Is Warren Buffett Wrong About Gold?

Very few assets spark debates as controversial as those over gold. Some investors, notably Warren Buffett, say it's just a shiny metal that doesn't yield any cash flows. Others argue that it's the best insurance policy when the outlook for paper currencies looks dire. Who's right?

The anti-gold argument
Buffett, one of the most famous gold opponents, recently reaffirmed his long-held view that gold has no place in an investment portfolio. The crux of Buffett's argument is that gold's value is entirely speculative, as the commodity itself doesn't generate any income. In his view, it's just a nonproductive asset that's worth only what others are willing to pay for it. In an interview with CNBC earlier this year, he articulated his view:

When we took over Berkshire, it was selling at $15 a share and gold was selling at $20 an ounce. Gold is now $1,600 and Berkshire is $120,000. Or you can take a broader example. If you buy an ounce of gold today and you hold it a hundred years, you can go to it every day and you could coo to it and fondle it and a hundred years from now, you'll have one ounce of gold and it won't have done anything for you in between. You buy 100 acres of farm land and it will produce for you every year. You can buy more farmland, and all kinds of things, and you still have 100 acres of farmland at the end of 100 years.

It's hard to argue with that. Yet some of the most highly respected and successful investors in the world disagree.

A growing number of gold bulls
Ray Dalio, David Einhorn, George Soros, and John Paulson are among the better-known names. Dalio, founder and co-chief investment officer at Bridgewater Associates, the world's largest hedge fund, recently expressed his views on gold in a rare interview with CNBC last Friday. He opined that gold "should be a part of everybody's portfolio to some degree, because it diversifies the portfolio." When asked about Buffett's reluctance to own gold, he added: "I think he's making a big mistake, yeah. Gold is my cash. It's an alternative version of cash."

Similarly, billionaire investors Soros and Paulson are also bullish about the outlook for gold. Both recently upped their ante on the precious metal by raising their investments in the largest gold-backed exchange-traded fund, the SPRD Gold Trust (NYS: GLD) . Soros Fund Management more than doubled its position to 884,400 shares as of the end of June, while Paulson and Co. raised its holdings by 26% to a whopping 21.8 million shares. Paulson's fund has invested a sizable percentage of its money in gold-related stocks, including NovaGold Resources (NYS: NG) , in which it bought more shares last quarter.

But it's not just hedge fund managers and individual investors who are rushing into gold. In recent years, the plethora of gold buyers has come to include not only gold bugs and Ron Paul fans, but also sophisticated monetary institutions and sovereign wealth funds. Central banks' official reserve managers are just one of many who appear to have turned bullish on the shiny yellow metal. They became major purchasers in 2010, after almost two decades as sellers. Last year, central banks amassed a whopping 456 tonnes, representing the greatest central bank accumulation of gold in more than four decades.

Gold as a hedge against inflation
Investors often rationalize their purchase of gold as an effective means of hedging against inflation. But is it really?

If you look back through history, the short answer is "not always." For instance, consider the 1980s. In 1980, the price of gold was around $400 an ounce. It rose to a high of nearly $700 in the following years only to end the decade back at $400. Meanwhile, the U.S. Consumer Price Index rose more than 60% during that decade, meaning gold failed miserably in keeping up with inflation.

On the flip side, though, gold has fared much better as an inflation hedge in recent years. Since 2000, its price has increased nearly 600%, more than keeping up with consumer price inflation. So its effectiveness as an inflation hedge really depends on when you buy it and over what time frame you hold it.

Final thoughts and two gold stocks to consider
Gold is no doubt a speculative investment, accompanied by high risk and high volatility. But it's also a liquid asset that can provide significant diversification benefits to a portfolio if acquired in the right amounts and at the right time. And unlike paper money, which can be printed at the whim of a central bank, gold's supply is very costly to increase. As such, the precious metal has proved itself as a store of value over time.

Societe Generale's global strategist Dylan Grice, in his characteristically blunt tone, sums up the advantages of gold nicely (emphasis mine):

Gold has no export sector, no pop-economists to be swayed by, and no populists to pander to. Gold might be a mere lump of dense, useless shiny metal, but it's one which crackpot central bankers can't print. Indeed, benchmarked against the printing of Ben Bernanke, the price of gold at which the U.S. dollar would be fully gold-backed is now $10,000.

If you're convinced that the price of gold will continue to move higher, there are numerous ways of gaining exposure to the precious metal. Individuals can purchase physical gold bullion, in the form of kilogram gold bars, gold futures contracts, exchange-traded gold funds that have claims on physical gold, or shares in gold mining companies.

Several of the more popular gold mining shares trade at penny-stock valuations. For instance, Minco Gold, a Canadian mining company focusing on gold properties in China, currently trades at just $0.64 a share. Many of these small-cap miners can be highly volatile, though, as illustrated by Great Basin Gold and its plunge from its January peak of $1.28 all the way down to around $0.09 a share currently.

But that's not to say there aren't promising opportunities among small-scale miners. Junior gold miner Claude Resources (NYS: CGR) looks especially attractive as a value play. The total value of all its reserves is many multiples of its $165 million enterprise value. Shares are currently trading significantly below book value. Fool contributor Sean Williams is one of many who sees "unbelievable value" in Claude Resources.

And for those who prefer dividends to growth, Gold Resource (NYS: GORO) might be a good place to look. Shares currently yield 3.3%, and the company recently initiated one of the most innovative dividend policies I've ever heard of. Shareholders now have the option of accepting their dividend in gold bullion. You heard right -- they'll be paying investors in gold! Fool contributor Christopher Barker, who writes extensively on precious metals, calls it the prettiest dividend in the world.

If you find gold stocks appealing or are worried about inflation, we have one idea that could knock your socks off. It's a smaller gold miner with massive potential and it's featured in The Motley Fool's special free report called "The Tiny Gold Stock Digging Up Massive Profits." The report is 100% free, but it won't be around forever, so click here to access it now.

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Fool contributorArjun Sreekumarowns no shares of any companies listed above. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days. The Motley Fool has adisclosure policy.

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