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Thursday, August 16, 2007

Intrinsic Value of Gold


Intrinsic Value Investing

When it comes to books written about investing in the stock market, two of the classics are "Security Analysis" and "The Intelligent Investor", both of which were written by Benjamin Graham and published in 1934 and 1949 respectively. Graham was a very successful investor in his own right, but is also well known as the mentor of Warren Buffett. Buffett built on the foundations provided by Graham's investment philosophy by adding a qualitative dimension to the completely quantitative approach adopted by his teacher. However, the basis of the success of these stock market legends was essentially the same - the realisation that the "intrinsic value" of a company was independent of its market price.

According to Graham, the market does not determine value. It is a "voting machine" in which countless people register choices that are the product partly of reason and partly of emotion. For most stocks the market tells you every minute of every day what it thinks those stocks are worth. The price that the market assigns may be much higher, much lower, or approximately equal to the intrinsic value. It is this difference between market price and intrinsic value which provides opportunities to investors astute enough to recognise it - the greater the difference the greater the opportunity. However, an investor who allows himself to become so concerned by a falling market price that he sells out has blown any advantage he may have had. "You are neither right nor wrong because the crowd disagrees with you".

The above thinking has been shown to work with phenomenal success when applied to stock market investment, but can it also be applied to investing in gold ? The intrinsic value of a stock can be determined using quantitative measures such as profit, net working capital, cashflow, and net tangible assets, and qualitative considerations such as the strength of the company's management. However, does gold have an intrinsic value which can be different from its market price and, if so, how could we go about calculating it ?

The Intrinsic Value of Gold

Supply Considerations

With such an enormous number of variables
affecting its price, including the
emotional response of individuals and the
whims of politicians throughout the
world, how can we possibly forecast a
future dollars per ounce gold price?

When there is an imbalance in supply versus demand, prices adjust to correct that imbalance. For example, if demand exceeds supply then prices will increase to the point where demand reduces or supply increases, thus correcting the imbalance. Because the "load" is forever changing, prices are continually adjusting. Vronsky's essay on gold's supply/demand dynamics in the "Analysis" section of the Gold Eagle website discusses the imbalance which has existed in the gold market for some time, with commercial demand greatly outstripping worldwide production. Had a similar situation prevailed with any other commodity then soaring prices would undoubtedly result. However, the fundamental difference between gold and all other commodities is that gold is not consumed, it is accumulated. Nearly 100% of all the gold mined in the history of the world forms part of today's aboveground gold stock. The total amount of this aboveground stock (currently around 120,000 tonnes) is an available source of supply at any time. During the past few weeks we have had some news regarding gold supply which has supposedly caused some fluctuations in the gold price. Firstly, Switzerland announced that it would sell some of its gold reserves (about 400 tonnes over a 10 year period). Secondly, the Busang gold deposit, which had been reported to contain up to 200 million ounces of gold, is now thought to be worthless. One event added future gold supply to the market whilst the other removed it. In my opinion both events were just "noise" as the amount of gold involved was trivial in comparison to the total aboveground supply of gold.

Another important point to note regarding the aboveground gold stock is that it increases at a fairly constant rate of around 1.7% per annum (during the last 50 years the largest annual increase was 2.1% whilst the smallest was 1.4%). Irrespective of what technological and political changes occur in the future, or how many more Busangs (real or otherwise) are discovered, it is reasonable to assume that the total supply of gold will continue to grow at an average rate of 1.7% per annum. In fact, technological improvements and vast new discoveries will be needed to maintain this growth rate.

Estimating a Future Gold Price

In other words, confidence in
US dollars is currently at a
historic high or, put another
way, gold is at its lowest
levels in 25 years relative to
the US dollar.

Further to the above we should be able to estimate, with a fair degree of accuracy, what the aboveground gold stock will be at some time in the future. It should also be possible to estimate the future commercial (fashion jewelry, industry, etc.) demand for gold. However, these considerations are only a small part of the equation. Much of the aboveground gold stock is held for monetary purposes and the willingness of the owners of this gold to sell at a particular price is dependent upon countless economic, political and psychological concerns. The willingness of others to purchase gold for monetary reasons at a certain price is dependent upon similar considerations. With such an enormous number of variables affecting its price, including the emotional response of individuals and the whims of politicians throughout the world, how can we possibly forecast a future dollars per ounce gold price? Yet another problem, in fact the very heart of the problem in forecasting a future gold price, is that we measure the price in terms of something which is constantly changing, that is, the US dollar (or any other national currency). Every day the US dollar changes its character due to changes in its quantity and quality, with its true value linked to something as fragile and fluctuating as faith in the financial and political system.

Although we cannot reliably estimate a future gold price, what we can do is calculate the relative values of gold and US dollars using the Fear Index. The Fear Index was developed by James Turk as a means of numerically expressing the competitive relationship between gold and dollars, and is calculated as follows :

Fear Index = (US Gold Reserve) X (Market Price of Gold)

Currently, with the gold price around $350 per ounce, M3 (total US money supply) of $5024.5 billion as of weekend 3rd March 1997, and a US gold reserve of 261.8 million ounces, we can calculate the Fear Index to be 1.82%.

The lower the Fear Index the higher the value of dollars relative to gold, that is, the higher the level of confidence (or the lower the level of fear) in paper currency. To put the above calculated figure of 1.82% into perspective, this is the lowest value for the Fear Index since 1972. In fact, the last 3 months have seen the Fear Index move below 2% for the first time since 1972. In other words, confidence in US dollars is currently at a historic high or, put another way, gold is at its lowest levels in 25 years relative to the US dollar.

I would also be interested in calculating a modified Fear Index where the total above ground stock of gold is substituted for the US Gold Reserve. However, this will have to be the subject of a separate discussion.

Gold Investment Based On Value

The above discussion suggests that although we cannot estimate a future gold price with any degree of accuracy, we can at least determine that gold is currently very cheap and should be purchased by investors seeking value. However, I believe that many people who identify that gold currently represents excellent value will lose money in their attempts to profit from this realisation. This is because they will attempt to profit from their well-founded conclusion via short term trading. The following quote from Benjamin Graham was written about stock speculation, but it can be equally well applied to the short term trading of commodities : "....speculation is largely a matter of A trying to decide what B, C and D are likely to think - with B, C and D trying to do the same". It is likely that many of the investors who purchase gold or gold related investments based on sound fundamental reasoning will sell out at a loss because they were unable to predict what others would do in the short term.


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