Happy Tax Day, I suppose. After filing my taxes, I have only one thing to say, and that is this: Taxes should be simpler.
Now, on to something less intractable and politically fraught.
Last Friday’s The New York Times included an interesting article on efforts to create a diamond-backed investment vehicle (you can read it here). I’m not surprised—as the article pointed out, commodity stores of value like gold are more popular investments than ever, and diamonds are the final frontier in that world. But the diamond market is one of the most unusual markets on earth, and I would be surprised if these new vehicles (an ETF from IndexIQ and a fund from Harry Winston, among possible others) manage to successfully turn diamonds into a viable investment class.
I’ve written about this odd market here before, and since you may not have gotten to read it the first time, I’d like to share my initial research again. Then we’ll get back to the new investments being proposed today. Here’s what I wrote about the diamond market on October 25, 2011:
“As you know, precious and even semi-precious metals have been enjoying several years of positive attention from investors. Between rising industrial demand in developing countries and fears about the stability of national currencies, it’s been a pretty good decade for gold, silver, platinum, palladium and even copper.
“But there’s another commodity, also expensive, and also mined from the ground, that has been altogether ignored by investors, despite its equally impressive price performance. In the last 11 years, this commodity has increased in price by approximately 65% (below is a chart of its price since 1960). During the 2008 market crash and recession, this commodity lost a mere 4% of its value. And like gold and silver, this commodity’s value is not dependent on the value of any currency. But unlike gold and silver, tiny quantities of this commodity can be worth millions—easily stored in your home or a lock box, or carried undetected from place to place ... even across borders.
“So why aren’t investors flocking to this recession-proof, portable commodity that constantly increases in value?
“Because the commodity in question is diamonds.
“When considered in the light above, diamonds seem like the perfect investment. Surely Ajediam, the diamond broker that created the graph above, would like you to believe so. On their website, the company touts diamonds as ‘the most concentrated store of value that exists.’ However, the diamond market is one of the world’s strangest free markets. And it’s a terrible place to be an investor.
“Edward J. Epstein explores this strange market in his 2011 book, Have You Ever Tried to Sell A Diamond?, based largely on his 1982 article of the same name in The Atlantic.
“Diamonds, like other luxury goods, are desirable precisely because they’re expensive. (In economics, this is called a Veblen good.) But keeping diamonds expensive is a lot harder than keeping, say, Louis Vuitton purses expensive. Louis Vuitton makes every single one of its purses, so it can limit production to keep prices high. It also brands every bag with its signature initials, so competitors can’t undercut it.
“Diamonds, on the other hand, are mined from the ground. And while productive diamond mines aren’t exactly around every corner, there are far more now than there were back in 1960-when diamonds sold for a 10th of their current price. Nine new mines have opened in the last 10 years alone.
“And diamonds can’t be branded—once they’re dug out of the ground and polished, diamonds from a De Beers mine in Botswana are pretty much identical to similar-quality diamonds from a Rio Tinto mine in Australia.
“So why are diamonds still so expensive?
“Aware that demand for them depends on keeping prices high, the major global producers of diamonds have managed to keep diamonds expensive against all odds. Luckily (for them), there are few enough players in this space that this feat—making a natural resource more expensive every year, even as supply increases—has been improbably possible.
“In 1955, for example, a giant new source of diamonds was discovered in Siberia. At the time, almost all of the world’s diamonds came from South Africa, where they were mined and sold exclusively by De Beers. De Beers’ owners knew that if all these new Soviet diamonds were allowed to flood onto the market (a market they had carefully created with an intense, decades-long advertising campaign) the price of diamonds would fall. So when the mine began producing, in 1962, De Beers agreed to buy virtually all of its production. For the next several decades, De Beers dutifully bought almost all of the Soviet production of diamonds, and placed them into a four-story deep vault in London.
“This monopolistic tactic served De Beers well for many decades, and the company employed it globally. After the political change of the 1990s caused De Beers to lose some of its production agreements with warlords and other leaders in West and Central Africa, the company had another new source of non-De Beers diamonds to worry about. In a brilliant (if disturbing) marketing coup, the company successfully branded all diamonds coming from small producers in African conflict zones as ‘blood diamonds.’ By the year 2000, the U.N. and many other organizations had condemned or banned the sale of these ‘undocumented’ diamonds from ‘conflict zones,’ unwittingly propping up De Beers’ monopoly.
“However, the monopoly isn’t what it once was. The European Union eventually declared its practice of buying and stockpiling Russian diamonds anti-competitive, and ordered De Beers to stop by 2009. De Beers cleverly turned the diamond production over to Alrosa, a state-owned Russian company. Because Alrosa controls 97% of Russia’s diamond production, it’s also in its best interest to keep prices high.
“In 2009, after the financial crisis and recession had caused a slight dip in diamond prices, the Russian government bought $1 billion worth of diamonds from Alrosa, to support the industry and keep the supply off the market.
“This is how the supply side of the diamond market operates around the world, controlled by barely a handful of large companies manipulating prices in their interest.
“But more diamonds are being discovered every year — in Canada, Angola, Brazil and elsewhere — and the monopoly frays more with every new source. What’s to keep a new player from undercutting the cartel?
“Another thing about diamonds: they’re practically indestructible.
“Almost every single diamond ever set in an engagement ring, tennis bracelet or necklace is still floating around somewhere. As Edward Epstein wrote in a 2009 article, ‘De Beers executives estimate that the public holds more than 500 million carats of gem diamonds, which is more than 50 times the number of gem diamonds produced by the cartel in any given year. The moment a significant portion of the public begins selling diamonds from this prodigious inventory, the cartel would be unable to sustain the price of diamonds, or maintain the illusion that they are such a rare stone that their value is, as the ad slogan claims, forever.’
