Friday, February 24, 2012

Who Has the Midas Touch?

By Weston Wellington

Over the course of a lengthy and illustrious business career, Warren Buffett has offered thoughtful opinions on a wide variety of investment-related issues—executive compensation, accounting standards, high-yield bonds, derivatives, stock options, and so on.

In regard to gold and its investment merits, however, Buffett has had little to say—at least in the pages of his annual shareholder letter. We searched through 34 years' worth of Berkshire Hathaway annual reports and were hard-pressed to find any mention of the subject whatsoever. The closest we came was a rueful acknowledgement from Buffett in early 1980 that Berkshire's book value, when expressed in gold bullion terms, had shown no increase from year-end 1964 to year-end 1979.

Buffett appeared vexed that his diligent efforts to grow Berkshire's business value over a fifteen-year period had been matched stride for stride by a lump of shiny metal requiring no business acumen at all. He promised his shareholders he would continue to do his best but warned, "You should understand that external conditions affecting the stability of currency may very well be the most important factor in determining whether there are any real rewards from your investment in Berkshire Hathaway."

As it turned out, the ink was barely dry on this gloomy assessment when gold began a lengthy period of decline that tested the conviction of even its most fervent devotees. Fifteen years later, gold prices were 25% lower, and even after thirty-one years (1980–2010), had failed to keep pace with rising consumer prices. By year-end 2011, gold's appreciation over thirty-two years finally exceeded the rate of inflation (205% vs. 195%) but still trailed well behind the total return on one-month Treasury bills (398%).

Perhaps to compensate for his past reticence on the subject, Buffett has devoted a considerable portion of his forthcoming shareholder letter (usually released in mid-March) to the merits of gold.

With his customary gift for explaining complex issues in the simplest manner, Buffett deftly presents a two-pronged argument. Like a sympathetic talk show host, he quickly acknowledges the darkest fears among gold enthusiasts—the prospect of currency manipulation and persistent inflation. He points out that the US dollar has lost 86% of its value since he took control of Berkshire Hathaway in 1965 and states unequivocally, "I do not like currency-based investments."

But where gold advocates see a safe harbor, Buffett sees just a different set of rocks to crash into. Since gold generates no return, the only source of appreciation for today's anxious purchaser is the buyer of tomorrow who is even more fearful.

Buffett completes the argument by asking the reader to compare the long-run potential of two portfolios. The first holds all the gold in the world (worth roughly $9.6 trillion) while the second owns all the cropland in America plus the equivalent of sixteen ExxonMobils plus $1 trillion for "walking around money." Brushing aside the squabbles over monetary theory, Buffett calmly points out that the first portfolio will produce absolutely nothing over the next century while the second will generate a river of corn, cotton, and petroleum products. People will exchange their labor for these goods regardless of whether the currency is "gold, seashells, or shark's teeth." (Nobel laureate Milton Friedman has pointed out that Yap Islanders got along very well with a currency consisting of enormous stone wheels that were rarely moved.)

When Buffett assumed control of Berkshire Hathaway in 1965, the book value was $19 per share, or roughly half an ounce of gold. Using the cash flow from existing businesses and reinvesting in new ones, Berkshire has grown into a substantial enterprise with a book value at year-end 2010 of $95,453 per share. The half-ounce of gold is still a half-ounce and has never generated a dime that could have been invested in more gold.

Few of us can hope to duplicate Buffett's record of business success, but the underlying principles of reinvestment and compound interest require no special knowledge. Every financial professional can point to individuals who have accumulated substantial real wealth from investment in farms, businesses, or real estate, and sometimes the success stories turn up in unlikely places.

Where are the fortunes created from gold?


Warren Buffett, "Warren Buffett: Why Stocks Beat Gold and Bonds," Fortune, February 27, 2012. Available at:

Milton Friedman, Money Mischief (Boston: Houghton Mifflin Harcourt, February 1992).

Stocks, Bonds, Bills and Inflation, March 2011.


Berkshire Hathaway Inc. Available at: (accessed February 21, 2012).

Wednesday, February 15, 2012

Cracks in the Crystal Ball

By Jim Parker

One of the mysteries of life in the financial markets is that many people still seem to believe you can build a successful investment strategy around forecasting, despite the road being littered with the corpses of those who got it wrong.

This month, twenty-four out of twenty-seven market economists polled by Bloomberg forecast that the Reserve Bank of Australia would cut its benchmark official cash rate by one-quarter of a percentage point to 4.0%, the third such move since November last year.1

The rationale seemed clear enough. The global economy was moderating, local activity was slowing, household spending had eased, employment growth was weakening, inflation pressures had receded, and the strength of the local currency was making life tough for non-commodity exporters and import-competing businesses.

A Bloomberg journalist wrote: "The Reserve Bank of Australia is poised to respond to the nation's weakest job market in almost 20 years by lowering interest rates for a third time tomorrow, the most aggressive rate cuts since the global financial crisis."

In its own preview, the Sydney Morning Herald's reporter was even more emphatic: "A betting plunge on financial markets puts an interest rate cut today as good as certain with weak retail sales figures indicating the worst growth on record."2

Yet, the central bank confounded market expectations and kept rates on hold. The market reaction was dramatic. The Australian dollar took off like a rocket, hitting its highest levels in six months against the US dollar and rising on the cross rates. Shares eased and bond yields rose.

At this point, the very same economists who had carefully parsed the bank's language going into its decision proceeded to analyze in great detail the wording of the statement announcing that rates would stay where they were for another month.

Actually, there really wasn't that much remarkable about what the RBA said. Essentially, it had decided that, with economic growth close to its long-term trend and inflation on target, the RBA could afford to wait another month to see how events in Europe and elsewhere panned out.

Local bank economists immediately pushed out their expectations for the next policy easing to March. Some had second thoughts altogether and decided the central bank might be done on interest rates for the foreseeable future.

For everyday investors, there are a few lessons out of this episode. The first is that there is very little evidence market professionals—including the ones closest to policymakers—are any better than anyone else in forecasting the prices of securities, commodities, interest rates, or currencies.

Last August, for instance, a global bond fund manager admitted he felt like "crying in his beer" over his call in March 2011 to dump almost all of his flagship fund's US government bond holdings because interest rates were unsustainably low.3

The second lesson is that trying to time markets—picking the turn in performance of bonds versus equities or government bonds versus corporate bonds or value stocks versus growth stocks—is a pretty tough job. In fact, few (if any) people seem to get it consistently right.

The third takeout is that it really doesn't matter how strong you think the fundamental case is for an interest rate change or a lower currency or a higher stock price; events have a distinctive and unerring way of messing up your impeccable logic.

An example: In the US in February this year, strategists at some of the world's biggest investment banks capitulated on their bearish forecasts after global stocks registered their best start to a year since 1994. In a summary of recent research, Bloomberg quoted strategists at several banks as admitting they had gotten their timing badly wrong.4

The final message is that you don't really need any of this fundamental analysis to build long-term wealth. Markets are unpredictable because news is unpredictable.

This means the best approach is to structure a diversified portfolio that is built according to your own investment goals and risk appetite, both across and within asset classes. Occasional rebalancing of the portfolio ensures you maintain an asset allocation consistent with your risk profile. The rest is all about discipline.

This may not be a particularly exciting investment story. But it's one that works. And it doesn't require you to make forecasts about interest rates, currencies, stock prices, or economies. As we have seen, there are some serious cracks in the crystal ball.