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Gold riot

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Warren Buffett’s thoughts on gold or how looking at the return on gold might reduce the glitter

The riot over gold has calmed down a little, however, there is still significant interest in the metal. An interesting perspective on gold comes by way of value investor par excellence, Warren Buffet.

Will all the gold that glitters glitter less?

There is no denying gold has had a great run. What people forget when gold performs spectacularly is that it has often caused investors an enormous amount of pain as well. Gold is volatile. It soars, but it has also come down very hard throughout its history – part of the reason that most recommendations limit gold to about 5 per cent of a portfolio (in order to smooth out volatility).

Gold has performed very well this year and over the last few. The S&P/TSX Global Gold Index has doubled the S&P/TSX 60 this year. But gold’s performance comes with a lot more volatility. The fact that gold is such a big sector within the Canadian stock market has been advantageous this year. Gold often kept the Canadian market buoyant when other stocks turned downward. It acted as kind of a built in hedge. However, should gold turn south in a significant way, it will also hold the Canadian market back because of its large weighting. In fact, by just holding an index fund or ETF tracking the S&P/TSX 60, you have about 20 per cent exposure to the materials sector, and, a large portion of that is in gold. The broad Canadian market has a lot of gold exposure already.

Unfortunately, gold is on everyone’s tongue lately.

But what does Buffett say about gold?

Gold just sits there

Buffet has become wealthy by being a value investor. He believes in goods and services and buying the undervalued companies that deal in them.

If you don’t listen to Warren Buffett at some level, you’re odd. Whether pundits agree with him or not, his opinion is focused on and respected. Buffett says there is no place for gold in his portfolio – intriguing, because, unlike Canadian investors who have seen appreciation in their currency, Americans have been dealing with a declining dollar, resulting in the rush to gold as a hedge against devaluation. Throw in the troubles in the world economy, the devaluation of the Euro, etcetera, etcetera, and the rush to gold isn’t exactly surprising.

Buffett’s logic on the metal is definitely interesting. He thinks gold is useless.

That’s right. Useless.

Buffet on gold:

“(Gold) gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

Ah, the Ziggy Stardust gold analysis …

In Fortune, Buffett recently said:

“You could take all the gold that’s ever been mined, and it would fill a cube 67 feet in each direction. For what that’s worth at current gold prices, you could buy all — not some — all of the farmland in the United States,” Buffett said. “Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?”

A very, very interesting illustration …

Buffett has stayed consistent with his messaging on gold.

  • Expensive to store
  • Has no practical use
  • Doesn’t generate income

Of course, some of the large players that mine gold do generate income, but Buffet’s talking more about buying the metal itself.

The S&P/TSX Gold Index has done very well in the last ten years. It has returned about four times the S&P/TSX 60. However, during the dog days of the financial crisis, it collapsed along with everything else, and that collapse wiped out all gains since about 2002. Gold has recovered spectacularly since then though not without some equally spectacular volatility. Without a doubt, placing a big bet on gold increases risk immensely. If you’re looking to steer away from volatility, putting more than 5% of your portfolio into gold could leave you with a nasty surprise.

Gold stocks, because of their leveraged positions with respect to gold perform even better than the metal, generally, yet that outperformance goes the other way in a hurry at times. So, gold stocks can be a great hedge, but they also have some explosive volatility built into them – volatility which can go either way faster than most people can monitor.

The big question is which way will gold go in the near future? And, how much has the risk premium for holding gold increased?

For Canadian investors, this question doesn’t hinge on a declining currency. Our market has a huge piece of gold already. If you own the broad market, you’re already exposed to gold. That can be a good thing or a bad thing. In the last ten years, it’s been a great thing, but all good things come to an end. Are we closer to the end of gold’s aggressive increases or is there still room to shine?

For the average Canadian investor, if you just own the broad market you have exposure to gold and its advantages. At the same time, should gold have a significant correction, you’ll feel it.

Buffett’s comments on holding gold bullion (even though it’s easier to do with ETFs now) bear some thought. Expensive to store. No practical use. No income.

Looking for value makes one a big fan of dividend-paying investments. Canadians already have exposure to gold. Would you take a flyer on gold at these prices? Such an idea may have lost its sheen.

If you are a trader, that’s one thing, but if you are an investor, polishing gold may leave less of a glimmer lately.

Now, if there were a significant correction in gold, that would change things, but right now gold looks like its bumping its head on a ceiling. Whether that will be temporary or longer lasting depends on many different interconnected moving parts within the economy.

The questions it’s prudent to ask yourself with every investment are:

  • Am I likely to get the same return on my investment next year?
  • Will I get even half of that return?
  • Am I using sensible portfolio approaches regarding the construction of my investment portfolio?

A portfolio of gold stocks I was looking at recently has returned over 70 per cent year-over-year. The broad market has returned less than a third of that. Over 50 per cent of that return has come in the last six months. Recently, this portfolio has pulled back 6 per cent – and it is a broad portfolio that has increased over 800 per cent over the last ten years.

Is it cheap? Does a correction of 6 per cent add much value? …

Not exactly a huge pullback.

Every Canadian investor who holds the broad market holds gold. Loading up on gold may not be the best of all portfolio moves. At this point in time, Canadian investors find themselves in a different situation compared to their American counterparts.

The gold rush may not be over but there certainly are a lot of people panning in the stream.

 

For an update on gold stocks, gold bullion and dividend-paying stocks click here.

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