Bracing for Inflation

I'm no economist. Neither I have a crystal ball. Nonetheless, all I hear is talk about inflation. I don't know where it is, but from all I've read and thought about, one thing is clear: the US dollar will continue to lose value (as has been the case in the last 40 years or so since coming off of the gold standard), and it is likely to lose value faster than in the last ten years.

Again, I'm no economist. I don't know that there isn't a perfectly acceptable magic way out of this. But economists too have predicted seven of the last three recessions...

Anyway, it doesn't take much understanding about money to figure out that the USD is toast. With 30% of GDP compromised as debt and with the Greenspan-Guidotti rule out-of-the-whack the picture doesn't look rosy for Uncle Sam.

So what's an investor to do?

Well, by and large, nothing much one wouldn't do in normal times: buy undervalued, dividend-paying stocks. In the long run, if anything is going to hold value, it's a well run company with valuable assets (physical or intellectual) with a strong franchise.

Ok, but there might be something else investors can do to tweak their portfolios a bit: they should move their cash away from the USD and bonds and into:

1. Diversified baskets of foreign currencies
2. Physical assets (commodities, oil, gold)
3. More stocks, favoring global companies with business presence in large foreign markets.

TIPS is not an unreasonable option, but being a taxable security and being tied to the official inflation rate (which is computed by those devaluing the currency), I tend to leave them as a distant fourth option.

Foreign currencies

I've discussed the role of foreign currencies before. So I'll just add that there's no reason to completely avoid emerging markets. The Brazilian Real is old news. But the Mexican Peso (FXM) pays a reasonable interest and I don't see it defaulting or going into hyper inflation anytime soon.

Physical assets

My beef with commodities and physical assets in general is their lack of dividends, lack of internal growth rate. Nonetheless, it doesn't hurt to have some as a backup plan.

My favorite commodity would be oil, given its importance as an industrial raw product and its finite production. Also, gold tends to do well in uncertain times like now.

But my favorite physical asset is really real estate. With real estate, one can obtain dividends (rent) and increase its value over time, through proper maintenance, and upgrades.

More stocks

As you may have guessed, investing in businesses is still my favorite option, be them your own business (assuming you're competent and are in a good industry) or someone else's, under the same assumptions, plus the condition that these companies trade for a discount and/or pay juicy, growing dividends.

However, there's no telling what will happen with the US or the USD. If the country defaults, we lose. If we go to war, we lose (as Phillip Fisher said in his book, "War is always bearish on money. To sell stock at the threatened or actual outbreak of hostilities so as to get into cash is extreme financial lunacy. Actually just the opposite should be done") and if do nothing, well, nothing will be resolved.

Disclosures: Long brazilian Real and global real estate.

A Place for the Shiny Metal in a Value Investor's Portfolio

I'm often asked about whether I like gold as an investment medium.

Personally, I don't use gold and have never used. But that doesn't mean I don't believe there is a place for gold in one's portfolio. There is. Let me explain by stating a few true facts that can be confirmed with a bit of your own research:

Pros and Cons of Gold

Pros

1. Historically, over long time periods, gold mostly retains its purchasing power.
2. Gold doesn't go bankrupt, doesn't overstate earnings, doesn't write-down anything (its weight, for example).
3. Physical ownership of gold cannot be confiscated by law or by electronic methods; force is required to take gold from someone.
4. Gold is universally accepted.
   

Cons

1. Gold doesn't pay a coupon or dividend.
2. Gold can't cut costs, become more effective, increase earnings, expand market share or come up with a great new idea.
   
3. Gold can't take advantage of acquisitions, market opportunities or low interest rates.
4. Gold is hard to value. There's little industrial utility for gold, so demand is mostly speculatory and fear-driven.

Basically,  what this all tells an investor is that 1) gold provides little in terms of a decent, predictable, long-term return but that 2) gold is a good store of value for times of political and monetary uncertainty.

Let's break it down in parts.


Little upside

As a commodity, the price of gold depends on "the market" and there is little in the way of assigning it a fair value. Bonds, on the other hand, can be assigned a value given a discount rate, inflation, maturity, credit quality and coupon rate. Stocks, though harder to value, can be valued independently of their market price too. Gold cannot.

As such, how can one "invest" in gold and expect returns from it, without having a crystal ball?


Store of wealth

On the other hand, gold has historically(*), in modern times (last 100 years or so) held its value over time.  Due to its fungibility and international acceptance it's a good medium of exchange ("currency") to have in times of trouble, war, economic instability, inflation,  and maybe even deflation. This mostly applies to physical gold held close to the investor, not in a vault or via proxies.

Gold is, then, a good hedge against inflation over long time periods.

How to use gold?

So how should an investor use gold? To me, it only makes sense to have gold as part of one's cash reserves. As I've said before, every investor, experienced or not, should have at least six months worth (more for increased safety) of living expenses in readily available currency such as money markets and savings accounts. And in my view, part of this reserve can be held in physical gold (other commodities may also qualify, but let's focus on gold here).

If one is fearful of high inflation, political or economic instability, then increasing this allocation to a year or more makes sense. It also makes sense that this extra reserve be in gold.

Currently, I don't own gold and have no intention of buying it anytime soon. The time to buy gold is when everyone is talking about prosperity, peace and low inflation. And even then, the role of gold should be limited to that half-year to a year reserve of readily available "currency", for emergencies.

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* Appendix: How well does the value of gold really hold up?

I couldn't help but try to find what an ounce of gold could buy many centuries ago. Perhaps the historians could help? So, here's my uber non-scientific, back-of-the-envelope-ish analysis.

According to this site, prices in ancient Rome during the 6th century were as follows:

1 donkey = 3-4 solidii
1 lb of fish = 6 folles

Now, some units:

1 solidus = 1/72th of a half pound of gold = 226.79/72 g of gold = US$ 101 (@ 1 troy ounce = US$ 1000)
1 folle = 1/180th of 1 solidus = US$ 0.5626

Hence, we get the following prices in today's USD:

1 donkey in ancient Rome = US$ 303-405 today.
1 lb of fish in ancient Rome = US$ 3.375 today

But in reality, we see the following prices currently:

1 donkey today = at least US$ 500, sometimes close to $3000 (sources: http://www.equinenow.com/donkey.htm, http://www.littlefriendsranch.com/Donkeys%20for%20Sale.htm)
1 lb of fish today = US$ 15-20 (source: http://www.allfreshseafood.com/p-tilapia-fillet.htm)

The interesting thing is that the prices are in the general ballpark despite the centuries that have gone by. Neither the fish cost a tiny fraction of a penny nor the donkey was found to cost a trillion dollars.

So, if that's even close to correct (which I can't confirm), it means that gold mostly retains its value, but "inflation" can catch gold too -- after all, it can be mined and thus diluted.  Also, despite all the increased efficiency in farming techniques, raising donkeys and fish didn't seem to get much cheaper over the years but instead have appreciated in gold terms.

This analysis, however, is mostly for entertainment value as I can't verify the validity of the prices above. Take it for what it's worth.