Summary
De Beers and other major players in the diamond industry are now supporting the concept of diamonds as an investment alternative to Gold. This prompts the following questions: - Why is this relevant now? - What are the investment merits of diamonds? - How do Diamonds compare to Gold?
Analysis
Effect of current economic climate
The onset of a global recession has surfaced after a record period of growth. Many investors have lost confidence in paper stocks and are now seeking a flight to quality. Traditionally during these periods commodities such as gold and silver are seen as a popular investment, as company stocks can lose their total value whilst commodities retain their intrinsic value. Commodity prices have followed this pattern with precious metals and oil all reaching record highs in 2008. General commodities have sharply fallen in price since the economic downturn except the precious metals which are still trading close to their record highs.
The emergence of both China and India's growing economies has played a particularly significant role. Firstly they were partly responsible for keeping commodity prices on highs due to the perception of continuing growth, but also it is generally the eastern investor who values intrinsic worth and many private individuals hold large hard asset portfolios.
Perhaps the most significant consequence of this new economic climate is that real money has become scarce and interest on borrowed money has risen as a consequence. Therefore, industries reliant on credit, including the common practice of dealing goods on memo within the polished diamond industry, has been negatively affected and new investment and credit streams are needed to fill the inevitable void caused by this economic upheaval.
The credit crunch has affected all areas of the world in an increasingly globalised economy. As a result, risk management has come to the fore more than ever and investors are increasingly seeking de-correlated assets to reduce overall portfolio risk. Asset allocation strategies for 2009 exhibit far greater degree of diversification and in particular a shift away from paper securities to hard assets and commodities that will always retain some intrinsic worth.
Why diamonds are a hard asset class and how they compare to gold?
The traditional hard asset classes are gold, silver and other precious metals. Diamonds too are a hard asset class, but one which has only partially been realised. Diamonds exhibit a number of similarities to gold as an asset class. The primary use for both gold and diamonds is for jewellery. Demand for gold as jewellery absorbs around 75% of the gold supplied to the market each year. Industrial applications of gold account for approximately 10% and the balance is made up by investment. Currently diamonds are seen as a luxury item primarily for jewellery and the percentage of investment is relatively small, but the fundamentals point to an increasing opportunity for this to rise significantly.
The major significant use of gold today is for investment, that is, as a currency or a store of value. This includes jewellery and the fundamental purpose of gold jewellery is to store something valuable in your personal safekeeping. Gold has some non-investment industrial uses, such as in electronics, but the amount of gold used in these ways is relatively small. With all its practical uselessness gold has one serious utility: reliable rarity. And that is what ordinary savers look for when they want to store future purchasing power. Gold provides a tangible asset to hold in uncertain economic environments. It is effectively a currency which acts as a safe haven and is often used as a portfolio diversifier. With a falling dollar, a falling economy, or high unemployment gold can offer investors security and a hedge against inflation. It is also a useful barometer to measure the global economy. These are just some of the reasons people invest in gold and they are not likely to change.
Due to the current global economy being in the midst of a deep recession investing in hard assets offers a measure of support for investment portfolios. A weak US dollar produces a strong gold price which has been proven over the years. This has not yet been realised for diamonds.
There will always be a demand for gold. There always has been. Similarly, diamonds have a continued demand and many of the fundamental benefits gold offers as an investment can be applied to diamonds. Diamonds are the most concentrated store of value that exists. They are tangible, portable and liquid investments. Investors can use diamonds without decreasing their value and they pay no property tax on their investment.
Additionally, today’s global currencies are known as ‘fiat’ currencies by investors, which means they do not represent anything tangible but are only worth something due to government decree (namely legal tender laws). As Voltaire famously said in 1729, “Paper money eventually returns to its intrinsic value - ZERO”. The value of gold and diamonds, on the other hand, is independent of any government laws. Unlike fiat currencies, gold and diamonds are accepted as valuable without needing protection by laws.
Both are extremely rare mined natural resources, with diamonds in fact being significantly rarer than gold. Both are also US $ denominated assets (over 60% of gold holdings are still in US$) and diamonds are already used as a currency hedge in a similar manner to gold by HNWI’s in Russia and India. Diamond prices have in fact steadily appreciated over the last 25 years, but despite this price increase diamonds now look historically cheap against most other asset classes.
Supply and Demand
Whilst there has been a clear fall in diamond prices over the last two quarters, there is a well documented expected supply deficit in the medium to long term future. The demand / supply equation looks increasingly favourable from an investment perspective in the future.
Supply levels are globally expected to fall in 2009 as mining companies react to the impact of the credit crisis freezing elements of the supply chain, coupled with the price correction seen at the end of 2008 and beginning of 2009. De Beers and Alrosa have already stated their intentions to reduce production and restructure their businesses.
A global lack of exploration discoveries means that the medium term supply has little capacity to increase beyond 2008 levels in the near future. There is a long lead time - averaging 8 years - for mine development, and this absence of major new discoveries leads to a structural supply constraint across the industry which is displayed with ageing mines, a move to underground mining, increasing costs and the lack of new large scale mining developments. Furthermore, there are significant barriers to entry for potential new entrants to the diamond mining industry with huge exploration costs and the long lead time for new mines.
There is a proven continuous and steady historical growth rate in demand for polished diamonds, even in economic downturns. The US retail market still accounts for over half of all polished diamond consumption, with Japan the second largest followed by Europe.
Recent years have seen emerging market demand for diamonds, primarily from the BRIC countries and the Middle East, grow significantly. Emerging market demand is forecast to continue to grow over thye next decade driving the supply deficit further.
Price Performance
Polished prices are currently trading around levels seen in 2004/5. Historical price performance of polished diamonds since 1982 is strong relative to gold, yet in the last 10 years it has lagged behind gold and other commodities.
With supply cut by the major mining companies some level of price support is filtering through to the polished market as inventories are run down and demand stabilises. Coupled with increasing investment demand and also demand growth from China prices stabilised in mid April and have shown marginal increases in some categories.
