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Is Warren Buffett Right About Gold?

By Jay Yao – Mar 11, 2014 at 9:15AM

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Since his 2011 comments, the Oracle of Omaha has been right about gold. Will he be right over the next decade as well?

Many investors, Warren Buffett among them, believe that gold is an inferior investment to equities.

Buffett made the following famous statement in May 2011:

I will say this about gold -- if you took all the gold in the world, it would roughly make a cube 67 feet on a side. Now for that same cube of gold, it would be worth at today's market prices about $7 trillion dollars – that's probably about a third of the value of all the stocks in the United States. For $7 trillion dollars, you could have all the farmland in the United States, you could have about seven ExxonMobils, and you could have a trillion dollars of walking-around money. And if you offered me the choice of looking at some 67 foot cube of gold and looking at it all day, and you know me touching it and fondling it occasionally Call me crazy, but I'll take the farmland and the ExxonMobils. 

Since May 2011, SPDR Gold Trust (GLD -1.05%) is down 14% while the SPDR S&P 500 ETF  is up 38%. Owning gold has not been a rewarding investment over this period as the U.S.10 year yield has risen and the U.S. economy has improved. 

Source: Ycharts

Despite the pessimism, many investors still believe in gold's prospects over the coming years. Here's why. 

Federal Reserve's trillions
First, the Federal Reserve has a $4.1 trillion balance sheet. That number is simply gigantic versus historical norms. Currently, the Fed is getting away with it because the U.S. is in a Goldilocks zone, where inflation and interest rates are low while growth is pretty steady.

This type of macro situation has not been historically sustainable. Eventually the U.S. will run into inflation when the economy reaches full employment. When that time comes, it remains to be seen whether the Federal Reserve can withdraw enough liquidity to avoid further inflation. If inflation becomes a big problem, demand for hard assets like gold will increase greatly. 

China and India demand for gold will only increase over the next 10 years
Second, as they get wealthier, China and India will consume larger quantities of gold. Even though their economies are not doing well at the moment, on a ten year time-frame, China and India's wealth will only increase. Since gold is a luxury good, as Chinese and Indian wealth increases, gold demand should likewise increase.

Data over the past decade backs this up. According to the China Gold Association, China became the largest consumer of physical gold in the world last year. Chinese gold jewelry consumption grew 43% to 716.50 tonnes in 2013.   

That number absolutely blows away Greater China's 2003 gold jewelry consumption of 232.2 tonnes. 

Similarly, India's total gold jewelry consumption last year was 612.7 tonnes versus 2003's 565 tonnes. 

The dollar and twin deficits
Third, the dollar is pretty strong right now because the U.S. economy is the best house on a bad block. On a ten year timeline, however, the dollar still has questions. The U.S. still has twin deficits: a large fiscal deficit and a large trade deficit. The dollar has not depreciated because the Chinese have been buying treasuries en masse, but as China becomes more of a consumer nation, it will buy less treasuries and the dollar may fall. Other major economies may also improve their competitiveness versus the United States, which would further weaken the dollar. If the dollar weakens, gold's value versus the dollar will strengthen.

The bottom line
I believe the principle reason to invest in gold is the growing Chinese and Indian demand over the next decade. Gold's protection against inflation is kind of like a free call option in this case.

Buying low-cost producers with disciplined management is probably the best way to go. Low-cost producers will still be around if gold prices fall below the $1,200 per ounce level and companies with disciplined management will contain costs better than companies with average management.

Some names to consider are Goldcorp (GG) and Barrick Gold (GOLD -1.40%). Goldcorp has a 2014 all-in sustaining cost of between $950 and $1,000 per ounce. The company forecasts production increases of 50% and a reduction in all-in sustaining costs of between 5% and 20% over the next two years. 

For 2014, Barrick Gold has an all-in sustaining cost forecast of between $920 to $980 per ounce. Soros Fund Management also recently added 6.3 million shares of Barrick Gold to its portfolio. 

Despite the recent rally, gold is still a pretty controversial investment. Warren Buffett may be right on gold over the next ten years. Equities may continue to outperform gold. There are, however, some good reasons to take the opposite side. 

Jay Yao has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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