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Warren Buffett is cold on gold, and why you should be too

Each year, usually toward the end of February, many investors look forward to the release of the Berkshire Hathaway (NYSE: BRK-A, BRK-B) annual report. The numbers are useful, but a key highlight for most readers is Berkshire Chairman and CEO Warren Buffett’s Letter to Shareholders.

For the uninitiated, this isn’t your usual public company CEO spiel. For too many (but not all) listed companies, the pieces written by their key office holders are little more than spin – documents written to reassure investors that their money is invested in the right place, and that their management and board is doing a great job.

Of sins and all-stars
Buffett’s letter is different. For as long as he has been writing these letters , Buffett has used them as a tool to share more information with his investors. He and Berkshire’s Vice-Chairman Charlie Munger take an approach of treating investors as partners, and Buffett has written these letters to convey the information he’d want to know, were the positions reversed.

Buffett’s letters are part information update, part investment lesson. He’s quick to admit his mistakes and quick to praise the managers of the Berkshire Hathaway businesses that have succeeded throughout the year. He also takes great care to share his thoughts on investing in general and on the issues of the day in particular.

In that vein, investors keenly read an abstract of Buffett’s upcoming letter to shareholders which was published online by Fortune magazine.

‘You can fondle it, but it won’t respond’
One of Buffett’s favourite topics of late has been investors’ fascination with gold and with cash (in the form of bonds). As usual, Buffett explains a complex issue in simple terms.

Buffett characterises gold as an asset “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.”

I can already hear the gold fans shouting at this point. The last few years have seen the price of gold skyrocket. With the risk of government default and the inflationary effects of ‘quantitative easing’ (a gentleman’s expression for cranking up the printing presses to deflate the currency and stimulate demand), many see gold as something real, solid and measurable – an asset whose quantity can’t simply be increased at the whim of a nervous central banker.

The need for monetary mothballs
Buffett agrees – but with the diagnosis, not the treatment. Buffett agrees that holding cash is a path to the poor-house. In fact, he says they may be “thought of as “safe”. In truth they are among the most dangerous of assets.”

While the nominal dollar value of your investment may be protected, the purchasing power of that cash is being eaten away while it sits there. To cement the point, Buffett remarks that the US dollar has fallen in value by 86% since 1965, due to just that phenomenon.

The Oracle of Omaha restates the greater fool (note the lower case ‘f’!) theory: “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”.

The case for shares
Instead, and unsurprisingly, Buffett makes the case for investing in shares – the productive capacity of democratic capitalism. He also gives a sense of the best businesses to own. Buffett prefers ‘first-class’ companies that can keep up with inflation and that also require only minimal new capital to produce their returns. Buffett cites Coca-Cola (NYSE: KO) as one such example.

He says “I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we’ve examined. More important, it will be by far the safest.”

That’s a critical point – equities are often characterised as risky, volatile and complex (and some companies’ shares can be all three), but when compared to the risk taken by buying assets that don’t sustain your purchasing power, Buffett argues that the safest way to secure your financial future is to swap some shorter term volatility for longer term ‘purchasing power’ protection.

The article is accompanied by a picture – which may or may not have been Buffett’s work – comparing the returns from investing in the three asset classes discussed since 1965. US$100 invested in US government bonds would have compounded to be worth US$1,336 by the end of 2011. Gold would have far outpaced cash, turning into US$4,455, but equities would have done over one-third better, compounding its way to $6,072.

Foolish take-away
For what it’s worth, I think the difference will be more pronounced in 10 years time. Stocks are still fighting their way back from the recent slump and gold is riding the wave of uncertainty – I think each is likely to revert to the mean in due course, widening the gap.

Oh, and in case you were wondering, the same US$100 in Berkshire Hathaway book value in 1965 became US$490,000 at the end of 2010 (the most recent data available).

Ignoring Buffett’s words in the past has been an expensive exercise – it’s a brave person who does so now.

(Editor’s Note: The original version of this article contained an error regarding the asset class comparison. The 1965 investment in the graphic is $100, not $1,000 as originally published).

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Scott Phillips is The Motley Fool’s feature columnist. Scott owns shares in Berkshire Hathaway and Coca-Cola. You can follow him on Twitter @TMFGilla . The Motley Fool’s purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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