Selected letter from Valuentum’s Brian Nelson on 1) price versus value and 2) investing versus speculating…
Subject: RE: Gold is But a ShinyYellow Metal
Thank you very kindly for your email and the length and thoughtfulness of your response. Trust me, I want to agree with you, but there are two structural reasons of thought and understanding as to why I cannot. These two items aren’t necessarily opinions, but rather definitions.
One is the difference between price and value. Price is what you pay for something, and value, objectively, is the sum of the asset’s discounted future free cash flows and net balance sheet (or what you get). All assets are valued on the basis of their future free cash flows and the net cash on the books, whether it is a company’s stock, a house for rent, an auto for lease, and yes, even gold. No reasonable investor will ever pay more for an asset than they can receive from that asset in terms of future free cash flows. Otherwise, they are willingly opening up the chance for value destruction.
Again, anyone can pay anything for any asset, but that doesn’t mean that they are getting any value. Price almost never equals value.
Gold’s “value” mostly hinges on the expectations that its “price” will go higher due to financial demand characteristics rather than pure jewelry and/or industrial/retail demand. This is completely different than other investments such as a company’s stock which has a defined future free cash flow stream outside the parameter of the company itself. Gold has no such thing, but gold is not alone in that dynamic either. Many real estate professionals, for example, “value” a home based on comps in a given area, but this, too, is incorrect, because a home’s value (if we suspend the concept of sentimentality) is actually what the house could be rented for in terms of discounted free operating cash flows.
This is why we had the housing bust during the Great Recession because price and value are two different concepts. Housing speculators were buying homes hoping to sell them to a “greater fool” at a higher price instead of valuing them on the basis of what they could get from future free cash flows. It is partly because of the real estate industry’s “concept of valuation” where many investors are confused. Being able to sell something at a higher price in the future for only that reason alone simply fits the definition of the “greater fool theory.” Only through future free cash flows can value actually be created. Don’t get me wrong — a company’s stock price hardly ever equals its fair value either.
If we try to map out gold’s future free cash flow stream to the financial investor, it is merely its price at the time that the financial investor sells the metal in the future. This is different than stock investing, where an investor can buy the whole company and exploit the company’s future free cash flow stream if the stock price gets completely out of whack. This is what Warren Buffett does at times, and why his perspective is logical and so valuable. If the stock price of a company is misaligned, investors can take the company private and generate returns from its future free cash flows.
Investors just can’t do that with gold. At what point do we take gold private? There’s no answer.
Gold, therefore, is merely a “greater fool” metal in that its future “value” (discounted cash flows) to the financial investor is completely based on its future price. But that doesn’t mean that price equals value. Gold fits the mold of alternative investments like baseball cards, comic books, paintings and the like, in my opinion. People want gold, just like every kid wanted Mickey Mantle’s rookie card back in the day. Mickey Mantle’s rookie card can be sold for a lot of money, but does it really have “value” in this definitional sense?
Again, gold speculation, in my opinion, is different than investing in a company, which generates free cash flows that are completely separate than the company itself. I can tell by your response that it is very possible that you are using price and value interchangeably. Real estate speculators do it all the time, and it is very confusing.
Second, investing and speculating are distinct and different.
Investing is about identifying mispriced (mis-valued) assets that have future free cash flow streams and gauging the likelihood of price-to-fair value convergence, while speculating is “playing around” in the markets to find out what might “be working” through learned buyer behavior, as in the case of traders chasing earnings/guidance beats and misses, for example. Benjamin Graham largely defined the difference between speculating and investing many years ago.
I want to agree with you, and I very much appreciate your response, but I cannot suspend these two truisms that make all of the difference in the world when it comes to 1) price versus value and 2) investing versus speculating.
Hope this helps further explain my perspective and opinion.
Metals & Mining – Gold: ABX, AUY, EGO, GG, GORO, KGC, NEM
Homebuilders: DHI, GFA, JOE, KBH, LEN, MDC, MTH, NVR, PHM, RYL, SPF, TOL