighted. Markets by definition in any growth industry are about the accumulation of more investors over time who believe the price of the market will go up. And secondly, a large part of Buffett’s strategy for acquiring wealth over the long term stands on his ability to identify markets where bandwagon investors will drive the market higher. While he clearly denigrates people who jump on the bandwagon of some market, his success is fundamentally dependent on that continuing to happen at some level. Also interesting to note is the usage of “for a while”. Again, time comes into play and just as Buffett has in the past made money on currency assets when the price was right, one would think that he would be open to making money on hard commodities when the time was right. All markets are right “for a while”. The key is knowing when that time is. And that brings us to what Buffett most likely thinks about gold and that is that the time is not right. He most likely believes that gold has reached the end of its run and will thus at some point in the not so distant future begin to lose value perhaps dramatically. The question is, is he right? We’ll look at that more in a bit.
Buffett then goes on to talk about two recent bubbles, Internet stocks and housing. The issue there is of course that those bubbles were driven largely by a Federal Reserve policy that eased the money supply in exactly the way Buffett outlines in his first section. Those bubbles were driven by cash chasing return. I believe the current gold boom is being driven by a completely different impetus and that is the collapse of the dollar as the world reserve currency though certainly the gold market is aided by the fact that the Federal Reserve, with the implicit and explicit support of the Treasury and an inept Congress, is greatly increasing the money supply forcing people to find alternative stores of wealth for their cash because the US Government is actively destroying it in an attempt to prop up a broken financial system.
If we look at the next ten years as it relates to the financial picture of the US Government, we see that the Federal Reserve has expanded its balance sheet in a manner unheard of in history. US Debt to GDP may reach 159% or more by 2020 which in and of itself may not be the death knell but is certainly the symptom of a very sick patient. Because the US Government will likely never default on its debts, the only other reasonable solution is to inflate our way out of the mess. When we do this, the dollar will be worth much, much less and gold will be worth much, much more. The important key here is see that the market for hard commodities including gold has a time frame. Buffett believes that the time frame is near the end of the bull run and thus he is not interested in investing in it. I, and many other people far smarter than me, believe that we are nowhere near the end of the bull run because I see no way out of the mess we are currently in short of inflating our way out of it. Our government could wake up tomorrow realizing the error of its ways and move onto a path of fiscal responsibility that included drastic cuts in spending. However, that would cause immense short term pain in the economy and I think we all know how likely our politicians are to implement something that directly affects their ability to get reelected.
When it’s all said and done (and I promise, I’ve about said everything I can), the outlook for hard commodities including gold is promising over the next 8-10 years in my opinion. I do not see the world economies stabilizing substantially until we either rein in run away spending or a collapse happens. Either way, gold will serve as a store of wealth in the interim, not as a fifty year investment but instead as a way to protect our wealth from the vagaries and shortsightedness of our political leaders. Until a balance can be returned to the financial markets, gold (and possibly far more profitably, silver) will be attractive to investors throughout the world including large governmental buyers like China who most certainly can see the writing on the wall for their investment in US debt and who are even now moving to acquire large reserves of other currencies including gold.
I largely admire Buffett and his success. Fundamentally, his outlook on the US economy is similar to my own in that I think the US is the best place for investing in the future and will continue to be so. However, our time frames are fundamentally different and that leads to a divergence on our views of the yellow metal, among other things. While Buffett has no interest in putting Berkshire’s money into the metals, I believe the bull market will run for at least another 8 years and at that point, depending on the economic factors of the time, perhaps a reevaluation of owning gold will be in order. Until then, I plan to acquire not sell gold until I’m proven otherwise wrong in the market.