With the recent trend of political turmoil boiling over into our everyday lives and the increasing threat of inflation withering away at the purchasing power of our dollar, gold has become a topic of conversation recently. It is the asset that is classically associated with protection against both uncertain times (picture someone’s basement stocked with gold bars) and inflation. With that in mind, some have suggested that it is an attractive addition to any investor’s portfolio to mitigate any impact fear and inflation may have on a portfolio.
While I am typically one for the classics, it is my belief that this is terrible investment advice. Here’s why:
Imagine for a moment that you have $1.0 million dollars and you have 2 mutually exclusive investment choices. At roughly $1,200 per troy ounce, you can buy 2 gold bars and put them away for safe keeping. Or, you can purchase a business that will perform fundamentally similar to most American businesses. Which do you choose if your goal is to preserve and increase real purchasing power over a decade or more?
If you choose to purchase the gold, the results of that decision will be determined purely by what someone else is willing to pay you at the time you look to sell, in this case, 10 years from now. As gold has no meaningful economic purpose, outside of limited uses in electronics and jewelry, its price is determined by how deeply buyers and sellers believe it protects against inflation and uncertainty and how those two factors are expected to progress over time. In my view, this seems to be a largely speculative exercise.
In the case of the business, a few more details are needed before we can move on. This million dollar business generated about $45,000 in net income last year selling widgets on a global basis, it distributed roughly $20,000 in dividends to its owner last year, and moving forward its income will grow in line with the average large to mid-size American business (usually between 5% – 10% per year). Further, the business will require no operational involvement from you as the owner. While the ultimate value realized by this investment, outside of the dividends, will be dependent on what others are willing to pay for it 10 years from now, what those potential buyers are willing to pay is based in large part on the underlying net income generated by that business. That is why the valuation of businesses often tracks profitability. An added bonus is that the business will have distributed close to 25% of the original purchase price back to its owners in the form of dividends throughout the 10 year hypothetical scenario.
So how does this business protect against uncertainty over the 10 year time horizon? Well, the beauty of our consumer driven economy is that no matter how bad the underlying economy is, consumers will line up to purchase the next best product, and they will always be buying the basic necessities, like food. A recent example can be seen in the number of iPhones Apple sold in 2008 (11.6 million units) vs. 2009 (20.73 million units) when many were feeling the effects of the great recession. This unwavering demand is a product of our free market system and it has been present throughout our entire history as a country. If you believe this to be true in the future, it should eliminate a large portion of doubt surrounding what is considered “safe” as an investment over longer periods of time.
In regards to inflation, investors in American businesses can be sure that consumers are likely to demand products and services, and in exchange, they will pay using whatever form of currency or barter system that is most efficient at the time. This allows businesses to maintain significant pricing power overall, in turn protecting the business and its owners from inflationary pressures. As an example, the average price of Corn Flakes in 2003 was approximately $0.13 per ounce. In 2013, this price rose to $0.22 per ounce, close to a 70% rise. This was during a period of stagnant demand for cold breakfast cereal. During that same time frame, that pile of gold you may have bought will have sat there, essentially as a paperweight, rather than a productive asset spitting off cash dividends. Its price will be determined by the emotions of others in the market place, not by the economic value of the asset itself, which in the case of gold is close to zero.
So, Next time you are thinking of purchasing some gold as a hedge against either inflation or fear, I suggest you instead buy a business or businesses through a diversified portfolio of common stocks. Save the gold purchases for jewelry to give to your sweetheart.