“The most likely catalyst for the public to start doing such a thing would be a significant decline in diamond prices. The public has been successfully conditioned to believe that diamonds never lose their value—that they’re ‘forever’. If that faith were shaken, there would be nothing the cartel could do to stop people from selling their diamonds, ‘before they lose any more value.’ (Sound familiar?)
“And that’s why it’s very, very important to diamond producers everywhere to keep prices very, very high.”
For what it’s worth, after publishing that back in October, a reader replied, “Unlike gold, which is paid per what current market price is, I found all of our diamonds we bought over the years to only be worth about 33% LESS when looking to sell them.”
It may actually be quite interesting to see how the diamond-backed investments now being proposed shake up this strange market. As The New York Times article pointed out; “unlike gold and oil, diamonds have not had much price volatility, in part because they have not been touched by large flows of speculative money, though that could change if the new efforts succeed.”
In addition, trying to create an investable commodity out of diamonds would most likely affect the way diamonds are priced and traded. Right now, the wholesale diamond trade is a world of “smoke and mirrors,” as an industry participant told The New York Times. As the article explained: “The end of the [De Beers] monopoly still left perhaps the biggest barrier to investment: the lack of uniform standards for diamond pricing. Unlike gold, which is sold for essentially the same price in financial markets around the world, diamonds have been sold mostly through bazaar-like areas like the Manhattan jewelry district and the Antwerp Diamond Bourse, which advertises that a ‘binding handclasp fixes price, delivery and conditions.’ ... Investment professionals say that retail investors should be very careful, given the difficulty of establishing consistent prices for diamonds of widely different cuts and quality, and the traditional secrecy of the industry.”
Is it possible that diamond-based investments designed to appeal to a broad public might clear away some of that smoke and secrecy? Certainly. But it seems equally possible that some investors will get hurt along the way—after all, the public has been conditioned to think of diamonds as rare, inherently valuable and unchangeable... but if they’re exposed to market forces, they may not be any of those things.
The best advice for investors considering diamonds comes from Ron Rowland, a mutual fund and ETF adviser quoted in the NYT article as saying, “Stay away until you know exactly how it works, and can be sure it’s acting like you think it will. ... It’s going to be a difficult market to create.”
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In keeping with that advice, today’s investment has nothing to do with diamonds. Instead, it’s a company that mines a commodity that is actually investable—copper. Copper’s primary use is industrial—it’s essential for making pipes, wires and electric cables, among other things, and it’s irreplaceable in many of its uses. As Gregory Spear wrote in the most recent issue of Spear’s Security Industry Analyst, “Copper prices are also likely to stay high because of the lack of good substitutes. Michael Widmer of Bank of America believes that the current price is probably high enough to spur serious efforts to find alternatives. But the easy substitution has already been done.
“Plumbers have switched to plastic where they can. The Chinese have engineered air-conditioning units with bulkier, aluminum heat exchangers. Aluminum can also be used for electric wiring, but with inferior and sometimes dangerous repercussions. An attempt to wire homes with aluminum in the 1970s resulted in several burning down because of poor connections—U.S. building codes now ban aluminum from most domestic wiring.”
He adds that demand for copper in emerging economies is expected to continue increasing—analysts are expecting global demand to increase by 40% over the next decade—but supplies will likely remain constrained for the near future. New mines coming online now are smaller, deeper (e.g. more expensive) and in less-stable parts of the world (Zambia and the Congo), while the world’s number-one producer, Codelco of Chile, doesn’t expect to be able to increase production this year.
The final thing I like about this investment is that, while it’s leveraged to copper, it’s not a direct investment in the metal. I know many disagree with me on this point, but I prefer investments in companies—that can grow, increase production and make acquisitions—to investments in funds or other vehicles that own commodities directly. With that, here’s Gregory Spear’s recommendation, published March 20 in Spear’s Security Industry Analyst:
“A major beneficiary of higher copper prices would be Southern Copper Corporation (SCCO - yield 6.6%). The Phoenix, Arizona-based company owns mining and smelting operations in Mexico and Peru. We profiled the company back in August. Shares are still trading around $30. Here’s why we are being patient with SCCO.
“Integrated, low-cost operations combined with world-class assets create top-tier margins
“SCCO is the world’s sixth-largest copper mining company. It has the world’s largest copper reserves at 60 million metric tons. Providing an estimated mine life of over 80 years, more than double the 34 years of the next longest firm. Full integration makes SCCO one of the lowest-cost producers of copper with margins at the top end of the industry (SCCO at 56% vs. about 50% average for its leading competitors).
“High production growth led by an attractive line up of projects
“SCCO has strong growth prospects, with mined copper production expected to grow from 587,500 tons in 2011 to 1.1 million tons by around 2015, for an annualized growth rate of 17%. The company has approved a capital expenditure program of $4.8 billion through fiscal year 2015 that will drive significant production increases.
“Sound copper-market fundamentals, underpinned by Asia growth
“Long-term demand for copper remains sound, driven by growth in Asian economies (Asia accounts for 60% of the total world demand, with China consuming 40% of total copper output). The supply situation for 2012 is expected to remain tight, given little incremental production. Copper demand is linked to electrical, construction, and industrial applications, and will pick up as global economic growth rebounds.
“SCCO has trading liquidity and strong institutional investor support, improving fundamentals, growing operations and a strong franchise.”
Wishing you success in your investing and beyond,
Chloe Lutts
Editor of Investment of the Week
