Justin Smyth
7 March 2011

Warren Buffet released his annual shareholder letter last week and also conducted what has become an annual interview on CNBC with Becky Quick. During the interview they covered an array of topics including the economy, the U.S. government's fiscal situation, inflation, Berkshire's investments, and oil. At one point during the interview Joe Kiernan asked Buffet about gold and commodities. Kiernan said:

"…And there are periods where financial assets are great from the like early '80s to 2000. And I just wonder if there's then periods where hard assets are great. And you see Paulson and gold and some of these other guys and gold or commodities. Are you just not comfortable with commodities? Are there times where you should be downplaying maybe stocks or businesses and going totally full-bore into commodities but you're just not comfortable doing that?"

Buffet gave a lengthy reply, which included the following:

"…I've said consistently for the last few years I would vastly prefer to own common stocks than fixed dollar investments over a five or 10-year period. I don't know any about the next five hours or five days. And that might very well extend to rental real estate, it might extend to farms. I mean, an investment you're looking for something where you put out money now and that asset that you buy gives you back more money over time. Now, the problem with commodities is that you're betting on what somebody else will pay for them in six months. The commodity itself isn't going to do anything for you.

So there's two types of assets to buy. One is where the asset itself delivers a return to you, such as, you know, rental properties, stocks, a farm. And then there's assets that you buy where you hope somebody else pays you more later on, but the asset itself doesn't produce anything. And those are two different games. I regard the second game as speculation. Now there's nothing immoral or illegal or fattening about speculation, but it is an entirely different game to buy a lump of something and hope that somebody else pays you more for that lump two years from now than it is to buy something you expect to produce income for you over time…"

Buffet also made this comment about gold:

"…With an asset like gold, for example, you know, basically gold is a way of going along on fear, and it's been a pretty good way of going along on fear from time to time. But you really have to hope people become more afraid in the year or two years than they are now. And if they become more afraid you make money, if they become less afraid you lose money. But the gold itself doesn't produce anything…"

When you analyze Buffet's answer it does seem to be consistent with his investment philosophy. Buffet is only interested in businesses that produce cash flow, and that create products that people need. He's not interested in speculating on the price of a specific asset class. Obviously gold doesn't produce cash flow, so the only way to make a return on gold is to speculate on its price appreciation, which Buffet said is a game he's not interested in.

The biggest flaw though in Buffet's response is when he makes the comment: "the problem with commodities is that you're betting on what somebody else will pay for them in six months". This isn't totally true since an investment into commodities could be either short term or long term in nature. Only commodity futures and options carry fixed time periods that expire, but expiration dates can go well into the future, and it's also possible to roll over a position into a new contract. Speculating on the long term trend in commodities is possible through stocks and ETFs as well as the futures markets.

Buffet seems to be not interested in speculating on the price appreciation of an asset, even if there is an established long term trend higher in the price of the asset. That's just his investment philosophy. Other institutional investors do not share that philosophy, and believe in the concept of long term trends in the prices of different assets. And that is what separates a value investor in the Warren Buffet sense, from a value investor that looks at the price of an asset in relation to where a long term trend could take it. Buffet sees the value from the income produced by an asset, in relation to the price paid for the asset. He wants a low price compared to income, but is not overly concerned with what the future trend of that price might be. A value investor concerned only with the fixed price of an asset wants a low price for the asset, but more importantly wants a low price with a reasonable expectation that the longer term trend is going higher.

There's no question that Buffet's investment philosophy has been hugely successful. But it should be known that the lump of gold that Buffet isn't interested in investing in has beaten him in investment returns over the past 10 years. For not "producing anything", gold has shown that it was remarkably undervalued in 2001 given its price appreciation to the current date. The table below shows the annual percentage change in per-share book value of Berkshire Hathaway, as reported in the Berkshire Hathaway annual letter, compared to the annual change in the price of gold based on the closing London PM fix for the year. As the table shows below, in 9 out of 10 years from 2001-2010, gold produced a better return than Berkshire Hathaway.


Gold's cousin silver has shown an even greater outperformance. Silver beat Berkshire Hathaway in 8 out of the last 10 years, and outgained Berkshire by an average of 15% per year over the period.