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What Do We Know That Warren Buffet Doesn’t?

Monday September 09, 2013 13:51

I think we’re all very familiar with the concept of a “Recipe for Success” or for that matter “Recipe for Failure.” If you follow a certain path in life you invariably get similar results to others who’ve walked the same route. Be it the way you do your job, play your sport or invest your money.

To maximise your chances of success it’s best to emulate those who’ve succeeded rather than those who’ve failed. Although constant practice is no guarantee of success, by repeatedly following a proven process you substantially improve your chances of success. Set yourself up to win.

Warren Buffett, the Oracle of Omaha is one of the most famous investors of all time. He’s clearly a genius at stock selection and largely seems to follow the same “Recipe” that clearly works. This billionaire has made so much money that he hardly knows what to do with it. Still, for all of the successes and endeavors that Buffett has taken on, there is one asset that he never quite warmed to; gold

“Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head” Warren Buffet

So as investors in gold and maybe silver - what do we know that he doesn’t?

Well firstly let’s take a look at a few of his investment strategies and see whether they apply to gold miners.

There are 24 which are set out in an excellent book by James Pardoe (McGraw Hill). Many of these touch on his psychology of investing:

  1. Be patient
  2. Maintain proper temperament
  3. Practice inactivity, not hyperactivity

But I’m going to take a look at some of his strategic approaches that relate to the underlying investments. Dig around a little there and see how they relate to gold and silver miners.

Before I kick off I’d like to highlight one very important point. I’m only comparing his approach to producers and not explorers.

Let’s get started.

  1. Choose simplicity over complexity

“When investing, keep it simple. Do what’s easy and obvious, advises Buffet; don’t try to develop complicated answers to complicated questions.”

He only invests in easy-to-understand, solid, enduring businesses that have a simple explanation for their success and never invests in anything complicated he doesn’t understand.

“Keep it simple - Here’s your goal: Buy stock in a great company. Pay less for your share of that business than that share is actually worth in terms of its future earnings potential. Then hold on to that stock and wait for the market to confirm your assessment.

If you don’t understand the business, don’t buy it.”

I believe gold miners are relatively simple businesses to understand. I’d also add that at current and recent valuations they present great value. Similarly, given their huge potential cash generation as well as exploration prospects they’ve the makings of a quality income stream. Yes, the volatile gold price does add an element of complexity, but many quality businesses are to some extent at the mercy of a commodity price.

  1. View Market Downturns as Buying Opportunities

“Market downturns aren’t body blows; they are buying opportunities. If the herd starts running away from a good stock, get ready to run towards it.

It goes without saying that mining stocks can give us a bumpy ride and the recent tumbles in the gold price sent the stocks plummeting.

But if you go to their websites, take a look at what they’re achieving. There’s clearly a disconnect between where the share prices are and what many companies are achieving. The share price is simply the market’s view of valuation. The volatility for miners does not affect production or reserves and resources. They don’t change their mining plan every time the share price moves.

Of course the gold price is important – but it’s already bouncing back to productive levels with both the fundamental and technical analysis pointing to further improvement.

Bad things happen out there, markets fall, get oversold. People panic and sell out for far less than they should. Then good things happen and markets bounce back – get overbought.

There’s one person who won’t be selling when market’s plunge. Warren Buffet invariably views these times as buying opportunities. To coin some of his wisdom

“Be greedy when others are fearful and fearful when others are greedy”

Most of his best investments were made either during bear markets when prices of good businesses collapsed or when great companies were experiencing temporary, yet surmountable difficulties which had pulled down their share price. His investment in Goldman Sachs during the 2008 financial crisis being a case in point.

  1. Buy Businesses, not stocks

“Once you get into the right business, you can let everyone else worry about the stock market”

According to Buffet, it’s critical to remember that you are buying part of an actual business. In other words, it’s not about “playing the market” it’s about buying businesses – the right businesses.  You only have to look back at the dot-com bubble to see what happens when you buy the wrong ones. People ignored value and leapt into the market with little to no appreciation of what they were buying; some losing everything.

 

“How does Buffet determine which businesses to buy? He looks for four main things:

  1. Businesses he can understand
  2. Companies with favourable long term growth prospects
  3. Businesses priced very attractively
  4. Businesses operated by honest and competent people

 

He adds that if you don’t have a good idea of what the business is going to be like in 10 years then you do not understand the business”
Let’s take a look at these one by one.

  1. Mining producers are relatively simple businesses to understand. Yes there have been issues with the reporting of costs, but as more and more adopt the new costs reporting guidelines there should be more clarity on that. Similarly, they’re all sensitive to the gold price, especially at current levels. However, this very much depends on where they’re producing. Australia typically being at the higher end of the cost curve, with places like the Philippines towards the bottom.

    Their reserves and resources are also set out for all to see. Obviously there’s risk attached to this (especially the resources!), but there is an element of visibility moving forward that many other sectors are unable to offer.

  2. Most quality mining producers have mine lives in excess of seven years, with many over 10 years. Further exploration invariably further increases mine life. So one could argue that although income levels may be volatile, the better companies should have decent long term growth prospects.
  3. Even following the recent bounce in prices, many of the major and intermediate mining stocks are close to multi-year lows. Personally I think this is about as good as it gets.
  4. There have and continue to be a lot of criticism about management. Things were clearly very bad, but following the removal of some senior management, it’s getting better. There’s undoubtedly some way to go, but the recent crash in the gold price has forced management to be more decisive and often ruthless about costs. I think this bodes well for the future and hopefully, when gold prices do bounce back, they’ll maintain this new found discipline.
  1. Ignore stock market forecasts

 

Short term forecasts of stock or bond prices are useless, says Warren Buffet. They tell you more about the forecaster than they tell you about the future..

So he prefers to focus on the performance of the business and not be distracted by larger trends that he believes are impossible to forecast with any accuracy.

If the price is right (as efficient market hypothesis would suggest), then why would anyone want to trade, volumes should be zero. Clearly that’s not the case and if there was ever a time to ignore stock market forecasts for quality gold companies then now it’s probably now. We all know that markets get both oversold and overbought and given the massive trends unfolding, I think we are very much in the domain of the former.

Similarly, given the nature of mining and the volatility in the gold price, miners earnings are very difficult to forecast. So it’s more important to focus on the QUALITY of those earnings. Keep it simple and look at a handful of factors such as

  1. Location of mines
  2. Grade of ore
  3. Exploration potential
  4. Life of mine and
  5. Costs of extraction

These should give you a pretty good feel for both the quality as well as longevity of these earnings. In some, but not all cases, these can be very compelling.

Clearly Buffet looks at a lot of other factors. I’ve only taken a quick look at 4 of his 24 strategies, but in my humble opinion, none of them should steer us away from the gold miners. Perversely, his strategies seem to be pointing us in that direction.

But perhaps he knows something we don’t!

By Simon Popple
http://www.brookvillecapital.com

Disclaimer: The views expressed in this article are those of the author and may not reflect those of Kitco Metals Inc. The author has made every effort to ensure accuracy of information provided; however, neither Kitco Metals Inc. nor the author can guarantee such accuracy. This article is strictly for informational purposes only. It is not a solicitation to make any exchange in precious metal products, commodities, securities or other financial instruments. Kitco Metals Inc. and the author of this article do not accept culpability for losses and/ or damages arising from the use of this publication.
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